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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004 Commission file number 1-9700
THE CHARLES SCHWAB CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 94-3025021
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation or organization)
120 Kearny Street, San Francisco, CA 94108
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (415) 627-7000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
Common Stock - $.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
As of June 30, 2004, the aggregate market value of the voting stock held by
nonaffiliates of the registrant was $10,683,699,987. For purposes of this
information, the outstanding shares of Common Stock owned by directors and
executive officers of the registrant, and certain investment companies managed
by Charles Schwab Investment Management, Inc. were deemed to be shares of the
voting stock held by affiliates.
The number of shares of Common Stock outstanding as of February 15, 2005 was
1,319,520,384.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Form 10-K incorporates certain information contained in the
registrant's definitive proxy statement for its annual meeting of stockholders
to be held May 19, 2005 by reference to portions of that document.
THE CHARLES SCHWAB CORPORATION
Annual Report On Form 10-K
For Fiscal Year Ended December 31, 2004
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TABLE OF CONTENTS
Part I
- ------
Item 1. Business ---------------------------------------------------- 1
General Corporate Overview ------------------------------ 1
Business Strategy and Competitive Environment ----------- 1
Products and Services ----------------------------------- 2
Regulation ---------------------------------------------- 4
Sources of Revenues ------------------------------------- 5
Available Information ----------------------------------- 5
Item 2. Properties -------------------------------------------------- 5
Item 3. Legal Proceedings ------------------------------------------- 5
Item 4. Submission of Matters to a Vote of Security Holders --------- 7
Part II
- -------
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities ------- 7
Item 6. Selected Financial Data ------------------------------------- 8
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations ------------------------------- 9
Description of Business --------------------------------- 9
Overview ------------------------------------------- 9
Results of Operations ----------------------------------- 11
Liquidity and Capital Resources ------------------------- 18
Risk Management ----------------------------------------- 22
Critical Accounting Policies ---------------------------- 25
Forward-Looking Statements ------------------------------ 27
Item 7A. Quantitative and Qualitative Disclosures About Market Risk -- 29
Item 8. Financial Statements and Supplementary Data ----------------- 31
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure -------------------------------- 65
Item 9A. Controls and Procedures ------------------------------------- 65
Item 9B. Other Information ------------------------------------------- 65
Part III
- --------
Item 10. Directors and Executive Officers of the Registrant ---------- 65
Item 11. Executive Compensation -------------------------------------- 68
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters --------------- 68
Item 13. Certain Relationships and Related Transactions -------------- 68
Item 14. Principal Accountant Fees and Services ---------------------- 68
Part IV
- -------
Item 15. Exhibits and Financial Statement Schedule ------------------ 68
Exhibit Index ------------------------------------------- 69
Signatures ---------------------------------------------- 75
Index to Financial Statement Schedule ------------------ F-1
THE CHARLES SCHWAB CORPORATION
PART I
Item 1. Business
General Corporate Overview
The Charles Schwab Corporation (CSC), headquartered in San Francisco,
California, and its subsidiaries (collectively referred to as the Company, and
primarily located in San Francisco except as indicated), was incorporated in
1986 and engages, through its subsidiaries, in securities brokerage, banking,
and related financial services. Client assets totaled $1.081 trillion in
7.3 million active client accounts(a) at December 31, 2004. Charles Schwab &
Co., Inc. (Schwab), incorporated in 1971 and entered the discