**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM10-Q**

 

**(MARKONE)**

**ý****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004**

 

**OR**

 

**o****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE TRANSITION PERIOD FROM**        **TO**        

 

**COMMISSION FILE NUMBER: 001-32274**

 

**ARCHIPELAGOHOLDINGS, INC.**

(Exactname of Registrant as specified in its charter)

 
| **DELAWARE**                                                      | ** ** | **36-4298373**                            |
|-------------------------------------------------------------------|------------|-------------------------------------------|
| (State  or other jurisdiction of  incorporation or  organization) |       | (I.R.S.  Employer  Identification Number) |

 

**100 South Wacker Drive, Suite 1800**

**Chicago, IL 60606**

**(312)960-1696**

(Address,including zip code, and

telephonenumber including area code, of

Registrant’sprincipal executive offices)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12B-2of the Exchange Act).  Yes o No ý

 

As of November 2, 2004, theRegistrant had approximately 47,135,000 shares of common stock, $0.01 par valueper share, outstanding.

 

 

----

 

ARCHIPELAGOHOLDINGS, INC.

QUARTERLYREPORT ON FORM 10-Q

TABLEOF CONTENTS

 
|                                                                                                                                     |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                     |   |
| PART I – Financial Information                                                                                                      |   |
| Item 1. Financial Statements                                                                                                             |   |
| Condensed  Consolidated Statements of Financial Condition as of September 30, 2004  (unaudited) and December 31, 2003          |   |
| Condensed  Consolidated Statements of Operations for the Three and Nine Months Ended  September 30, 2003 and 2004 (unaudited)       |   |
| Condensed  Consolidated Statement of Changes in Stockholders’ Equity for the Nine Months  Ended September 30, 2004 (unaudited) |   |
| Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended  September 30, 2003 and 2004 (unaudited)                 |   |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                        |   |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                      |   |
| Item 3.  Quantitative and Qualitative Disclosure about Market Risk                                                                       |   |
| Item 4. Controls  and Procedures                                                                                                         |   |
| PART II – Other Information                                                                                                         |   |
| Item 1. Legal Proceedings                                                                                                                |   |
| Item 2. Unregistered Sale of  Equity Securities and Use of Proceeds                                                                      |   |
| Item 6. Exhibits and Reports on  Form 8-K                                                                                                |   |
| Signatures                                                                                                                               |   |

 

2

----

 

**FORWARD-LOOKINGSTATEMENTS**

 

In addition to historical information, thisQuarterly Report on Form 10-Q contains forward-looking statements. Thesestatements relate to future events or our future financial performance, andinvolve known and unknown risks, uncertainties and other factors that may causeour actual results, levels of activity, performance or achievements to bematerially different from any future results, levels of activity, performanceor achievements, expressed or implied, by these forward-looking statements. Insome cases, you can identify forward-looking statements by terminology such as “may,”“will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,”“predicts,” “potential,” “continue” or the negative of these terms or othercomparable terminology. These statements are only predictions. Actual events orresults may differ materially and we undertake no ongoing obligation, otherthan that imposed by law, to update these statements.

 

Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, levels of activity,performance or achievements. Theseforward-looking statements are subject to numerous risks and uncertainties,including, but not limited to, general economic conditions, our futureoperating results, market penetration and financial condition, industry tradingactivity and fluctuations, regulatory changes and competition, as well as the risks and uncertainties described in the“Risk Factors” section of our final Prospectus filed with the Securitiesand Exchange Commission on August 12, 2004 and the factors discussed below under “Management’s Discussion and Analysis.” Youare urged to carefully consider these factors. All forward-looking statementsattributable to us are expressly qualified in their entirety by the foregoingcautionary statements.

 

3

----

** **

**PART I****– Financial Information**

 

**Item 1****.Financial Statements**

 

ArchipelagoHoldings, Inc.

CondensedConsolidated Statements of Financial Condition

(Inthousands, except per share data)

 
| ** **                                                                                               | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                                                                               | ** ** | ** **             | ** ** | **(unaudited)**         | ** ** |
| **Assets**                                                                                               |       |                   |       |                    |       |
| Current assets:                                                                                          |       |                   |       |                    |       |
| Cash and cash  equivalents                                                                               |       | $                      | 111,815    |                    | $          | 172,856 |   |
| Receivables from  brokers, dealers and customers, net                                                    |       | 38,666                 |       | 27,294                  |       |
| Receivables from  related parties                                                                        |       | 38,548                 |       | 42,843                  |       |
| Total current  assets                                                                                    |       | 189,029                |       | 242,993                 |       |
|                                                                                                     |       |                   |       |                    |       |
| Fixed assets,  net                                                                                       |       | 49,753                 |       | 49,176                  |       |
| Goodwill                                                                                                 |       | 129,666                |       | 131,865                 |       |
| Intangible asset  - Pacific Exchange facility agreement                                                  |       | 90,000                 |       | 90,000                  |       |
| Other intangible  assets, net                                                                            |       | 3,796                  |       | 2,576                   |       |
| Deferred tax  asset, net                                                                                 |       | —                 |       | 3,280                   |       |
| Other assets                                                                                             |       | 3,648                  |       | 9,856                   |       |
| Total assets                                                                                             |       | $                      | 465,892    |                    | $          | 529,746 |   |
|                                                                                                     |       |                   |       |                    |       |
| **Liabilities  and Stockholders’ Equity**                                                           |       |                   |       |                    |       |
| Current  liabilities:                                                                                    |       |                   |       |                    |       |
| Accounts payable  and accrued expenses                                                                   |       | $                      | 22,917     |                    | $          | 39,433 |   |
| Payables to  brokers, dealers and exchanges                                                              |       | 17,542                 |       | 15,039                  |       |
| Payables to  related parties                                                                             |       | 63,913                 |       | 24,955                  |       |
| Current portion  of note payable and capital lease obligations                                           |       | 4,089                  |       | 2,043                   |       |
| Total current  liabilities                                                                               |       | 108,461                |       | 81,470                  |       |
|                                                                                                     |       |                   |       |                    |       |
| Note payable                                                                                             |       | 2,593                  |       | —                  |       |
| Capital lease  obligations                                                                               |       | 1,545                  |       | —                  |       |
| Total liabilities                                                                                        |       | 112,599                |       | 81,470                  |       |
|                                                                                                     |       |                   |       |                    |       |
| Redeemable  convertible preferred shares                                                                 |       | 50,000                 |       | —                  |       |
|                                                                                                     |       |                   |       |                    |       |
| Commitments and  contingencies                                                                           |       |                   |       |                    |       |
|                                                                                                     |       |                   |       |                    |       |
| Stockholders’  equity                                                                               |       |                   |       |                    |       |
| Members’ equity                                                                                     |       | 303,293                |       | —                  |       |
| Common stock,  $.01 par value, 165,000 shares authorized; zero and 47,135 shares issued and  outstanding |       | —                 |       | 471                     |       |
| Additional  paid-in capital                                                                              |       | —                 |       | 451,591                 |       |
| Unearned  stock-based compensation                                                                       |       | —                 |       | (57                     | )          |
| Accumulated  deficit                                                                                     |       | —                 |       | (3,729                  | )          |
| Total  stockholders’ equity                                                                         |       | 303,293                |       | 448,276                 |       |
| Total liabilities  and stockholders’ equity                                                         |       | $                      | 465,892    |                    | $          | 529,746 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

4

----

 

ArchipelagoHoldings, Inc.

CondensedConsolidated Statements of Operations

(Inthousands, except per share data)

(unaudited)

 
| ** **                                                                                                       | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Revenues**                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Transaction fees  ($45,767, $45,546, $126,194 and $147,823 with related parties)                                 |       | $                                     | 116,015    |                                 | $          | 112,738 |   | $ | 307,253 |   | $ | 363,816 |   |
| Market data fees  ($3,611, $6,595, $7,005 and $15,992 with related parties)                                      |       | 10,852                                |       | 14,285                               |       | 19,318 |   | 38,457 |   |
| Listing fees                                                                                                     |       | 24                                    |       | 118                                  |       | 407 |   | 324 |   |
| Total revenues                                                                                                   |       | 126,891                               |       | 127,141                              |       | 326,978 |   | 402,597 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| **Cost  of revenues**                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Liquidity  payments ($11,689, $12,880, $34,101 and $42,209 with related parties)                                 |       | 42,765                                |       | 47,504                               |       | 104,204 |   | 148,959 |   |
| Routing charges  ($14,077, $10,934, $43,606 and $36,649 with related parties)                                    |       | 28,716                                |       | 20,289                               |       | 90,486 |   | 68,801 |   |
| Clearance,  brokerage and other transaction expenses ($8,131, $3,434, $33,439 and $14,033  with related parties) |       | 16,008                                |       | 8,888                                |       | 52,948 |   | 32,313 |   |
| Total cost of  revenues                                                                                          |       | 87,489                                |       | 76,681                               |       | 247,638 |   | 250,073 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| **Gross  margin**                                                                                                |       | 39,402                                |       | 50,460                               |       | 79,340 |   | 152,524 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| **Indirect  expenses**                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Employee  compensation and benefits                                                                              |       | 9,972                                 |       | 10,589                               |       | 29,205 |   | 31,753 |   |
| Depreciation and  amortization                                                                                   |       | 9,966                                 |       | 4,976                                |       | 19,509 |   | 21,228 |   |
| Communications  ($832, $1,322, $2,510 and $3,400 with related parties)                                           |       | 4,911                                 |       | 5,058                                |       | 16,470 |   | 14,218 |   |
| Marketing and  promotion ($151, $116, $478 and $357 with related parties)                                        |       | 2,391                                 |       | 7,825                                |       | 5,521 |   | 12,307 |   |
| Legal and  professional ($250, $525, $750 and $1,163 with related parties)                                       |       | 1,449                                 |       | 2,736                                |       | 6,882 |   | 8,612 |   |
| Occupancy                                                                                                        |       | 1,023                                 |       | 1,211                                |       | 3,130 |   | 3,197 |   |
| General and  administrative                                                                                      |       | 3,466                                 |       | 3,215                                |       | 9,645 |   | 7,771 |   |
| Total indirect  expenses                                                                                         |       | 33,178                                |       | 35,610                               |       | 90,362 |   | 99,086 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Operating income  (loss)                                                                                         |       | 6,224                                 |       | 14,850                               |       | (11,022 | ) | 53,438 |   |
| Interest and  other, net                                                                                         |       | 269                                   |       | 950                                  |       | 388 |   | 1,662 |   |
| Income (loss)  before income tax benefit                                                                         |       | 6,493                                 |       | 15,800                               |       | (10,634 | ) | 55,100 |   |
| Income tax  benefit                                                                                              |       | —                                |       | (1,315                               | )          | — |   | (1,315 | ) |
| **Net  income (loss)**                                                                                           |       | 6,493                                 |       | 17,115                               |       | (10,634 | ) | 56,415 |   |
| Deemed dividend  on convertible preferred shares                                                                 |       | —                                |       | (9,619                               | )          | — |   | (9,619 | ) |
| **Net  income (loss) attributable to common stockholders**                                                       |       | $                                     | 6,493      |                                 | $          | 7,496 |   | $ | (10,634 | ) | $ | 46,796 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Basic earnings  (loss) per share (a)                                                                             |       | $                                     | 0.18       |                                 | $          | 0.18 |   | $ | (0.29 | ) | $ | 1.23 |   |
| Diluted earnings  (loss) per share (a)                                                                           |       | $                                     | 0.18       |                                 | $          | 0.17 |   | $ | (0.29 | ) | $ | 1.13 |   |
|                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Basic weighted  average shares outstanding (a)                                                                   |       | 36,169                                |       | 41,640                               |       | 36,169 |   | 38,006 |   |
| Diluted weighted  average shares outstanding (a)                                                                 |       | 36,188                                |       | 43,994                               |       | 36,169 |   | 41,360 |   |

 

----

(a)   Adjustedto reflect our reorganization from a Delaware limited liability company to aDelaware corporation on August 11, 2004. See Note 1 to condensed consolidatedfinancial statements.

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

5

----

 

ArchipelagoHoldings, Inc.

CondensedConsolidated Statement of Changes in Stockholders’ Equity

Ninemonths ended September 30, 2004

(Inthousands)

(unaudited)

 
| ** **                                                                                                              | ** ** | ** **        | ** ** | ** **        | ** ** | ** **     | ** ** | **Additional**  | ** ** | **Unearned**     | ** ** | ** **             | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|----------------|------------|-----------------|------------|------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                              | ** ** | **Members’** | ** ** | **Common  Stock** | ** ** | **Paid-In**    | ** ** | **Stock-Based** | ** ** | **Accumulated**  | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                              | ** ** | **Equity**        | ** ** | **Shares**        | ** ** | **Par  Value** | ** ** | **Capital**     | ** ** | **Compensation** | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| Balance, January  1, 2004                                                                                               |       | $                 | 303,293    |              | —     |           | $          | —          |       | $                | —     |                   | $          | —     |       | $ | — |   | $ | 303,293 |   |
| Amortization of  stock-based compensation for the period from January 1 to August 11, 2004                              |       |              |       |              |       |           |       |            |       | 94               |       |                   |       | 94         |       |
| Members’  distribution                                                                                             |       | (24,613           | )          |              |       |           |       |            |       |             |       |                   |       | (24,613    | )          |
| Net income for  the period from January 1 to August 11, 2004                                                            |       | 50,525            |       |              |       |           |       |            |       |             |       |                   |       | 50,525     |       |
| Reorganization  from LLC to “C” Corporation                                                                   |       | (329,205          | )          | 36,169            |       | 362            |       | 329,013         |       | (170             | )          |                   |       | —     |       |
| Conversion of  redeemable convertible preferred shares to common                                                        |       |              |       | 3,732             |       | 37             |       | 49,963          |       |             |       |                   |       | 50,000     |       |
| Issuance of  common stock in initial public offering, net of underwriting discounts                                     |       |              |       | 6,325             |       | 63             |       | 67,583          |       |             |       |                   |       | 67,646     |       |
| Direct costs of  initial public offering                                                                                |       |              |       |              |       |           |       | (6,777          | )          |             |       |                   |       | (6,777     | )          |
| Issuance of  additional common stock to former REDIBook members                                                         |       |              |       | 192               |       | 2              |       | 2,197           |       |             |       |                   |       | 2,199      |       |
| Issuance of  additional common stock to GAP Archa Holdings and related deemed dividend on  convertible preferred shares |       |              |       | 717               |       | 7              |       | 9,612           |       |             |       | (9,619                 | )          | —     |       |
| Amortization of  stock-based compensation from the period from August 12 to September 30, 2004                          |       |              |       |              |       |           |       |            |       | 19               |       |                   |       | 19         |       |
| Net income for  the period from August 12 to September 30, 2004                                                         |       |              |       |              |       |           |       |            |       |             |       | 5,890                  |       | 5,890      |       |
| Balance,  September 30, 2004                                                                                            |       | $                 | —     |              | 47,135     |           | $          | 471             |       | $                | 451,591    |                   | $          | (57        | )          | $ | (3,729 | ) | $ | 448,276 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

6

----

 

ArchipelagoHoldings, Inc.

CondensedConsolidated Statements of Cash Flows

(Inthousands)

(unaudited)

 
| ** **                                                                                           | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                           | ** ** | **2003**                             | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities**                                                            |       |                                 |       |   |   |
| Net income  (loss)                                                                                   |       | $                                    | (10,634    | ) | $ | 56,415 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                 |       |   |   |
| Depreciation and  amortization                                                                       |       | 18,831                               |       | 20,007 |   |
| Amortization of  other intangible assets                                                             |       | 678                                  |       | 1,221 |   |
| Provision for  doubtful accounts                                                                     |       | 6,583                                |       | (500 | ) |
| Deferred taxes                                                                                       |       | —                               |       | (3,280 | ) |
| Stock-based  compensation                                                                            |       | 182                                  |       | 114 |   |
| Gain on sale of  investment owned                                                                    |       | (40                                  | )          | — |   |
| Changes in  operating assets and liabilities:                                                        |       |                                 |       |   |   |
| Accounts  receivable                                                                                 |       | (47,813                              | )          | 7,577 |   |
| Other assets                                                                                         |       | 438                                  |       | (6,209 | ) |
| Accounts payable  and accrued expenses                                                               |       | 14,316                               |       | (24,944 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | (17,459                              | )          | 50,401 |   |
|                                                                                                 |       |                                 |       |   |   |
| **Cash  flows from investing activities**                                                            |       |                                 |       |   |   |
| Additions to  fixed assets                                                                           |       | (15,906                              | )          | (19,431 | ) |
| Proceeds from  sale of investment                                                                    |       | 2,010                                |       | — |   |
| Net cash used in  investing activities                                                               |       | (13,896                              | )          | (19,431 | ) |
|                                                                                                 |       |                                 |       |   |   |
| **Cash  flows from financing activities**                                                            |       |                                 |       |   |   |
| Proceeds from  initial public offering, net of underwriting discounts                                |       | —                               |       | 67,646 |   |
| Direct costs of  initial public offering                                                             |       | —                               |       | (6,777 | ) |
| Cash  distribution to former Members                                                                 |       | —                               |       | (24,613 | ) |
| Proceeds from  issuance of note payable                                                              |       | 5,681                                |       | — |   |
| Repayments of  note payable                                                                          |       | (823                                 | )          | (4,429 | ) |
| Principal  payments under capital lease obligations                                                  |       | —                               |       | (1,756 | ) |
| Net cash  provided by financing activities                                                           |       | 4,858                                |       | 30,071 |   |
|                                                                                                 |       |                                 |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                |       | (26,497                              | )          | 61,041 |   |
| Cash and cash  equivalents at beginning of period                                                    |       | 48,964                               |       | 111,815 |   |
| Cash and cash  equivalents at end of period                                                          |       | $                                    | 22,467     |   | $ | 172,856 |   |
|                                                                                                 |       |                                 |       |   |   |
| **Supplemental  disclosures of cash flow information**                                               |       |                                 |       |   |   |
| Cash paid for:                                                                                       |       |                                 |       |   |   |
| Interest                                                                                             |       | 144                                  |       | 266 |   |
| Income taxes                                                                                         |       | —                               |       | 1,859 |   |
|                                                                                                 |       |                                 |       |   |   |
| **Non-cash  investing and financing activities**                                                     |       |                                 |       |   |   |
| Conversion of  convertible preferred shares to common                                                |       | —                               |       | 50,000 |   |
| Issuance of  common stock to former REDIBook Members                                                 |       | —                               |       | 2,199 |   |
| Issuance of  common stock to GAP Archa Holdings                                                      |       | —                               |       | 9,619 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

7

----

 

ArchipelagoHoldings, Inc.

Notesto Condensed Consolidated Financial Statements (unaudited)

 

**1.****    ****Organization and Basis ofPresentation**

 

**Organization**

 

Archipelago Holdings, Inc.operates the Archipelago Exchange, or ArcaEx® (“ArcaEx”), the first openall-electronic stock market in the United States for trading in all NYSE, Nasdaq,AMEX and Pacific Exchange-listed stocks. Archipelago Holdings, L.L.C. (“HoldingsLLC”), a Delaware limited liability company and the predecessor to the Company,was organized in January 1999.  InJuly 2000, Holdings LLC entered into a facility services agreement withthe Pacific Exchange, Inc. (“PCX”) which allowed it to establish andoperate ArcaEx. The Securities and Exchange Commission’s (“SEC”) approval ofArcaEx was announced in October 2001 and ArcaEx began trading operationsfor listed securities in March 2002 and for over- the-counter securities (“OTC”)in April 2003.  On August 11, 2004,Holdings LLC converted to a Delaware corporation, Archipelago Holdings, Inc.  We refer to Archipelago Holdings, Inc. and,prior to its conversion to a Delaware corporation, Holdings LLC, as the“Company”.  On August 19, 2004, theCompany completed an initial public offering (“IPO”) of its common stock. Seebelow discussion of the “Conversion Transaction” and the “Initial PublicOffering”.  Through certain subsidiaries,the Company also provides broker execution services to institutions for ordersinvolving Nasdaq and listed securities, as well as introducing broker servicesfor ArcaEx to broker-dealers that do not hold an exchange trading permit("ETP").

 

**ConversionTransaction**

 

On August 11, 2004, prior tothe consummation of the IPO, Holdings LLC converted from a Delaware limitedliability company to a Delaware corporation, Archipelago Holdings, Inc. As alimited liability company, all income taxes were paid by the members ofHoldings LLC. As a corporation, the Company is responsible for the payment ofall federal and state corporate income taxes. See Note 7.

 

As a result of thereorganization of Holdings LLC from a Delaware limited liability company into aDelaware corporation, the members of Holdings LLC received 0.222222 shares ofcommon stock of the Company for each membership interests held by such memberin Holdings LLC, which corresponds to a 4.5-for-1 reverse stock split. Theweighted average number of shares used in the basic and diluted earnings pershare computations gives retroactive effect to the 4.5-for-1 reverse stocksplit.

 

As approved by the Company’sboard of managers on July 16, 2004, the Company made a $24.6 million cashdistribution to the members of Holdings LLC immediately prior to the conversiontransaction. The cash distribution permits the members to pay the taxes thatthe members will owe for their share of the Company’s profits in 2004 as alimited liability company through the date of the conversion transaction,calculated primarily based on the highest federal and state income tax rateapplicable for the tax withholding purposes to an individual.

 

**InitialPublic Offering**

 

On August 19, 2004, theCompany completed the IPO of its common stock as a result of which the Companysold 6,325,000 shares of common stock at $11.50 per share.  The Company received net proceeds of $67.6million and incurred approximately $6.8 million in expenses in connection withthe IPO. In addition, 6,325,000 shares of common stock were sold in the IPO bycertain selling stockholders of the Company, for which the Company received noproceeds.  The Company’s stock is listedon the Pacific Stock Exchange under the symbol “AX”.  A summary of the terms of the IPO can befound in the Company’s Registration

 

8

----

 

Statement on Form S-1 (File No. 333-113226)(the “Registration Statement”), which was declared effective by the SEC onAugust 12, 2004.

 

**Basis ofPresentation**

 

The accompanying condensedconsolidated financial statements include the accounts of the Company and itswholly-owned subsidiaries, which principally include: Wave Securities, L.L.C. (formerly,Archipelago, L.L.C.), Archipelago Exchange, L.L.C. (“ArcaExchange”), ArchipelagoSecurities, L.L.C. (“ARCAS”), ARCA-GNC Acquisition, L.L.C. (“GNC”), ArchipelagoTrading Services, Inc. (“ATSI”), Archipelago Europe Limited (“AEL”), WaveSecurities Canada Inc., Archipelago Direct, L.L.C. (formerly, ArchipelagoTP Investment, L.L.C.), Archipelago Brokerage Services, L.L.C. (formerly,Archipelago Services, L.L.C.), Archipelago Market Data Services, L.L.C. andArchipelago Overseas, L.L.C.

 

The accompanying condensed consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America. In the opinion ofmanagement, all adjustments considered necessary for a fair presentation havebeen included. All material intercompany accounts and transactions have beeneliminated in consolidation. Certain information and footnote disclosuresnormally included in financial statements have been condensed or omitted;however, management believes that the disclosures are adequate to make theinformation presented not misleading.

 

The preparation of condensedconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets and liabilitiesand disclosure of contingent assets and liabilities as of the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Management believes that the estimates utilized inpreparing its financial statements are reasonable and prudent. Actual resultscould differ from these estimates.

 

The condensed consolidated financialstatements are unaudited and should be read in conjunction with the Company’s auditedfinancial statements as of and for the year ended December 31, 2003,included in the Company’s Registration Statement. Operating results for thethree and nine months ended September 30, 2004 are not necessarilyindicative of the results that may be expected for the year endingDecember 31, 2004.

 

**2.****    ****Fixed Assets**

 

Fixed assets consisted ofthe following:

 
| ** **                                      | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **(In thousands)**     | ** ** |
| Software,  including software development costs |       | $                      | 35,047     |                    | $          | 42,377 |   |
| Computers and  equipment                        |       | 32,791                 |       | 40,519                  |       |
| Leasehold  improvements                         |       | 17,409                 |       | 18,536                  |       |
| Equipment under  capital leases                 |       | 18,070                 |       | 18,070                  |       |
| Routers                                         |       | 4,920                  |       | 5,330                   |       |
| Furniture and  fixtures                         |       | 1,895                  |       | 2,883                   |       |
|                                            |       | 110,132                |       | 127,715                 |       |
| Accumulated  depreciation and amortization      |       | (60,379                | )          | (78,539                 | )          |
|                                            |       | $                      | 49,753     |                    | $          | 49,176 |   |

 

9

----

 

In June 2003, the Company determined that certainsoftware and computer equipment would be retired by March 2004 and,therefore, the Company accelerated depreciation on these assets. During thefirst quarter of 2004, the Company recorded $6.2 million in depreciationon these assets as opposed to $2.3 million had the depreciation period notbeen accelerated. As of March 31, 2004, the net book value of these assetswas reduced to zero.

 

In May 2004, the Companyvacated one of the floors in its headquarters. As a result, the Company wroteoff fixed assets with a net book value of approximately $0.6 million inthe aggregate, which consisted primarily of leasehold improvements.

 

In accordance with theprovisions of Statement of Position 98-1,*Accounting for the Costs of Computer Software Developed or Obtained forInternal Use*, the Company capitalizes qualifying computer softwarecosts incurred during the application development stage. During the nine monthsended September 30, 2003 and 2004, software development costs totaling $5.5 millionand $2.0 million were capitalized, respectively.

 

**3.****    ****Goodwill and OtherIntangible Assets**

 

*Goodwill*

 

In March 2002, the Companyacquired REDIBook in a transaction accounted for as a purchase businesscombination. Approximately $20.8 million of the $150.5 millionpurchase price was assigned to the net tangible and intangible assets received,with the remaining value of $129.7 million ascribed to goodwill.  In August 2004, the Company issued contingentconsideration to former REDIBook members in the form of 192,194 shares of theCompany’s common stock valued at $11.50 per share and recorded $2.2 million ofadditional goodwill.

* *

*PCX Exchange Facility Agreement*

 

In May 2001, theCompany acquired the right to operate as the exclusive equity trading facilityof the PCX Equities, Inc. for an aggregate consideration of$90.0 million. The Company determined that this intangible asset had anindefinite life and, as such, it is not subject to amortization.

 

*Other Intangible Assets*

 

In October 2002, theCompany acquired Globenet Securities, Inc. and the net assets of itsparent, Globenet Capital Corporation in a transaction accounted for as an assetacquisition. The Company assigned $4.9 million to an intangible assetrelated to the technology acquired. This intangible asset is amortized overthree years from the implementation of the technology in May 2003. As ofSeptember 30, 2004, the net book value of this intangible asset was $2.6million.

 

10

----

 

**4.****    ****Related Party Transactions**

 

The following is a summaryof the related party transactions involving the Company and certain formermembers (*i.e.*, owners of HoldingsLLC prior to the IPO) and current stockholders (*i.e.,*stockholders of the Company after the IPO), PCX and other affiliates as part ofits operations:

 
| ** **                                                                                                                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                                      | ** ** | **(In thousands)**                    | ** ** |
| **Revenues**                                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Transaction fees  earned from stockholders/former members and affiliates(1)                                                     |       | $                                     | 45,767     |                                 | $          | 45,546 |   | $ | 126,194 |   | $ | 147,823 |   |
| Market data fees  received from PCX (net of amounts shared with customers of $3,456, $5,879,  $7,184 and $14,192)(2)            |       | 3,611                                 |       | 6,595                                |       | 7,005 |   | 15,992 |   |
| **Cost  of revenues**                                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Liquidity  payments to stockholders/former members and affiliates(1)                                                            |       | 11,689                                |       | 12,880                               |       | 34,101 |   | 42,209 |   |
| Routing charges:                                                                                                                |       |                                  |       |                                 |       |   |   |   |   |
| Routing fees  paid to stockholder/former member(4)                                                                              |       | 13,474                                |       | 10,404                               |       | 40,878 |   | 34,350 |   |
| Routing fees for  listed securities paid to stockholders/former members(5)                                                      |       | 603                                   |       | 530                                  |       | 2,728 |   | 2,299 |   |
| Clearance,  brokerage and other transaction expenses:                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| PCX’s cost of  obtaining market data(3)                                                                                    |       | 41                                    |       | —                               |       | 77 |   | — |   |
| Clearing services  provided by a stockholder/former member(6)                                                                   |       | 7,220                                 |       | 2,137                                |       | 26,106 |   | 9,374 |   |
| Clearing  services provided by an affiliated clearing broker(6)                                                                 |       | 782                                   |       | 646                                  |       | 2,183 |   | 2,698 |   |
| Management fees  paid to a stockholder/former member for support of REDIBook ECN(7)                                             |       | —                                |       | —                               |       | 4,502 |   | — |   |
| Regulatory  services fees paid to PCX(8)                                                                                        |       | 1,335                                 |       | 1,832                                |       | 4,112 |   | 5,337 |   |
| Registered  representative fees received from PCX(8)                                                                            |       | (1,247                                | )          | (1,181                               | )          | (3,541 | ) | (3,376 | ) |
| **Indirect  expenses**                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Communications:                                                                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Back office  services provided by an affiliate(10)                                                                              |       | 300                                   |       | 300                                  |       | 900 |   | 900 |   |
| Software related  services provided by an affiliate (net of amounts charged to customers of  $774, $559, $2,499 and $1,829)(11) |       | 532                                   |       | 1,022                                |       | 1,610 |   | 2,500 |   |
| Marketing and  promotion:                                                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Business  development costs(12)                                                                                                 |       | 151                                   |       | 116                                  |       | 478 |   | 357 |   |
| Legal and  professional:                                                                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Professional  fees for services provided by an affiliate(9)                                                                     |       | 250                                   |       | 525                                  |       | 750 |   | 1,163 |   |
|                                                                                                                                 |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

----

*(1)*          Certain stockholders/former members ofHoldings LLC and affiliates execute transactions through ArcaEx, and previouslythrough the Company’s ECN, and are charged a transaction service fee by theCompany for such activities. Liquidity payments are made to stockholders/formermembers of Holdings LLC and affiliates in relation to such transaction fees.

 

*(2)*          The Company participates in theconsolidation, dissemination and sale of market data in U.S. exchange-listedsecurities and Nasdaq-listed securities through ArcaEx. In connection withthat, the Company receives market data fees, based on the level of tradingactivity on ArcaEx, for providing data to centralized aggregators that in turnsell the data to third-party consumers. PCX is a direct participant in theplans governing the consolidation and dissemination of market data and as adirect participant in these plans collects tape revenues for trading activitieson ArcaEx. Under the terms of the facility services agreement, the Company isentitled to all tape revenues earned in connection with trading activities onArcaEx.

 

*(3)*          In connection with its operation of anoptions’ trading floor, PCX is a consumer of consolidated market data collectedand sold under the plans discussed in the previous footnote. BetweenApril 2002 and December 2003, the Company agreed to cover PCX’s costof obtaining consolidated market data by reducing the amount of market datafees to which the Company was entitled under the facility services agreement bythe amount of PCX’s cost for obtaining consolidated market data for use in connectionwith its options trading floor.

 

11

----

 

*(4)*          A stockholder/former member of Holdings LLC receivesrouting fees for trades executed through ArcaEx, and previously through theCompany’s ECN, that ultimately route through to the stockholder/former member’sECN.

 

*(5)*          Certain stockholders/former members ofHoldings LLC provide routing services for listed securities through the NewYork Stock Exchange, Inc. on behalf of the Company.

 

*(6)*          The Company clears its transactions forinstitutional customers through an affiliated clearing broker and transactionsfor non-institutional customers through a stockholder/former member of HoldingsLLC/clearing broker.

 

*(7)*          In 2002, the Company entered into a servicingagreement with a stockholder/former member of Holdings LLC/clearing broker forthem to provide for the development, operation, management and support of theREDIBook ECN until trading in ArcaEx commenced, for which the Company paid amonthly fee.

 

*(8*)           Under the terms of the facility servicesagreement, PCX provides certain regulatory services to the Company in returnfor regular payments as negotiated between the parties. Also, PCX forwardsregistered representative fees received from the NASD to the Company.

 

*(9)*          An affiliate provides software related services to the Company.

 

*(10)*        An affiliate provides back-office services toWave. The services include offering and managing connectivity to alternativeexecution venues, clearing technology, as well as reporting to the NASD’s OrderAudit Trail Systems through which NASD members are required to reportinformation regarding Nasdaq transactions.

 

*(11)*        An affiliate provides software relatedservices to the Company, a portion of which is charged to the Company’s customers.

 

*(12)*        The Company paid rental fees for the yachtthat it leases for certain business development functions, which is operated bythe domestic partner of a sister of a member of management.

 

An affiliate providedsoftware development services to the Company in the amount of $1.0 millionand zero for the three months ended September 30, 2003 and 2004, and $3.0 millionand $1.5 million for the nine months ended September 30, 2003 and 2004,respectively.

 

Effective June 1, 2004,the Company entered into a consulting agreement with a consulting firm and itsprincipal, in their separate capacities. The principal serves as a director of theCompany. This consulting agreement provides for a minimum fee of $150,000 perquarter and a minimum term of one year. For the three and nine months ended September 30,2004, the Company paid $150,000 and $200,000, respectively, under thisagreement.

 

In October 2003,ArcaExchange entered into a $20.0 million credit facility with a stockholder/formermember of Holdings LLC, pursuant to which trade receivables were pledged ascollateral. No amounts have been drawn under the credit facility and the full$20.0 million was available for borrowing at September 30, 2004.

 

As of September 30,2004, cash and cash equivalents held at affiliated financial institutionsamounted to $4.3 million.

 

12

----

 

In connection with the IPO, theCompany paid commission, consisting primarily of underwriting discounts, tocertain stockholders/former members of Holdings LLC totaling approximately $4.4million.

 

In the opinion ofmanagement, transactions were made at prevailing rates, terms and conditionsand do not involve more than the normal risk of collectibility or present otherunfavorable features.

 

**5.****    ****Stock-Based Compensation**

 

The Company accounts forstock option grants to employees in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” and,accordingly, recognizes compensation expense using the Intrinsic Value Method.Under the Intrinsic Value Method, compensation cost for stock options, if any,is measured as the excess of the estimated fair value of the Company’s stockover the option exercise price.

 

The Company adopted thedisclosure provisions of the Statements of Financial Accounting Standards (“SFAS”)No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure.”  Had compensation expense for the Company’sstock option plans been determined based upon fair value consistent with SFASNo. 123, the Company’s net income and earnings per share would have beenchanged to the following pro forma amounts (in thousands, except per sharedata):

 
| ** **                                                                                                                                                             | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                                             | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Net income  (loss) attributable to common stockholders, as reported                                                                                                    |       | $                                     | 6,493      |                                 | $          | 7,496 |   | $ | (10,634 | ) | $ | 46,796 |   |
| Add: Stock-based  employee compensation cost included in net income                                                                                                    |       | 182                                   |       | 38                                   |       | 182 |   | 114 |   |
| Deduct:  Stock-based employee compensation cost determined under the fair value based  method for all awards, net of related tax effects of $445, $240, $691 and  $509 |       | 668                                   |       | 339                                  |       | 1,036 |   | 717 |   |
| Net income  (loss) attributable to common stockholders, pro forma                                                                                                      |       | $                                     | 6,007      |                                 | $          | 7,195 |   | $ | (11,488 | ) | $ | 46,193 |   |
|                                                                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Earnings per  share:                                                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Basic, as  reported                                                                                                                                                    |       | $                                     | 0.18       |                                 | $          | 0.18 |   | $ | (0.29 | ) | $ | 1.23 |   |
| Basic, pro forma                                                                                                                                                       |       | $                                     | 0.17       |                                 | $          | 0.17 |   | $ | (0.32 | ) | $ | 1.22 |   |
| Diluted, as  reported                                                                                                                                                  |       | $                                     | 0.18       |                                 | $          | 0.17 |   | $ | (0.29 | ) | $ | 1.13 |   |
| Diluted, pro  forma                                                                                                                                                    |       | $                                     | 0.17       |                                 | $          | 0.16 |   | $ | (0.32 | ) | $ | 1.12 |   |

 

The fair value of eachoption grant was estimated on the date of grant using the Black-Scholes optionpricing model with the following assumptions:

 
| ** **                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Dividend yield            |       | —                                |       | —                               |       | — |   | — |   |
| Expected  volatility      |       | 30.0                                  | %          | 30.0                                 | %          | 30.0 | % | 30.0 | % |
| Risk-free  interest rate  |       | 3.8                                   | %          | 4.0                                  | %          | 3.8 | % | 4.0 | % |
| Expected life  (in years) |       | 7                                     |       | 7                                    |       | 7 |   | 7 |   |

 

TheBlack-Scholes option pricing model was developed for use in estimating thevalue of traded options that have no vesting restrictions and are fullytransferable.  In addition, optionpricing models require the input of highly subjective assumptions.  Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions

 

13

----

 

can materially affect the estimate, in management’sopinion, the existing valuation models do not provide a reliable measure of thefair value of the Company’s employee stock options.

 

Theabove pro forma information gives effect to the Company’s conversion into aDelaware corporation as if it occurred at the beginning of the periodspresented.  In addition, the pro formainformation was tax effected at combined Federal and State rates of 40.0% and41.5% for the three and nine-month periods ended September 30, 2003 and 2004,respectively.

 

**6.****    ****Computation of Earnings PerShare**

 

The following is areconciliation of the basic and diluted earnings per share computations:

 
| ** **                                                                               | ** ** | **Three months ended  September 30,**     | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                               | ** ** | **2003**                                  | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                               | ** ** | **(In thousands, except per share data)** | ** ** |
| Net income  attributable to common stockholders for basic and diluted earnings per share |       | $                                         | 6,493      |                                 | $          | 7,496 |   | $ | (10,634 | ) | $ | 46,796 |   |
| Shares of common  stock and common stock equivalents:                                    |       |                                      |       |                                 |       |   |   |   |   |
| Weighted average  shares used in basic computation                                       |       | 36,169                                    |       | 41,640                               |       | 36,169 |   | 38,006 |   |
| Dilutive effect  of:                                                                     |       |                                      |       |                                 |       |   |   |   |   |
| Preferred shared  converted to common in August 2004                                     |       | —                                    |       | 1,704                                |       | — |   | 3,051 |   |
| Additional  shares of common stock issued at IPO                                         |       | —                                    |       | 475                                  |       | — |   | 160 |   |
| Stock options  and other                                                                 |       | 19                                        |       | 175                                  |       | — |   | 143 |   |
|                                                                                     |       |                                      |       |                                 |       |   |   |   |   |
| Weighted average  shares used in diluted computation                                     |       | 36,188                                    |       | 43,994                               |       | 36,169 |   | 41,360 |   |
|                                                                                     |       |                                      |       |                                 |       |   |   |   |   |
| Basic earnings  (loss) per share                                                         |       | $                                         | 0.18       |                                 | $          | 0.18 |   | $ | (0.29 | ) | $ | 1.23 |   |
|                                                                                     |       |                                      |       |                                 |       |   |   |   |   |
| Diluted earnings  (loss) per share                                                       |       | $                                         | 0.18       |                                 | $          | 0.17 |   | $ | (0.29 | ) | $ | 1.13 |   |

 

At September 30, 2004 and2003, approximately 1.4 million and 0.6 million securities, respectively, wereexcluded from the computation of diluted earnings per share because theireffect would have been antidilutive.

 

**7.****    ****Income Taxes**

 

Theincome tax benefit for the three and nine months ended September 30, 2004consisted of the following (in thousands):

 
| Current:            |   |   |   |
|---------------------|--------|--------|--------|
| Federal             |   | $      | 1,657  |   |
| State               |   | 308    |   |
| Total current       |   | 1,965  |   |
| Deferred            |   | (3,280 | )      |
| Income tax  benefit |   | $      | (1,315 | ) |

 

14

----

 

Significant components of the Company’s deferred tax assets andliabilities at September 30, 2004 were as follows (in thousands):

 
| Deferred tax  assets:                                                  |   |   |   |
|------------------------------------------------------------------------|--------|--------|--------|
| Bonuses                                                                |   | $      | 3,826  |   |
| Allowance for  doubtful accounts                                       |   | 1,587  |   |
| Net operating  loss carryforwards (“NOL”) of ATSI subsidiary |   | 1,560  |   |
| Valuation  allowance                                                   |   | (1,560 | )      |
| Other                                                                  |   | 177    |   |
| Total deferred  tax assets                                             |   | 5,590  |   |
|                                                                   |   |   |   |
| Deferred tax  liabilities:                                             |   |   |   |
| Depreciation  & amortization                                       |   | 2,248  |   |
| Other                                                                  |   | 62     |   |
| Total deferred  tax liabilities                                        |   | 2,310  |   |
|                                                                   |   |   |   |
| Deferred tax  asset, net                                               |   | $      | 3,280  |   |

 

Asof September 30, 2004, ATSI had approximately $3.9 million of net operatinglosses for Federal and State tax purposes, which will begin to expire in 2012.A full valuation allowance was recorded against the $1.6 million tax effect ofthese losses as it appears more likely than not that the corresponding assetwill not be realized due to certain tax limitations. There is no valuationallowance recorded against any of the remaining $5.6 million deferred taxassets based on management’s belief that it is more likely than not that suchassets will be realized. The Company does not have any deferred tax assetsrelated to Holdings LLC’s net operating losses, as those losses were incurredwhen the Company was treated as a partnership for federal income tax purposes.

 

Forthe quarter ended September 30, 2004, the effective tax rate varied from theU.S. Federal statutory income tax rate due to the following:

 
| Federal statutory rate            |   | 35.0  | %  |
|-----------------------------------|--------|-------|----|
| State, net of federal tax benefit |   | 6.5   | %  |
| Benefit from deferred taxes (1)   |   | (22.1 | )% |
| Former Members’ income (2)   |   | (29.5 | )% |
| Other                             |   | 1.8   | %  |
| Effective tax rate                |   | (8.3  | )% |

 

----

(1)           The Company recognized a $3.5 million net deferredtax asset for temporary differences when Holdings LLC converted into a Delawarecorporation. The corresponding deferred tax benefit lowered the Company’seffective tax rate.

 

(2)           For the income earned from the date of the conversionto a Delaware corporation through September 30, 2004, the Company provided forincome taxes based on a 41.5% blended tax rate. Prior to August 12, 2004, allincome taxes were paid by Holdings LLC’s former members.

 

15

----

** **

**8.****    ****Segment Reporting**

 

The Company operates in two reportablesegments: Transaction Execution Services and Agency Brokerage Services.

 

Transaction ExecutionServices consist primarily of transaction execution services, market dataservices on a real-time or summary basis and, through the Company’s alliancewith PCX, a trading venue for issuers of equity securities, exchange tradedfunds and structured products. Under PCX rules, issuers are listed on PCX fortrading on ArcaEx. The customers in this segment are required to hold an ETP orbe a broker-dealer introduced to ArcaEx by an ETP. An ETP holder must be abroker-dealer.

 

Agency Brokerage Servicesare provided through Wave and consist of order execution services, on an agencybasis, for orders received exclusively from institutions involving primarily Nasdaqand listed securities. This segment provides institutions that are not ETPholders or are not sponsored by ETP holders access to all U.S. Nasdaq andexchange-listed securities markets through ArcaEx.

 

Revenues are generatedprimarily in the United States of America. Revenues derived from one stockholder/formermember of Holdings LLC and its affiliates represented approximately 11.6% and 10.0%,of the consolidated revenues for the three months ended September 30, 2003and 2004, and 14.3% and 10.0%, of the consolidated revenues for the nine monthsended September 30, 2003 and 2004, respectively.

 

Summarized financialinformation concerning the Company’s reportable segments is as follows (inthousands):

 
| ** **                                | ** ** | **Transaction** | ** ** | **Agency**    | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------|------------|-----------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                | ** ** | **Execution**   | ** ** | **Brokerage** | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                | ** ** | **Services**    | ** ** | **Services**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Three  months ended September 30,**     |       |            |       |          |       |             |       |             |       |
| ** **                                |       |            |       |          |       |             |       |             |       |
| **2003**                                  |       |            |       |          |       |             |       |             |       |
| Revenues                                  |       | $               | 115,469    |          | $          | 12,967           |       | $                | (1,545     | ) | $ | 126,891 |   |
| Cost of revenues                          |       | 82,497          |       | 6,537         |       | (1,545           | )          | 87,489           |       |
| Gross margin                              |       | 32,972          |       | 6,430         |       | —           |       | 39,402           |       |
| Indirect  expenses                        |       | 27,889          |       | 5,289         |       | —           |       | 33,178           |       |
| Operating income                          |       | 5,083           |       | 1,141         |       | —           |       | 6,224            |       |
|                                      |       |            |       |          |       |             |       |             |       |
| **2004**                                  |       |            |       |          |       |             |       |             |       |
| Revenues                                  |       | $               | 116,452    |          | $          | 12,112           |       | $                | (1,423     | ) | $ | 127,141 |   |
| Cost of revenues                          |       | 71,354          |       | 6,750         |       | (1,423           | )          | 76,681           |       |
| Gross margin                              |       | 45,098          |       | 5,362         |       | —           |       | 50,460           |       |
| Indirect  expenses                        |       | 31,597          |       | 4,013         |       | —           |       | 35,610           |       |
| Operating income                          |       | 13,501          |       | 1,349         |       | —           |       | 14,850           |       |
|                                      | ** ** | ** **      | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Nine  months ended September 30,**      |       |            |       |          |       |             |       |             |       |
|                                      |       |            |       |          |       |             |       |             |       |
| **2003**                                  |       |            |       |          |       |             |       |             |       |
| Revenues                                  |       | $               | 294,893    |          | $          | 35,572           |       | $                | (3,487     | ) | $ | 326,978 |   |
| Cost of revenues                          |       | 234,952         |       | 16,173        |       | (3,487           | )          | 247,638          |       |
| Gross margin                              |       | 59,941          |       | 19,399        |       | —           |       | 79,340           |       |
| Indirect  expenses                        |       | 74,946          |       | 15,416        |       | —           |       | 90,362           |       |
| Operating income  (loss)                  |       | (15,005         | )          | 3,983         |       | —           |       | (11,022          | )          |
|                                      |       |            |       |          |       |             |       |             |       |
| **2004**                                  |       |            |       |          |       |             |       |             |       |
| Revenues                                  |       | $               | 367,072    |          | $          | 40,288           |       | $                | (4,763     | ) | $ | 402,597 |   |
| Cost of revenues                          |       | 230,679         |       | 24,157        |       | (4,763           | )          | 250,073          |       |
| Gross margin                              |       | 136,393         |       | 16,131        |       | —           |       | 152,524          |       |
| Indirect  expenses                        |       | 87,012          |       | 12,074        |       | —           |       | 99,086           |       |
| Operating income                          |       | 49,381          |       | 4,057         |       | —           |       | 53,438           |       |
|                                      |       |            |       |          |       |             |       |             |       |
| Identifiable  assets (September 30, 2004) |       | $               | 493,591    |          | $          | 39,371           |       | $                | (3,216     | ) | $ | 529,746 |   |

 

16

----

 

In 2004, the Company revisedits methodology for allocating certain expenses between the segments to reflectthe fact that Agency Brokerage Services had built out its own infrastructureand therefore relies less on Company shared services. Indirect costs allocatedto Agency Brokerage Services were $3.0 million and $1.5 million forthe three months ended September 30, 2003 and 2004, and $9.0 millionand $4.5 million for the nine months ended September 30, 2003 and2004, respectively.

 

**9.****    ****Net Capital Requirements**

 

Wave, ARCAS and ATSI areregistered broker-dealers and are subject to net capital requirements under SECRule 15c3-1. Wave and ATSI compute their net capital using the basicmethod. Under this method, these subsidiaries must maintain minimum net capital(as defined) and the ratio of aggregate indebtedness (as defined) to netcapital may not exceed 15 to 1. ARCAS computes its net capital under thealternative method. This method requires that minimum net capital not be lessthan the greater of $250,000 or 2% of aggregate debit items arising fromcustomer transactions.

 

As of September 30,2004, these subsidiaries were in compliance with their respective net capitalrequirements and their net capital, net capital in excess of required netcapital, and ratio of aggregate indebtedness to net capital were as follows (inthousands, except ratios):

 
| **Net  capital**                                    |   |      |   |
|-----------------------------------------------------|--------|-----------|--------|
| Wave                                                |   | $         | 15,176 |   |
| ARCAS                                               |   | 6,262     |   |
| ATSI                                                |   | 3,719     |   |
| **Net  capital in excess of required net capital**  |   |      |   |
| Wave                                                |   | $         | 14,096 |   |
| ARCAS                                               |   | 6,012     |   |
| ATSI                                                |   | 3,540     |   |
| **Ratio  of aggregate indebtedness to net capital** |   |      |   |
| Wave                                                |   | 1.07 to 1 |   |
| ARCAS                                               |   | N/A       |   |
| ATSI                                                |   | .72 to 1  |   |

 

Advances to affiliates,dividend payments and other equity withdrawals are subject to certainnotification and other provisions of the net capital rule of the SEC and otherregulatory bodies.

 

The Company’s internationalbroker-dealer subsidiaries are subject to capital adequacy requirementspromulgated by authorities of the countries to which they operate. As ofSeptember 30, 2004, these subsidiaries had met their local capital adequacyrequirements.

 

**10.**** ****Subsequent Event**

 

*AbovenetLitigation*

 

In connection with a lawsuitfiled in November 2003 in a state court in the State of New York regardingcertain telecommunication services, in November of 2004, the Company enteredinto a definitive settlement agreement in principal under which the Companypaid to Abovenet approximately $1.7 million in exchange for Abovenet’s releaseof all claims against the Company.

 

In accordance with SFAS 5, “Accountingfor Contingencies”, and FIN 14, “Reasonable Estimation of the Amount of a Loss”,the Company had recorded in fiscal 2003 a contingent liability for the amountof the settlement paid.

 

17

----

 

**Item 2****.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

You should read thefollowing discussions together with the condensed consolidated financialstatements and related notes as well as the forward looking statements includedin this document.

 

**Executive Overview**

 

We operate ArcaEx, the firstopen, all-electronic stock market in the United States for trading in NYSE-,Nasdaq-, AMEX- and PCX-listed equity securities, exchange-traded funds andother exchange-listed securities. During the nine months ended September 30,2003 and 2004, our customers executed 207.5 million and 304.4 milliontransactions in U.S. equity securities through ArcaEx, respectively, representing82.8 billion and 104.1 billion shares. Our trading platforms and services havebeen designed to enhance the speed and quality of trade execution for ourcustomers. Our trading platforms provide our customers with fast electronicexecution and open, direct and anonymous market access. The technological capabilitiesof our trading systems, together with our trading rules, have allowed us tocreate a large pool of liquidity that is available to our customers internallyon ArcaEx and externally through other market centers. We also operate TheArcaEdge®, a broker-dealer sponsored trading platform designed to bring thebenefits of ArcaEx—fast electronic execution, transparency and open marketaccess—to the trading of small-cap equity securities.

 

Weearn revenues and generate cash from transaction fees collected in connection withtrade execution (whether matchedinternally or routed out) on ArcaEx. We also generate revenues from feescollected for introducing broker-dealers that are not ETP holders to ArcaEx. Inaddition, we receive market data fees, based on the level of trading activityon ArcaEx, for providing data to centralized aggregators that in turn sell thedata to third-party consumers. Through our alliance with PCX, we also collectlisting fees from companies and index providers that list on PCX as a tradingvenue for their equity securities, exchange-traded funds and other structuredproducts. Through our wholly-owned subsidiary, Wave Securities, L.L.C., weoffer and derive revenues from fees collected in connection with agencybrokerage services for institutional customers seeking to access ArcaEx andother U.S. market centers electronically. Our total revenues grew from$155.2 million in 2001 to $458.3 million in 2003.  Our revenues were $402.6 million in thefirst nine months of 2004.

 

Our business is dependent on the liquidity (i.e.,the number and range of buy orders and sell orders posted on our system andavailable to our customers) of the Archipelago system (ArcaEx and itsprecursor, Archipelago Electronic Communications Network – ECN, which we operateduntil April 2003). As a result, our most significant cost of generatingrevenues is the cost of liquidity, which we pay for in one of two ways. First,to enhance the liquidity of our system, we pay a small fee per share(denominated in tenths of a cent per share) to participants, referred to as"liquidity providers," that post buy orders and sell orders on theArchipelago system, when the quote is executed against, or "hit," byliquidity takers purchasing or selling securities internally on our system.Second, as part of our best execution business model, we incur routing chargeswhen the Archipelago system does not have the best buy or sell order in themarket for a security that a customer is trying to buy or sell on our system.In that case, we will route the customer's order to the external market centerthat displays the best buy order or sell order. The external market center willcharge us a fee per share (denominated in tenths of a cent per share) forrouting to its system. 

 

Making liquidity payments and incurring routingcharges are part of the costs we incur to generate revenues through increasedliquidity on the Archipelago system. We seek to offset these costs by increasedtrade execution on the Archipelago system. Our cost of liquidity generallyfluctuates based on (i) trading volumes and (ii) the per share fee we payliquidity providers for trades executed internally on ArcaEx or the per sharerouting charge we pay to external market centers for outbound trades.  

 

We also incur clearance, brokerage and relatedtransaction expenses, which primarily include transaction expenses paid toclearing entities for clearing and settlement, service fees paid per trade toexchanges for trade execution. As the operator of a facility of PCX Equities, wedo not incur clearing charges for trades executed on ArcaEx by two independentmarket participants. As a result, our cost per trade is lower for tradesexecuted internally on ArcaEx. If we route a trade to an external marketcenter, we bear clearing and settlement costs. 

 

In addition to our direct cost of revenues, we incurthe following indirect expenses: 

 

•      employee compensation and benefitsexpenses, which include salaries, incentive compensation and related employeebenefits and taxes; 

 

•      depreciation and amortization expenses,which result primarily from the depreciation of the fixed assets we purchase,including computer software and hardware used in the development of our tradingsystems; 

 

•      communications expenses, which consistprimarily of costs for our network connection with our customers and our datacenters, as well as connectivity to various other market centers; 

 

•      marketing and promotion expenses, whichconsist primarily of media, print and other advertising expenses as well ascustomer marketing expenses; 

 

•      legal and professional expenses, whichconsist primarily of legal and accounting expenses; 

 

•      occupancy expenses, which consistprimarily of rental expenses; and 

 

•      general and administrative expenses, whichinclude travel and entertainment expenses and other administrative expenses andgeneral office costs. 

 

On August 11, 2004 weconverted from a limited liability company to a “C” corporation in connectionwith the consummation of our Initial Public Offering (“IPO”).  Please refer to Note 1 — Organization andBasis of Presentation under the sub-headings “Conversion Transaction” and “InitialPublic Offering” for further discussion in our unaudited financial statements.

 

For financial reportingpurposes, our business is divided into two reportable segments: transactionexecution services and agency brokerage services. Our transaction executionbusiness includes trade execution on the Archipelago system as well as fees wereceive for market data and from issuers with equity securities listed on thePacific Exchange for trading on ArcaEx. Our trade execution customers arerequired to hold an ETP or be a broker-dealer introduced to ArcaEx by an ETPholder in order to trade on ArcaEx. An ETP holder must be a broker-dealer. Ouragency brokerage services are provided through Wave Securities, L.L.C., ourbroker-dealer subsidiary, and consist of order execution services, on an agencybasis, for orders received exclusively from institutions involving primarily Nasdaqand listed securities. This segment provides institutions that are not ETPholders or are not sponsored by ETP holders access to all U.S. Nasdaq andexchange-listed securities markets through ArcaEx.

 

**KeyStatistical Information**

 

Our revenues and grossmargin are directly impacted by trading volumes of U.S. equity securities onthe Archipelago system. Our profitability depends to a significant extent onour ability to attract and retain trading volumes, both in absolute terms andrelative to other market centers. We derive revenues on both a per-share basisand a per-transaction basis, depending upon the source of revenue. Thetransaction fees we receive for trade execution and the payments we make toliquidity providers are determined on a per-share basis. Market

 

18

----

 

data fees for exchange-listed securities aredetermined on a per-transaction basis, and market data fees for Nasdaq-listedsecurities are determined on a combination of share volume and transactionvolume.

 

The following table presentsunaudited key transaction volume information, as well as selected operatinginformation, for the periods presented. A description of how we calculate ourmarket share, our trading volumes and other operating measures is set forthbelow.

 
| ** **                                                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Trading Days                                                              |       | 64                                    |       | 64                                   |       | 188 |   | 188 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Total U.S.  market volume (millions of shares)(1)                         |       | 235,804                               |       | 220,785                              |       | 688,489 |   | 730,203 |   |
| Our total U.S.  market volume (millions of shares)(1)                     |       | 31,813                                |       | 32,793                               |       | 82,845 |   | 104,138 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our share of  total U.S. market volume(1)(2)                              |       | 13.49                                 | %          | 14.85                                | %          | 12.03 | % | 14.26 | % |
| % of handled  shares matched internally(3)                                |       | 9.45                                  | %          | 11.50                                | %          | 7.83 | % | 10.86 | % |
| % of handled  shares routed out(3)                                        |       | 4.04                                  | %          | 3.35                                 | %          | 4.20 | % | 3.40 | % |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Total volume of  Nasdaq-listed securities (millions of shares)            |       | 110,672                               |       | 99,636                               |       | 311,971 |   | 334,278 |   |
| Our total volume  of Nasdaq-listed securities (millions of shares)        |       | 28,370                                |       | 26,460                               |       | 74,058 |   | 86,326 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our share of  total volume of Nasdaq-listed securities(2)                 |       | 25.63                                 | %          | 26.56                                | %          | 23.74 | % | 25.82 | % |
| % of handled  shares matched internally(3)                                |       | 17.93                                 | %          | 20.31                                | %          | 15.50 | % | 19.55 | % |
| % of handled  shares routed out(3)                                        |       | 7.70                                  | %          | 6.25                                 | %          | 8.24 | % | 6.27 | % |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Total volume of  NYSE-listed securities (millions of shares)              |       | 108,819                               |       | 104,025                              |       | 331,707 |   | 339,646 |   |
| Our volume in  NYSE-listed securities (millions of shares)                |       | 1,179                                 |       | 1,843                                |       | 3,660 |   | 5,547 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our share of  total volume of NYSE-listed securities(2)                   |       | 1.08                                  | %          | 1.77                                 | %          | 1.10 | % | 1.63 | % |
| % of handled  shares matched internally(3)                                |       | 0.55                                  | %          | 1.22                                 | %          | 0.49 | % | 1.04 | % |
| % of handled  shares routed out(3)                                        |       | 0.53                                  | %          | 0.55                                 | %          | 0.61 | % | 0.59 | % |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Total volume of  AMEX-listed securities (millions of shares)              |       | 16,313                                |       | 17,124                               |       | 44,811 |   | 56,279 |   |
| Our volume in  AMEX-listed securities (millions of shares)                |       | 2,264                                 |       | 4,490                                |       | 5,128 |   | 12,265 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our share of  total volume of AMEX-listed securities(2)                   |       | 13.88                                 | %          | 26.22                                | %          | 11.44 | % | 21.79 | % |
| % of handled  shares matched internally(3)                                |       | 11.30                                 | %          | 22.74                                | %          | 8.74 | % | 18.53 | % |
| % of handled  shares routed out(3)                                        |       | 2.58                                  | %          | 3.48                                 | %          | 2.70 | % | 3.26 | % |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our ETF volume  (millions of shares)                                      |       | 1,969                                 |       | 4,190                                |       | 4,380 |   | 11,019 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our U.S. equity  transaction volume (thousands of transactions)           |       | 82,282                                |       | 103,543                              |       | 207,516 |   | 304,374 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our average U.S.  equity transaction size (shares per transaction)        |       | 387                                   |       | 317                                  |       | 399 |   | 342 |   |
| Our average U.S.  equity transactions per day (thousands of transactions) |       | 1,286                                 |       | 1,618                                |       | 1,104 |   | 1,619 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Our average  transaction-related revenue (per share)(4)              |       | $                                     | 0.0036     |                                 | $          | 0.0034 |   | $ | 0.0037 |   | $ | 0.0035 |   |
| Our average  transaction-related cost of revenue (per share)(5)      |       | $                                     | 0.0022     |                                 | $          | 0.0021 |   | $ | 0.0024 |   | $ | 0.0021 |   |
| Our average  transaction-related gross margin (per share)(6)         |       | $                                     | 0.0014     |                                 | $          | 0.0013 |   | $ | 0.0013 |   | $ | 0.0014 |   |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| % of customer  order volume matched internally(7)                         |       | 82.2                                  | %          | 87.1                                 | %          | 78.4 | % | 86.3 | % |
| % of customer  order volume routed out(7)                                 |       | 17.8                                  | %          | 12.9                                 | %          | 21.6 | % | 13.7 | % |

 

----

*(1)*          U.S. market volume is calculated based on thenumber of shares of equity securities traded on the NYSE, AMEX and Nasdaq,including exchange-traded funds, as reported in the consolidated tape. The “consolidatedtape” is the system that continuously provides the last sale price and volumeof securities transactions in listed securities to the public.

 

*(2)*          Our market share is calculated based on thenumber of shares handled on the Archipelago system as a percentage of totalvolume.

 

*(3)*          Represents our share of the total volume ofsuch securities handled on ArcaEx that was either matched internally on ArcaExor routed out to an external market center.

 

19

----

 

*(4)*          The per share amount is calculated based onour total revenues derived from transaction fees of $116.0 million and $112.7 millionfor the three months ended September 30, 2003 and 2004, respectively, and $307.3million and $363.8 million for the nine months ended September 30,2003 and 2004, respectively, and our total U.S. market volume for the relevantperiod.

 

*(5)*          The per share amount is calculated based onour cost of revenues derived from transaction fees, which consist of routingcharges and liquidity payments, of $71.5 million and $67.8 million forthe three months ended September 30, 2003 and 2004, respectively, and $194.7 millionand $217.8 million for the nine months ended September 30, 2003 and 2004,respectively, and our total U.S. market volume for the relevant period. Thecost of revenue from transaction fees used in the per share computation doesnot include clearance, brokerage and other transaction expenses.

 

*(6)*          The per share amount is calculated based onour net revenues received from transaction fees, and our total U.S. marketvolume for the relevant period.

 

*(7)*          The percentage of customer order volumematched internally is calculated by dividing the volume of customer ordersexecuted within our internal liquidity pool (including the volume of both buyorders and sell orders) by the total volume of customer orders (again includingthe volume of both buy orders and sell orders when such orders are matchedinternally). The percentage of customer orders routed out is calculated bydividing the volume of customer orders routed to other market centers by thetotal volume of customer orders.

 

For purposes of calculatingour volume, we include all shares that are “handled” on the Archipelago system.Handled shares include both shares that are bought or sold within our internal liquiditypool and shares that are routed to external markets for execution. We countevery transaction handled by the Archipelago system exactly once; we do notcount both sides of any transaction. For example, if a customer’s 10,000 sharebuy order is matched with another customer’s 10,000 share sell order in ourinternal liquidity pool, our handled volume will be 10,000 shares. As anotherexample, if one of our customers sends us an order to buy 10,000 shares and thebest price for that order is displayed at another market center, we will routethat order to the other market center for execution. The other market centerwill report a 10,000 share transaction in the consolidated tape, and ourhandled volume will be 10,000 shares. As a result, the 10,000 shares we reportas handled by us in this example are also handled by the external marketcenter.

 

In computing the percentageof customer order volume matched internally and the percentage of customerorder volume routed out, we calculate the percentage based on the volume ofindividual customer orders, not the volume of matched trades (i.e., onlycounting one side of a matched transaction). For example, we calculate twocustomer orders matched internally on our system as two customer orders matchedinternally, and we include the volume of both the buy order and the sell orderin computing our percentages of customer order volume matched internally androuted out. We calculate one customer order routed to an external market center(which will be matched with an order at that other market center) as oneoutbound trade or one customer order. We calculate one customer order routed tous from an external market center and matched with an order on our system asone inbound trade or one customer order.

 

Transactions in Nasdaq andexchange-listed securities are reported in the consolidated tape, a high-speedsystem that continuously provides last sale price and volume in listedsecurities. Our handled volume is higher than our volume reported to thecentralized aggregators for inclusion in the consolidated tape for two reasons.First, we do not report trades routed to another market center to thecentralized aggregators of this data. Instead, the destination market centerreports these trades. For example, if a customer’s 10,000 share buy order isrouted to another market center for execution, our handled volume will be10,000 shares, but we will not report the trade.

 

20

----

 

Second, our handled volume includes odd lottransactions, generally defined as trades of fewer than 100 shares, which, byrule, we do not report to the centralized aggregators for inclusion in theconsolidated tape. For example, if one of our customers buys 50 shares, ourhandled volume will be 50 shares but we will not report this trade.

 

For purposes of calculatingour market share, we use the volume of shares that are handled on theArchipelago system (as described above) as the numerator, and the aggregatevolume of shares reported by all securities exchanges and associations in theconsolidated tape as the denominator. Our market share may be expressed as:

 

Numberof shares handled on the Archipelago system

Overallmarket volume as reported in the consolidated tape

 

As an alternative method ofcalculating market share, we could include in the numerator of the aboveformula only transactions that we report in the consolidated tape. This wouldexclude shares routed to other market centers and odd-lot transactions from ourmarket share calculation.

 

For purposes of calculatingthe percentage of handled shares matched internally or routed out, we count allshares that are “handled” on the Archipelago system as described above. Wecount every transaction handled by the Archipelago system exactly once; we donot count both sides of any transaction. Therefore, if five trades are executedon ArcaEx for 10,000 shares each, three of which are routed out, we will havehandled 50,000 shares and our percentage of that share volume matched internallywould be 40% and routed out would be 60%.

 

Alternatively, for thepurpose of calculating the percentage of customer order volume matchedinternally or routed out, we count each customer order exactly once. If twocustomers’ orders are matched within our internal liquidity pool, we count thevolume of both the buy order and the matched sell order. On the other hand, ifa customer’s order is routed to another market center and matched with an orderposted at that other market center, we count only the volume of the orderrouted out.

 

21

----

 

**Results of Operations**

 

***Three Months Ended September 30, 2004versus Three Months Ended September 30, 2003***

 

The following table sets forth ourconsolidated statements of operations data for the periods presented: 

 
| ** **                                           | ** ** | **Three months ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percentage of Revenues** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|
| **Amount**                                           | ** ** | **Percentage**                        |
| ** **                                           | ** ** | **2003**                              | ** ** | **2004**   | ** ** | **Change** | ** ** | **Change**                 | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(In millions)**                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** |
| **Revenues**                                         | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Transaction fees                                     |       | $                                     | 116.0      |       | $          | 112.7      |       | $                          | (3.3       | ) | (2.8 | )% | 91.4 | % | 88.6 | % |
| Market data fees                                     |       | 10.9                                  |       | 14.3       |       | 3.4        |       | 31.2                       | %          | 8.6 | % | 11.3 | % |
| Listing fees                                         |       | —                                |       | 0.1        |       | 0.1        |       | 100.0                      | %          | — | % | 0.1 | % |
| Total revenues                                       |       | 126.9                                 |       | 127.1      |       | 0.2        |       | 0.2                        | %          | 100.0 | % | 100.0 | % |
|                                                 |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Cost of Revenues                                     |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Liquidity  payments                                  |       | 42.8                                  |       | 47.5       |       | (4.7       | )          | (11.0                      | )%         | 33.7 | % | 37.3 | % |
| Routing charges                                      |       | 28.7                                  |       | 20.3       |       | 8.4        |       | 29.3                       | %          | 22.6 | % | 16.0 | % |
| Clearance,  brokerage and other transaction expenses |       | 16.0                                  |       | 8.9        |       | 7.1        |       | 44.4                       | %          | 12.6 | % | 7.0 | % |
| Total cost of  revenues                              |       | 87.5                                  |       | 76.7       |       | 10.8       |       | 12.3                       | %          | 68.9 | % | 60.3 | % |
|                                                 |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Gross margin                                         |       | 39.4                                  |       | 50.4       |       | 11.0       |       | 27.9                       | %          | 31.1 | % | 39.7 | % |
|                                                 |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Indirect  expenses                                   |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Employee  compensation and benefits                  |       | 10.0                                  |       | 10.6       |       | (0.6       | )          | (6.0                       | )%         | 7.9 | % | 8.3 | % |
| Depreciation and  amortization                       |       | 10.0                                  |       | 5.0        |       | 5.0        |       | 50.0                       | %          | 7.9 | % | 3.9 | % |
| Communications                                       |       | 4.9                                   |       | 5.1        |       | (0.2       | )          | (4.1                       | )%         | 3.9 | % | 4.0 | % |
| Marketing and  promotion                             |       | 2.4                                   |       | 7.8        |       | (5.4       | )          | (225.0                     | )%         | 1.9 | % | 6.1 | % |
| Legal and  professional                              |       | 1.4                                   |       | 2.7        |       | (1.3       | )          | (92.9                      | )%         | 1.1 | % | 2.1 | % |
| Occupancy                                            |       | 1.0                                   |       | 1.2        |       | (0.2       | )          | (20.0                      | )%         | 0.8 | % | 0.9 | % |
| General and  administrative                          |       | 3.5                                   |       | 3.2        |       | 0.3        |       | 8.6                        | %          | 2.8 | % | 2.5 | % |
| Total indirect  expenses                             |       | 33.2                                  |       | 35.6       |       | (2.4       | )          | (7.2                       | )%         | 26.3 | % | 27.8 | % |
|                                                 |       |                                  |       |       |       |       |       |                       |       |   |   |   |   |
| Operating income                                     |       | 6.2                                   |       | 14.8       |       | 8.6        |       | 138.7                      | %          | 4.9 | % | 11.6 | % |
| Interest and  other, net                             |       | 0.3                                   |       | 1.0        |       | 0.7        |       | 233.3                      | %          | 0.2 | % | 0.8 | % |
| Income before  income tax benefit                    |       | 6.5                                   |       | 15.8       |       | 9.3        |       | 143.1                      | %          | 5.1 | % | 12.4 | % |
| Income tax  benefit                                  |       | —                                |       | (1.3       | )          | 1.3        |       | 100.0                      | %          | — | % | (1.0) | % |
| Net income                                           |       | 6.5                                   |       | 17.1       |       | 10.6       |       | 163.1                      | %          | 5.1 | % | 13.4 | % |
| Deemed dividend  on convertible preferred shares     |       | —                                |       | (9.6       | )          | (9.6       | )          | (100.0                     | )%         | — | % | (7.6) | % |
| Net income  attributable to common stockholders      |       | $                                     | 6.5        |       | $          | 7.5        |       | $                          | 1.0        |   | 15.4 | % | 5.1 | % | 5.8 | % |

 

**Highlights**

 

Our income before taxesincreased to $15.8 million for the three months ended September 30, 2004, a$9.3 million improvement over the comparable period in 2003.  Our improved results of operations for theperiod reflect the following principal trends:

 

•      While total U.S. market volumes declined 6.4%from 235.8 billion shares traded to 220.8 billion shares traded, our totalvolume traded increased 3.1% from 31.8 billion shares to 32.8 billion shares,resulting in our share of the total U.S. market volume increasing from 13.5% to14.9%.

 

•      Increased the percentage of customer ordersmatched internally from 82.2% to 87.1% and reduced the percentage routed toother market centers, resulting in a change in the amount and mix of our costof revenues:

 

•      liquidity payments increased to $47.5million, or 37.3% of total revenues, from $42.8 million, or 33.7% of totalrevenues;

 

22

----

 

•      routing charges declined to $20.3 million, or16.0% of total revenues, from $28.7 million, or 22.6% of total revenues;

•      clearance, brokerage, and other transactionexpenses declined to $8.9 million, or 7.0% of total revenues, from $16.0million, or 12.6% of total revenues; and

•      gross margin improved by $11.0 million or27.9%, and represented 39.7% of total revenues for the three months endedSeptember 30, 2004, as compared to 31.1% for the same period a year earlier.

 

•      Increased the market data fees we earned bygenerating higher trading volumes and a higher percentage of customer sharesmatched internally.

 

•      Substantially reduced clearing costs pertrade as a result of both our renegotiation of existing clearing agreements andthe transition to self-clearing transactions effected by non-ETP broker-dealersaccessing ArcaEx through our subsidiary, Archipelago Trading Services, Inc.

 

Total U.S. market volumesdeclined to 220.8 billion shares for the three months ended September 30, 2004from 235.8 billion shares for the three months ended September 30, 2003, adecline of 6.4%.  Despite the decline inoverall trading volumes, our total volume traded increased to 32.8 billionshares from 31.8 billion shares in the same periods, respectively, representingan increase of 3.1%.  Our ability toincrease our trading volumes in a declining-volume environment enabled us toincrease our share of the total U.S. market trading volume to 14.9% for thethree months ended September 30, 2004 from 13.5% in the same period a yearago.  Our share of the trading ofNasdaq-listed shares increased to 26.6% from 25.6%; our share of the trading ofNYSE-listed shares increased to 1.8% from 1.1%; and our share of the trading ofAmex-listed shares increased to 26.2% from 13.9%.  Our increased volume and market share contributedto an increase in revenue to $127.1 million for the three months endedSeptember 30, 2004 from $126.9 million for the three months ended September 30,2003.

 

As a result of increasedliquidity posted on ArcaEx, we were able to increase our percentage of customershare volume matched internally to 87.1% for the three months ended September30, 2004 from 82.2% for the comparable period in 2003.  This change in trading behavior contributedto the improvement in our gross margin to $50.4 million, or 39.7% of our totalrevenues for the three months ended September 30, 2004, from $39.4 million, or31.1% of our total revenues for the three months ended September 30, 2003.  For the three months ended September 30,2004, the increased volumes and internal matches resulted in a significantchange in the amount and mix of our cost of revenues and the resulting grossmargin as compared to the three months ended September 30, 2003.

 

**Revenues**

 

Our total revenues increased$0.2 million, or 0.2%, to $127.1 million for the three months ended September30, 2004, from $126.9 million for the comparable period in 2003. The small increasein revenues was driven by:

 

•      a $3.4 million, or 31.2% increase in marketdata fees reflecting the increase in our share of the total U.S. market volumefrom 13.5% to 14.9% and an increase in customer orders matched internally from82.2% to 87.1%;

 

partially offset by

 

•      a $3.3 million, or 2.8% decrease intransaction fees, the result of an increase in the percentage of customerorders matched internally.

 

Market data fees increasedto $14.3 million for the three months ended September 30, 2004 from $10.9million for the three months ended September 30, 2003.  The increase in market data fees wasprimarily driven

 

23

----

 

by our increased transaction volume inAmex-listed shares, mainly ETF’s.  Marketdata fees derived from trading Amex-listed securities increased to $6.1 millionfrom $3.7 million; market data fees derived from trading Nasdaq-listedsecurities increased to $7.7 million from $7.0 million; and market data feesderived from trading NYSE-listed securities increased to $0.5 million from $0.2million.

 

Transaction fees decreasedto $112.7 million for the three months ended September 30, 2004 from $116.0million for the three months ended September 30, 2003 reflecting an increase inthe percentage of customer orders matched internally and a correspondingdecrease in the percentage of customer orders routed to other market centers.

 

Our agency brokerageservices segment contributed $12.1 million, or 9.5%, to our total revenues forthe three months ended September 30, 2004, compared to $13.0 million, or 10.2%,for the three months ended September 30, 2003. The absolute decrease in agency brokerage revenues was due primarily tolower volumes for the three months ended September 30, 2004 compared to the threemonths ended September 30, 2003.   Totalvolume and average rate charged for this segment for the three months endedSeptember 30, 2004 was approximately 0.8 billion shares and $0.015 per share(inclusive of soft dollar arrangements). Total volume and average rate charged for the three months endedSeptember 30, 2003 was approximately 0.9 billion shares and $0.014 per share(inclusive of soft dollar arrangements).  The decline in agency brokerage revenues as apercentage of our total revenues is due to relatively stronger growth withinour core transaction execution service segment.

 

**Cost of Revenues**

 

Our total cost of revenuesdeclined $10.8 million, or 12.3%, to $76.7 million for the three months endedSeptember 30, 2004 from $87.5 million for the three months ended September 30,2003.  The decline is significantconsidering that our trading volume was 3.1% higher in the third quarter 2004than in the same quarter last year.  As apercentage of total revenues, our cost of revenues declined to 60.3% from68.9%.  The composition of our cost ofrevenues changed significantly.  Notably,liquidity payments increased $4.7 million, or 11.0%, offset by an $8.4 million,or 29.3% decrease in routing charges, and a $7.1 million, or 44.4% decrease inclearance, brokerage and other expenses.

 

Our increased liquiditypayments primarily reflect an increase in the percentage of customer ordervolume matched internally on ArcaEx and, to a lesser extent, the largertransaction volumes we achieved in the third quarter 2004 compared to the thirdquarter 2003.  The percentage of customerorder volume routed out to other markets for execution decreased to 12.9% forthe three months ended September 30, 2004 from 17.8% for the comparable 2003period due to increased internal liquidity on the ArcaEx trading platform.  This shift in trading behavior contributed tothe decline in routing charges we incurred. In addition, in May of 2004 we became an Electronic Access Member of theNYSE which also helped drive our routing costs lower as it reduced our usage ofthird party access providers.

 

Clearing, brokerage andother transaction expenses decreased due to reduced clearing costs per trade thatbecame effective in November 2003.  Inaddition, the number of trades subject to clearing costs was reduced relativeto our total number of trades as a result of an increase in the percentage ofcustomer order volume matched internally. Finally, effective August 2004, we began self-clearing trades effectedby non-ETP broker-dealers accessing ArcaEx through our wholly-owned subsidiary,Archipelago Trading Services, Inc.

 

Our agency brokerage servicessegment accounted for $6.8 million, or 8.9% of our total cost of revenues forthe three months ended September 30, 2004, compared to $6.5 million, or 7.4%,for the three months ended September 30, 2003. Total volume for this segment for the three months ended September 30,2004 was approximately 0.8 billion shares, compared to 0.9 billion shares forthe three months ended September 30,

 

24

----

 

2003.  The increase in agency brokerage expenses as a percentage of our totalcost of revenues is primarily due to increased soft dollar expenditures.

 

**Gross Margin**

 

Gross margin increased to$50.4 million for the third quarter of 2004 from $39.4 million for the thirdquarter of 2003, representing an increase of $11.0 million, or 27.9%.  As a percentage of total revenues, grossmargin increased to 39.7% from 31.1% during the same period.  The improvement in gross margin was driven inpart by an increase in market data revenues as a percentage of total revenuesto 11.3% for the three months ended September 30, 2004 from 8.6% for thecomparable period in 2003.  In addition,our gross margin improved due to the reduction in clearing costs we achieved inboth absolute and relative terms. Clearing, brokerage and other expenses as percentage of total revenuesdecreased to 7.0% for the three months ended September 30, 2004 from 12.6% forthe comparable period in 2003.   Finally,our combined liquidity and routing expenses declined to 53.3% of total revenuesfrom 56.3% of total revenues for the three months ended September 30, 2004 andSeptember 30, 2003, respectively.

 

**Indirect Expenses**

 

Total indirect expensesincreased $2.4 million, or 7.2%, to $35.6 million for the three months endedSeptember 30, 2004 from $33.2 million for the three months ended September 30,2003.  The increase was primarily due tothe following:

 

•      a $5.4 million increase in marketing andpromotion expenses attributable to our brand recognition advertising campaignlaunched in September 2004; and

 

•      a $1.3 million increase in legal andprofessional fees;

 

partially offset by

 

•      a $5.0 million decrease in depreciation andamortization expense*.*

 

In June 2003, we determinedthat certain software and computer equipment would be retired by March 2004and, therefore, we accelerated depreciation on these assets starting July 1,2003.  During the three months endedSeptember 30, 2003 we recorded $4.6 million of accelerated depreciation onthese assets.

 

**Interest and Other**

 

For the three months endedSeptember 30, 2004, interest and other income was $1.0 million compared to $0.3million for the same period in 2003.  Theincrease was primarily due to increased average cash and cash equivalent balancesand to a lesser extent increased interest rates.

 

**Income Tax Benefit**

 

For the income earned fromthe date of our conversion to a Delaware corporation through September 30,2004, we provided for income taxes based on a 41.5% blended tax rate. Prior toAugust 12, 2004, all Federal and State income taxes were paid by the members ofHoldings LLC. Upon our conversion from a limited liability company to a “C”Corporation, we recognized a $3.5 million net deferred tax asset correspondingto our net deferred tax position as of the conversion date. The correspondingdeferred tax benefit lowered our effective tax rate for the three months endedSeptember 30, 2004. Since we were not a taxpayer prior to August 12, 2004 anddue to the one-time deferred tax benefit, our income tax provision for thethree months ended September 30, 2004 resulted in a $1.3 million benefit.

 

25

----

 

**Deemed Dividend on ConvertiblePreferred Shares**

 

Upon the conversion ofredeemable preferred shares into common shares as part of our IPO, we issuedapproximately 717,000 additional shares of common stock attributable to abeneficial conversion feature included in the previously issued redeemablepreferred interest. The $9.6 million intrinsic value of such shares is a deemeddividend on convertible preferred shares, which is reported after net income toreach net income attributable to common stockholders.

 

**Net Income Attributable to CommonStockholders**

 

As a result of theforegoing, we reported net income attributable to common stockholders of $7.5million for the three months ended September 30, 2004, representing a $1.0million improvement from the $6.5 million we reported for the three monthsended September 30, 2003.

 

***Nine Months Ended September 30, 2004 versus Nine Months Ended September 30,2003***

 

The following table setsforth our consolidated statements of operations data for the periods presented:

 
| ** **                                             | ** ** | **Nine months ended  September 30,** | ** ** | **Amount  Change** | ** ** | **Percentage  Change** | ** ** | **Percentage of Revenues** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|--------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | **2003**                             | ** ** | **2004**           | ** ** | ** **             | ** ** | **2003**                   | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(In millions)**                    | ** ** | ** **         | ** ** | ** **             | ** ** | ** **                 | ** ** |
| **Revenues**                                           | ** ** | ** **                           | ** ** | ** **         | ** ** | ** **             | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Transaction fees                                       |       | $                                    | 307.3      |               | $          | 363.8                  |       | $                          | 56.5       |   | 18.4 | % | 94.0 | % | 90.3 | % |
| Market data fees                                       |       | 19.3                                 |       | 38.5               |       | 19.2                   |       | 99.5                       | %          | 5.9 | % | 9.6 | % |
| Listing fees                                           |       | 0.4                                  |       | 0.3                |       | (0.1                   | )          | (25.0                      | )%         | 0.1 | % | 0.1 | % |
| Total revenues                                         |       | 327.0                                |       | 402.6              |       | 75.6                   |       | 23.1                       | %          | 100.0 | % | 100.0 | % |
|                                                   |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Cost of Revenues                                       |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Liquidity  payments                                    |       | 104.2                                |       | 149.0              |       | (44.8                  | )          | (43.0                      | )%         | 31.9 | % | 37.0 | % |
| Routing charges                                        |       | 90.5                                 |       | 68.8               |       | 21.7                   |       | 24.0                       | %          | 27.7 | % | 17.1 | % |
| Clearance,  brokerage and other transaction expenses   |       | 52.9                                 |       | 32.3               |       | 20.6                   |       | 38.9                       | %          | 16.2 | % | 8.0 | % |
| Total cost of  revenues                                |       | 247.6                                |       | 250.1              |       | (2.5                   | )          | (1.0                       | )%         | 75.8 | % | 62.1 | % |
|                                                   |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Gross margin                                           |       | 79.4                                 |       | 152.5              |       | 73.1                   |       | 92.1                       | %          | 24.2 | % | 37.9 | % |
|                                                   |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Indirect  expenses                                     |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Employee  compensation and benefits                    |       | 29.2                                 |       | 31.8               |       | (2.6                   | )          | (8.9                       | )%         | 8.9 | % | 7.9 | % |
| Depreciation and  amortization                         |       | 19.5                                 |       | 21.2               |       | (1.7                   | )          | (8.7                       | )%         | 6.0 | % | 5.3 | % |
| Communications                                         |       | 16.5                                 |       | 14.2               |       | 2.3                    |       | 13.9                       | %          | 5.0 | % | 3.5 | % |
| Marketing and  promotion                               |       | 5.5                                  |       | 12.3               |       | (6.8                   | )          | (123.6                     | )%         | 1.7 | % | 3.1 | % |
| Legal and  professional                                |       | 6.9                                  |       | 8.6                |       | (1.7                   | )          | (24.6                      | )%         | 2.1 | % | 2.1 | % |
| Occupancy                                              |       | 3.1                                  |       | 3.2                |       | (0.1                   | )          | (3.2                       | )%         | 0.9 | % | 0.8 | % |
| General and  administrative                            |       | 9.6                                  |       | 7.8                |       | 1.8                    |       | 18.8                       | %          | 2.9 | % | 1.9 | % |
| Total indirect  expenses                               |       | 90.3                                 |       | 99.1               |       | (8.8                   | )          | (9.7                       | )%         | 27.5 | % | 24.6 | % |
|                                                   |       |                                 |       |               |       |                   |       |                       |       |   |   |   |   |
| Operating income  (loss)                               |       | (10.9                                | )          | 53.4               |       | 64.3                   |       | 589.9                      | %          | (3.3 | )% | 13.3 | % |
| Interest and  other, net                               |       | 0.4                                  |       | 1.7                |       | 1.3                    |       | 325.0                      | %          | 0.1 | % | 0.4 | % |
| Income (loss)  before income tax benefit               |       | (10.5                                | )          | 55.1               |       | 65.6                   |       | 624.8                      | %          | (3.2 | )% | 13.7 | % |
| Income tax  benefit                                    |       | —                               |       | (1.3               | )          | 1.3                    |       | 100.0                      | %          | — | % | (0.3 | )% |
| Net income  (loss)                                     |       | (10.5                                | )          | 56.4               |       | 66.9                   |       | 637.1                      | %          | (3.2 | ) % | 14.0 | % |
| Deemed dividend  on convertible preferred shares       |       | —                               |       | (9.6               | )          | (9.6                   | )          | (100.0                     | )%         | — | % | (2.4 | )% |
| Net income  (loss) attributable to common stockholders |       | $                                    | (10.5      | )                  | $          | 46.8                   |       | $                          | 57.3       |   | 545.7 | % | (3.2 | )% | 16.4 | % |
|                                                        |            |                                      |            |                    |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

26

----

 

**Highlights**

 

Our income before taxesincreased to $55.1 million for the nine months ended September 30, 2004, a$65.6 million improvement compared to the nine months ended September 30,2003.  Our improved results of operationsfor the period reflect the following principal trends:

 

•      While total U.S. market volumes increased6.1% to 730.2 billion shares traded, our total volume traded increased 25.7% to104.1 billion shares, resulting in our share of the total U.S. market volumeincreasing to 14.3%.

 

•      Increased the percentage of customer ordersmatched internally from 78.4% to 86.3% and reduced the percentage routed toother market centers, resulting in a change in the amount and mix of our costof revenues:

 

•      liquidity payments increased to $149.0million, or 37.0% of total revenues, from $104.2 million, or 31.9% of totalrevenues;

•      routing charges declined to $68.8 million, or17.1% of total revenues, from $90.5 million, or 27.7% of total revenues;

•      clearance, brokerage, and other transactionexpenses declined to $32.3 million, or 8.0% of total revenues, from $52.9million, or 16.2% of total revenues; and

•      gross margin improved by $73.1 million, or92.1%, and represented 37.9% of total revenues for the nine months endedSeptember 30, 2004, as compared to 24.2% for the same period a year earlier.

 

•      Realized the full benefits of operating asArcaEx as a facility of PCX Equities rather than an ECN or alternative tradingsystem effective April 11, 2003, including increased market data revenues andreduced clearing costs.

 

•      Reduced clearing costs per trade as a result ofboth the renegotiation of existing clearing agreements and the transition toself-clearing transactions effected by non-ETP broker-dealers accessing ArcaExthrough our subsidiary, Archipelago Trading Services, Inc.

 

Total U.S. market volumes inNasdaq-, NYSE-, and AMEX-listed securities improved moderately to 730.2 billionshares for the nine months ended September 30, 2004 from 688.5 billion sharesfor the nine months ended September 30, 2003, representing an increase of6.1%.  Our total U.S. market volumeincreased by 21.3 billion to 104.1 billion shares for the nine months endedSeptember 30, 2004 from 82.8 billion shares for the comparable period in 2003, representingan increase of 25.7%.  For the ninemonths ended September 30, 2004, we handled 25.8%, 1.6%, and 21.8% of the totaltrading volume in Nasdaq-, NYSE-, and AMEX-listed securities,respectively.  This compares with 23.7%,1.1%, and 11.4% for the same period in 2003. The growth in our trading volume of AMEX-listed securities was driven byour volume growth in exchange-traded funds.

 

**Revenues**

 

Our total revenues increased$75.6 million, or 23.1%, to $402.6 million for the nine months ended September30, 2004 from $327.0 million for the comparable period in 2003.  Revenue growth was driven by:

 

•      a $56.5 million, or 18.4%, increase intransaction fees, reflecting both industry-wide volume growth and expandedmarket share, and

 

•      a $19.2 million, or 99.5%, increase in marketdata fees, reflecting primarily our transition to the ArcaEx platform in April2003, and to a lesser extent increased trading volume, and an increase incustomer orders matched internally.

 

27

----

 

Transaction fee revenueincreased 18.4% to $363.8 million for the nine months ended September 30, 2004from $307.3 million for the nine months ended September 30, 2003.  The increase was driven by the 25.7% increasewe experienced in transaction volumes and was partially offset by the increasein the percentage of customer shares matched internally.

 

Market data fees increasedto $38.5 million for the nine months ended September 30, 2004 from $19.3million for the nine months ended September 30, 2003.  Market data fees derived from trading Nasdaq-listedsecurities increased by $10.3 million to $22.4 million for the nine monthsended September 30, 2004 compared to $12.1 million for the comparable period in2003.  The remaining increases in marketdata fees were derived from trading Amex-listed securities which increased to$14.7 million from $6.8 million and from trading NYSE-listed securities whichincreased to $1.4 million from $0.3 million. During the nine months ended September 30, 2004, we benefited fully fromthe improved economics of operating ArcaEx as a facility of PCX Equities, whichbecame fully transitioned for Nasdaq-listed securities in April 2003.  As a facility of PCX Equities, we derivemarket data fees in transactions executed on ArcaEx that we did not receivewhen these transactions occurred on our ECN.

 

Revenues from listing feesdecreased to $0.3 million for the nine months ended September 30, 2004 from$0.4 million for the comparable period in 2003.

 

Our agency brokerageservices segment contributed $40.3 million, or 10.0%, to our total revenues forthe nine months ended September 30, 2004, compared to $35.6 million, or 10.9%,for the comparable period last year.  Theincrease in agency brokerage revenues was due to both increased transactionvolume and a higher average rate charged per share for the nine months endedSeptember 30, 2004 compared to the same period last year.  Total volume increased to 2.69 billion sharesfrom 2.64 billion shares and the average rate charged per share, inclusive ofsoft dollar arrangements, increased from $.013 per share to $.015 per share.  The decline in agency brokerage revenues as apercentage of our total revenues is due to relatively stronger growth withinour core transaction execution services segment.

 

**Cost of Revenues**

 

Our total cost of revenuesincreased by $2.5 million, or 1.0%, to $250.1 million for the nine months endedSeptember 30, 2004 from $247.6 million for the comparable period a yearearlier.  As a percentage of totalrevenues, our cost of revenues declined to 62.1% from 75.8% for the comparableperiods.  The composition of our cost ofrevenues changed significantly primarily as a result of our increased internalmatch rate.  Notably, liquidity paymentsincreased while routing charges and clearance, brokerage and other expensesdeclined.

 

Liquidity payments increasedby $44.8 million, or 43.0%, to $149.0 million for the nine months endedSeptember 30, 2004 from $104.2 million for the nine months ended September 30,2003.  Our increased liquidity paymentsprimarily reflect an increase in the percentage of customer order volume matchedinternally on ArcaEx and, to a lesser extent, the larger transaction volumes weachieved in the nine months ended September 30, 2004 compared to the sameperiod last year.

 

The percentage of customerorder volume routed out to other markets for execution decreased to 13.7% forthe nine months ended September 30, 2004 from 21.6% for the comparable periodin 2003.  This shift in trading behaviorresulted in the decline in routing charges of $21.7 million, or 24.0%, to $68.8million for the nine months ended September 30, 2004 from $90.5 million for thecomparable period last year.

 

28

----

 

Clearing, brokerage andother transaction expenses declined $20.6 million, or 38.9%, to $32.3 millionfor the nine months ended September 30, 2004 from $52.9 million for the ninemonths ended September 30, 2003.  Thiswas the result of reduced clearing costs per trade that became effective inNovember 2003, the migration of trading from the Archipelago ECN to ArcaEx as afacility of PCX Equities (as a result of which we did not incur clearingcharges for trades executed internally), and a reduction in the relative numberof trades subject to clearing costs due to the lower percentage of ordersrouted out.

 

Clearing, brokerage andother transaction expenses for the nine months ended September 30, 2003included $4.5 million in costs related to fees charged by Spear, Leeds &Kellogg L.P., a subsidiary of The Goldman Sachs Group, Inc., under our servicebureau agreement with them for development, operation, management and supportservices provided to the REDIBook ECN in connection with the integration of theREDIBook ECN into the Archipelago system. We did not incur these charges in 2004 due to the migration of tradingof Nasdaq-listed securities from the Archipelago ECN to ArcaEx in April 2003.

 

Our agency brokerageservices segment accounted for $24.2 million, or 9.7%, of our total cost ofrevenues for the nine months September 30, 2004, compared to $16.2 million, or6.5%, for the comparable period in 2003. The increase relative to our consolidated cost of revenues was driven bya lower cost of revenues relative to total revenues in our core transactionservices segment and increased soft dollar expenditures at our agency brokerageservices segment.

 

**Gross Margin**

 

Gross margin increased $73.1million, or 92.1%, to $152.5 million for the nine months ended September 30,2004 from $79.4 million for the comparable period in 2003.  Our gross margin percentage increased to37.9% from 24.2%.  The improved in grossmargin was primarily the result of reduced clearance, brokerage, and otherexpenses.  These costs declined by $20.6million not withstanding the fact that transaction volumes increased25.7%.  The increase in market datarevenues to 9.6% of total revenues for the nine months ended September 30, 2004from 5.9% for the comparable period in 2003 also contributed to our grossmargin improvement.  Our combinedliquidity and routing expenses declined as a percentage of our total revenuesto 54.1% from 59.6%.

 

**Indirect Expenses**

 

Total indirect expensesincreased $8.8 million, or 9.7%, to $99.1 million for the nine months endedSeptember 30, 2004 from $90.3 million for the nine months ended September 30,2003.  The increase was primarily due tothe following:

 

•      a $6.8 million increase in marketing andpromotion expenses primarily attributable to our brand recognition advertisingcampaign launched in September 2004,

 

•      a $2.6 million increase in employeecompensation and benefits as a result of increased staffing, and

 

•      a $1.7 million increase in legal andprofessional costs,

 

partially offset by

 

•      a $2.3 million decrease in communicationexpenses chiefly associated with a reduction in customer connection costs, and

 

•      a $1.7 million decrease in general andadministrative expenses due primarily to reduced computer lease expenses.

 

29

----

 

**Interest and Other**

 

Interest and other itemsincreased to $1.7 million for the nine months ended September 30, 2004 from$0.4 million for the same period in 2003. The increase was due to increased average cash and cash equivalent balancesand to a lesser extent increase interest rates.

 

**Income Tax Benefit**

 

For the income earned fromthe date of our conversion to a Delaware corporation through September 30,2004, we provided for income taxes based on a 41.5% blended tax rate. Prior toAugust 12, 2004, all Federal and State income taxes were paid by the members ofHoldings LLC. Upon our conversion from a limited liability company to a “C”Corporation, we recognized a $3.5 million net deferred tax asset correspondingto our net deferred tax position as of the conversion date. The correspondingdeferred tax benefit lowered our effective tax rate for the nine months endedSeptember 30, 2004. Since we were not a taxpayer prior to August 12, 2004 anddue to the one-time deferred tax benefit, our income tax provision for the ninemonths ended September 30, 2004 resulted in a $1.3 million benefit.

 

**Deemed Dividend on ConvertiblePreferred Shares**

 

Upon the conversion ofredeemable preferred shares into common shares as part of our IPO, we issuedapproximately 717,000 additional shares of common stock attributable to a beneficialconversion feature included in the previously issued redeemable preferredinterest. The $9.6 million intrinsic value of such shares is a deemed dividendon convertible preferred shares, which is reported after net income to reachnet income attributable to common stockholders.

 

**Net Income (Loss) Attributable toCommon Stockholders**

 

As a result of theforegoing, we reported net income attributable to common stockholders of $46.8million for the nine months ended September 30, 2004, representing a $57.4million improvement from the $(10.6) million loss we reported for the ninemonths ended September 30, 2003.

 

**Liquidityand Capital Resources**

 

Historically, our primarysources of liquidity have been cash provided by operations and proceedsgenerated from the sale of our common equity and preferred shares.  On August 19, 2004, we completed the sale of 6,325,000shares of common stock at $11.50 per share in our IPO, for which we receivednet proceeds of $67.6 million.  Weincurred approximately $6.8 million in expenses related to our IPO.  Certain former members of Holdings LLC soldanother 6,325,000 million shares to the public, for which we received noproceeds.  We intend to use the netproceeds from our IPO for general corporate purposes, including providingadditional funds for our operations and to expand and diversify our productsand service offerings, although we have not yet determined a specific use.

 

Our principal liquidityrequirements are for working capital, capital expenditures and generalcorporate purposes. Our capital expenditures have historically relatedprimarily to developing our trading platforms, which included investments insoftware development and hardware, as well as building our data centers. Weestimate that our capital expenditures for 2004 will be approximately $22.0 millionfor continued development of our trading platforms, the development of newproducts and services, including market data products, and the relocation ofour data center currently located in New York, New York. For the nine monthsended September 30, 2004, capital expenditures amounted to $19.4 million.

 

30

----

 

At September 30, 2004, wehad cash and cash equivalents of $172.9 million, an increase of $61.1 millionas compared to December 31, 2003.  As ofSeptember 30, 2004 and December 31, 2003, cash and cash equivalents includedSection 31 fees (which consist of transaction fees collected from customers onsales of certain securities transacted on our trading platform and subsequentlyremitted to the SEC) of $6.1 million and $34.6 million, respectively. Duringthe nine months ended September 30, 2004, we provided cash of $50.4 millionfrom our operating activities, consisting of net income of $56.4 millionpartially offset by the $6.0 million net effect of non cash items and workingcapital management. We used $19.4 million in investing activities to purchasefixed assets and develop software. Also, we provided cash of $30.1 million fromfinancing activities consisting of the $67.6 million net proceeds from our IPO,partially offset by (i) $6.8 million of direct costs related to the IPO, (ii) a$24.6 million cash distribution to our former members of Holdings LLC, and(iii) repayment of a note and principal payments under capital leaseobligations of $6.1 million in the aggregate.

 

We believe that cash flowsfrom operating activities, together with net proceeds from our IPO, should besufficient for us to fund our current operations for at least the next twelve months.We believe that the net proceeds from our IPO strengthened our balance sheetand provide us with available cash to pursue our business strategy of expandingour business by increasing our market share, developing new products andservices and pursuing acquisitions and strategic alliances. To the extent werequire additional capital to fund our working capital or capital expenditures,we may borrow under a credit facility entered into in October 2003 by oursubsidiary, Archipelago Exchange, L.L.C., with J.P. Morgan Chase Bank. Underthis facility, trade receivables of Archipelago Exchange, L.L.C. will bepledged as collateral in connection with any future borrowing. No amounts havebeen drawn under the credit facility and the full $20.0 million remainsavailable for borrowing. If this proves insufficient, we intend to seekadditional financing in the credit or capital markets, although we may beunsuccessful in obtaining additional financing on acceptable terms or at all.

 

Our broker-dealersubsidiaries are subject to regulatory requirements intended to ensure theirrespective general financial soundness and liquidity, which require that theycomply with certain minimum capital requirements. These regulations, whichdiffer in the United States, the United Kingdom and Canada—the three countriesin which our broker-dealer subsidiaries do business—generally prohibit abroker-dealer subsidiary from repaying borrowings from us or our affiliates,paying cash dividends, making loans to us or our affiliates or otherwiseentering into transactions that would result in a significant reduction in itsregulatory net capital position without prior notification or approval of itsprincipal regulator.  Our capitalstructure is designed to provide each of our subsidiaries with capital andliquidity consistent with its business and regulatory requirements.

 

**SummaryDisclosures about Contractual Obligations and Off-Balance Sheet Arrangements**

 

Thefollowing table reflects a summary of our contractual cash obligations andother commercial commitments at November 5, 2004:

 
| ** **                  | ** ** | **Payments due by period** | ** ** |
|-----------------------------|------------|----------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| ** **                  |       | **(in  thousands)**        |       |
| Operating leases            |       | $                          | 28,862     |   | $ | 2,976 |   | $ | 6,464 |   | $ | 5,684 |   | $ | 13,738 |   |
| Purchase  obligations       |       | 5,570                      |       | 5,070 |   | 500 |   | — |   | — |   |
| Capital leases              |       | 2,043                      |       | 2,043 |   | — |   | — |   | — |   |
| Total                       |       | $                          | 36,475     |   | $ | 10,089 |   | $ | 6,964 |   | $ | 5,684 |   | $ | 13,738 |   |

 

InNovember 2004, we entered into an agreement to lease approximately 24,000square feet of office space in New York with aggregate lease payments in theamount of $12.7 million.

 

31

----

 

**Off-BalanceSheet Arrangements**

 

InNovember 2004, pursuant to a lease agreement, we applied for a $1.2 millionirrevocable standby letter of credit, which has periodic reductions to theamount required to be maintained until expiration in July 2015.  In connection with this letter of credit, weentered into a compensating balance agreement with our bank for one andone-half times the amount of the letter of credit.

 

InJune 2004, pursuant to a lease agreement, we applied for a $350,000 irrevocablestandby letter of credit, which expires on March 31, 2005.

 

Therespective beneficiaries of these letters of credit are the landlords ofcertain office space leased by us in New York and Chicago.

 

**CriticalAccounting Policies**

 

In addition to previously disclosed critical accounting policies (see “CriticalAccounting Policies” in our Final Prospectus filed with the SEC on August 12,2004), management has determined that the following represented a new criticalestimate:

 

*Income Taxes*

 

The objectives of accountingfor income taxes are to recognize the amount of taxes payable or refundable forthe current year and deferred tax liabilities and assets for the future taxconsequences of events that have been recognized in an entity’s financialstatements or tax returns. Significant judgment is required in assessing thefuture tax consequences of events that have been recognized in our financialstatements or tax returns. Fluctuations in the actual outcome of these futuretax consequences could have a material impact on our financial position orresults of operations.

 

**Seasonality**

 

Ourbusiness experiences seasonal fluctuations, reflecting reduced trading activityduring summer months, particularly in August.

 

**Item 3****.****Quantitative and Qualitative Disclosure about Market Risk**

 

Wedo not have material exposure to interest rate changes, commodity pricechanges, foreign currency fluctuations, or similar market risks. Furthermore,we have not entered into any derivative contracts to mitigate such risks. Inaddition, as the operator of an exchange facility and as an agency broker, wedo not trade securities for our own account or maintain inventories ofsecurities for sale, and therefore are not subject to equity price risk.

 

We are exposed to creditrisk from third parties, including customers, counterparties and clearingagents. These parties may default on their obligations to us due to bankruptcy,lack of liquidity, operational failure or other reasons. In particular, oursubsidiaries, Archipelago Securities, L.L.C. and Wave Securities, L.L.C., maybe exposed to credit risk, due to the default of trading counterparties, inconnection with the external routing and agency brokerage services we provideour customers. While we are not exposed to counterparty risk for tradesexecuted on ArcaEx (which are cleared through the National Securities ClearingCorporation), we are exposed to counterparty risk in connection with tradesexecuted by our outbound routing broker-dealer and our agency brokeragebroker-dealer.

 

32

----

 

**Item 4****. Controls and Procedures**

 

**Evaluationof Disclosure Controls and Procedures**

 

As of the end of the periodcovered by this report, an evaluation was carried out under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures. Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that the designand operation of these disclosure controls and procedures were effective. No significant changes were made in our internal controls or in other factorsthat could significantly affect these controls subsequent to the date of theirevaluation.

 

**PART II – Other Information**

 

**Item 1. Legal Proceedings**

 

**Matters Relating to Our Company**

 

Thefollowing is a description of developments with regard to litigation mattersrelating to our Company that were previously reported in our final Prospectusdated August 12, 2004.

* *

*Nasdaq Litigation.* In October 2003,Nasdaq filed a complaint against our Company and the Pacific Exchange in NewYork federal district court alleging that we have improperly used the “Nasdaq”and “QQQ” trademarks in our advertising activities without entering into alicense agreement to do so. Nasdaq has alleged that, among other things, wehave violated federal and common law and unfair competition laws, and havemisappropriated intellectual property. Nasdaq seeks to recover damages andprofits relating to the use of the symbol “QQQ,” including our use of “QQQ” inadvertising, and to preliminarily and permanently enjoin us from trading theQQQ product and any other proprietary financial product of Nasdaq without alicense from Nasdaq.

 

OnSeptember 15, 2004, Judge Denise Cote of the Southern District issued anorder granting our motion to dismiss Nasdaq’s common-law claims and ruled thatArcaEx has the right to facilitate trading of the Nasdaq-100 Tracking stock,QQQ; and, that Nasdaq had no rights in the QQQ that would permit Nasdaq torestrict trading by ArcaEx through imposing a licensing regime. In her orderJudge Cote also denied Archipelago’s motion to dismiss Nasdaq’s Lanham Actclaim against Archipelago’s advertisements, although she stated that the claim “appear[s]weak.” We filed an answer in response to Nasdaq’s remaining Lanham Act claim onOctober 6, 2004.

* *

*Lozman Litigation.*    Withrespect to an August 1999 civil action filed by Fane Lozman and Blue WaterPartners, Inc. in the Circuit Court of Cook County, Illinois against,among others, Archipelago Holdings, L.L.C. (the predecessor to the Company),Archipelago, L.L.C., and Mr. Putnam (the Chairman, CEO and a Director ofthe Company), on April 7, 2004, the Circuit Court denied the plaintiffs’motion to reinstate the two Archipelago defendants as parties to the litigationand vacate a March 20, 2000 order. The plaintiffs have not yet taken an appealfrom this decision. The plaintiff’s claims with respect to the remainingdefendants, including Mr. Putnam, are scheduled for trial on November 8, 2004.

* *

*Abovenet Litigation.*  In connection with a lawsuit filed in November 2003 in a state court in the State of New York regarding certain telecommunication services, in November 2004, the Company entered into a definitive settlement agreement in principal under which the Company paid to Abovenet approximately $1.7 million in exchange for Abovenet’s release of all claims against the Company.

 

33

----

 

*Borsellino Litigation.*On March 23, 2004, plaintiffs Lewis Borsellino and I.M. Acquisitions, L.L.C. filed a complaint in a state court in Illinois against Archipelago Holdings, L.L.C. and “ArcaEx”, among others, alleging unjust enrichment in connection with certain alleged activities of former members of Chicago Trading and Arbitrage, L.L.C. ("CTA"), an entity in which Mr. Borsellino claimed an interest.  In this action, the plaintiffs alleged that the former members of CTA, including Mr. Putnam, wrongfully diverted CTA assets to Archipelago Holdings and ArcaEx. The complaint sought a constructive trust on all property received as a result of the alleged activities. On May 21, 2004, the Company filed a motion to dismiss plaintiff’s claims against Archipelago Holdings, L.L.C. and “ArcaEx.” On September 14, 2004 the Illinois Circuit Court entered an order dismissing both Archipelago Holdings and “ArcaEx” from this litigation with prejudice. The Borsellino Litigation is described in greater detail below under — *Matters Relating to Mr. Putnam*.

 

In addition to the mattersdescribed above, from time to time we are involved in various legal proceedingsarising in the ordinary course of our business. We do not believe, based oncurrently available information, that the results of any of these proceedingswill have a material adverse effect on our operating results or financialcondition.

 

**Matters Relating to Mr. Putnam**

 

Inaddition to the *Lozman Litigation*which is scheduled for trial on November 8, 2004 and described above under — *Matters Relating to Our Company*, Mr. Putnam is currentlyinvolved in the following legal proceeding, to which the Company had also beena party, although the Company was dismissed from it on September 14, 2004.

 

*Borsellino Litigation.*    In September of 2000,plaintiffs Lewis Borsellino, a former business partner of Mr. Putnam and equityholder in CTA, and I.M. Acquisitions, L.L.C, an entity owned by Mr. Borsellino,filed a complaint in Illinois State Circuit Court naming Mr. Putnam and otherformer members of CTA as defendants. The complaint alleged that Mr. Putnam andthe other defendants secretly diverted assets of CTA to their other businessventures. The complaint also alleges that a 1998 Settlement Agreement betweenthe parties addressing these allegations was based on fraud, and that thedefendants violated their fiduciary duties with respect to plaintiffs byallegedly failing to disclose material information during the 1998 settlementnegotiations. Archipelago, L.L.C. (the predecessor company to the Company’swholly-owned subsidiary Wave Securities, L.L.C.) was also named as a defendantin this action although it was never a member of CTA.

 

On April 11, 2001, the courtdismissed Archipelago L.L.C. and the other defendants with prejudice from theSeptember 2000 complaint.  On May 2,2001, the plaintiffs filed a motion to vacate the court’s April 2001 dismissalorder and for leave to file an amended complaint against the originaldefendants.  On May 7, 2001, the courtdenied the plaintiffs’ motion to vacate the April 2001 dismissal order, butgranted to the plaintiffs the right to file another amended complaint againstall of the defendants except Archipelago L.L.C., stating that “there is no justreason to delay the enforcement or appeal of this Court’s Order of April 11,2001, dismissing defendant Archipelago L.L.C. with prejudice.” The plaintiffsdid not appeal the court’s decision with respect to Archipelago, L.L.C.

 

On May 21, 2001, plaintiffsfiled a second motion to vacate the court’s April 2001 dismissal order, and forleave to file an amended complaint against all of the defendants, exceptArchipelago L.L.C.  In November 2001, thecourt granted the plaintiffs’ motion and allowed the plaintiffs to file theiramended complaint against Mr. Putnam and the other defendants, exceptArchipelago L.L.C.

 

On January 16, 2002, theplaintiffs filed a second amended complaint that seeks compensatory andpunitive damages in excess of $80.0 million, as well as reimbursement ofattorneys’ fees and cost of litigation.

 

34

----

 

On November 12, 2002, Mr. Putnam and theother defendants filed a motion to dismiss the second amended complaint;however on October 27, 2004, the court denied the defendants’ motion.

 

On March 24, 2004, theplaintiff filed a motion for leave to file a third amended complaint, which, ifgranted, would replace the second amended complaint. On April 28, 2004 thedefendants filed a motion in opposition to the plaintiff’s motion for leave tofile a third amended complaint.  Nohearing date has been set for argument on this motion.

 

In addition to thelitigation described above, on March 23, 2004, plaintiffs filed a separatecomplaint against Archipelago Holdings, L.L.C. (the predecessor to the Company)and “ArcaEx” alleging, among other things, unjust enrichment in connection withthe alleged activities of the CTA member defendants, including Mr. Putnam. Thecomplaint sought a constructive trust on all property received as a result ofthe alleged activities. On May 21, 2004, the Company filed a motion to dismissplaintiffs’ claims against Archipelago Holdings, L.L.C. and “ArcaEx”.  On September 14, 2004, the Illinois CircuitCourt entered an order dismissing both Archipelago Holdings and “ArcaEx” fromthis litigation with prejudice.

 

**Item 2. Unregistered Sales of Equity Securities and Use ofProceeds**

 

*(a) Unregistered Sale of Equity Securities*

 

Between August 12, 2004 and September 30, 2004, wegranted options to purchase 811,479 shares of common stock at a purchase priceof $11.50 per share to certain employees and officers of the Company, as wellas 25,634 restricted stock units to the non-management directors of the Companyunder our 2004 Stock Incentive Plan**.**Thesetransactions were effected under Rule 701 of the Securities Exchange Act of1933, as amended, as transactions by an issuer under compensatory benefit plansand contracts relating to compensation within the parameters required byRule 701.

 

*(b) Use of Proceeds*

 

Our initial public offering of 11,000,000 shares ofcommon stock was effected through a Registration Statement on Form S-1 (FileNo. 333-113226) that was declared effective by the Securities and ExchangeCommission (“SEC”) on August 12, 2004. On August 12, 2004, 5,500,000 shares ofcommon stock were sold on our behalf, and 5,500,000 shares of common stock weresold by our selling stockholders at an initial public offering price of $11.50per share, for an aggregate offering price of $126.5 million with Goldman,Sachs & Co. and J.P. Morgan Securities Inc. as the lead managingunderwriters for the offering. In connection with the offering, theunderwriters were granted a 30-day option to purchase up to 1,650,000additional shares of common stock at the public offering price, less theunderwriting discount, to cover any over-allotments, which they exercised onAugust 19, 2004, resulting in the purchase of 1,650,000 shares (825,000 sharessold by the selling stockholders and 825,000 shares sold by the Company).

 

Goldman, Sachs & Co., JP Morgan, Bank of AmericaCorporation, Credit Suisse First Boston, Lehman Brothers Inc., Merrill Lynch& Co and Piper Jaffray (either directly or through their affiliates) wereboth underwriters for, and selling stockholders in the initial public offering.Collectively, these institutions sold in the offering and received offeringproceeds for 2,284,563 shares. Currently, Goldman, Sachs & Co. (either directly or through affiliates)owns approximately 15.5% of the Company’s common stock.

 

We paid to the underwriters underwriting discountsand commissions of approximately $5.1 million (with the over-allotment option)in connection with the offering. In addition, we estimate that we incurredadditional expenses (including finders fees and expenses paid to or forunderwriters) of approximately $6.8 million in connection with the offering,which when added to the underwriting discounts and commissions paid by us,amounts to total estimated expenses of approximately $11.9 million. Of theseoffering expenses $1.7 million was paid to

 

35

----

 

Goldman,Sachs & Co. No other offering expenses were paid directly or indirectly toany of our directors or officers (or their associates) or persons owning tenpercent or more of any class of our equity securities or to any otheraffiliates or others.

 

The net initial public offering proceeds to us,after deducting underwriting discounts and commissions and estimated offeringexpenses, were approximately $60.8 million. No net offering proceeds receivedby the Company have been paid directly or indirectly to any of our directors orofficers (or their associates) or persons owning ten percent or more of any classof our equity securities or to any other affiliates or others.****All of the net initial public offering proceeds remaininvested in short-term marketable securities pending application of the fundsto general corporate purposes, as described in the Registration Statement onForm S-1. There has been no material change in the planned use of the initialpublic offering proceeds as described in our final Prospectus filed with theSEC pursuant to Rule 424(b).

 

**Item 6. Exhibitsand Reports on Form 8-K**

 

*(a)** **Exhibits*

** **
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Exchange  Agreement, dated as of January 17, 2002, among Archipelago Holdings, L.L.C.,  REDIBook ECN LLC and the parties named therein. †                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 2.2                 |       | Contribution  Agreement, dated as of November 12, 2003, between Archipelago Holdings,  L.L.C. and GAP Archa Holdings, Inc. †                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 2.3                 |       | Agreement  and Plan of Merger, dated as of February 27, 2004, between Archipelago  Holdings, L.L.C. and GAP Archa Holdings, Inc. †                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 2.4                 |       | Letter  Agreement, dated February 27, 2004, among GAP-W, LLC, Archipelago  Holdings, L.L.C. and GAP Archa Holdings, Inc. †                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 2.5                 |       | Contribution  Agreement, dated July 12, 2000, among Archipelago Holdings, L.L.C., Pacific  Exchange, Inc. and PCX Equities, Inc. †                                                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 3.1                 |       | Form  of Certificate of Incorporation of Archipelago Holdings, Inc. †                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 3.2                 |       | Form  of Bylaws of Archipelago Holdings, Inc. †                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 3.3                 |       | Ninth  Amended and Restated Limited Liability Company Agreement of Archipelago  Holdings, L.L.C. †                                                                                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 3.4                 |       | Amendment  No.1 to Ninth Amended and Restated Limited Liability Company Agreement of  Archipelago Holdings, L.L.C. †                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 4.1                 |       | Specimen  Certificate of Common Stock. †                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 4.2                 |       | Registration  Rights Agreement, dated November 12, 2003, among Archipelago Holdings,  L.L.C., General Atlantic Partners 77, L.P., GAP Coinvestment Partners II,  L.P., GapStar, LLC, GAPCO GmbH & Co. KG, GAP-W, LLC, GAP Archa Holdings,  Inc., and the Class A Members of the Archipelago Holdings, L.L.C. and the  affiliates of certain of such Class A Members. † |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1*               |       | Lease  by and between Paramount Group, Inc., as Agent for 1177 Avenue of the  Americas, L.P. and Archipelago Holdings, Inc. dated November 4, 2004                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 31.1                |       | Section  302 Certification of the Chief Executive Officer                                                                                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 31.2                |       | Section  302 Certification of the Chief Financial Officer                                                                                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                            |
| 32.1                |       | Section  906 Certification of the Chief Executive Officer and Chief Financial Officer                                                                                                                                                                                                                                                                                           |

 

----

†Incorporated herein by reference from the Company’s Registration Statement onForm S-1 (File No. 333-113226) that was filed with and declared effective bythe SEC on August 12, 2004.

 

* Confidential treatmenthas been requested with respect to certain portions of this exhibit. Omittedportions have been filed separately with the Securities and ExchangeCommission.

 

*(b) Reports on Form 8-K*

 

TheCompany did not file any reports on Form 8-K during the quarter ended September30, 2004.

 

Pursuant to the requirementsof the Securities Act of 1934, the registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized, on November9, 2004.

 
|   | ARCHIPELAGO  HOLDINGS, INC. |
|--------|----------------------------------|
|   |                             |   |
|   |                             |   |
|   | By:                              | /s/  NELSON CHAI |
|   | * *                         | Nelson Chai*Chief Financial Officer* |

 

36

----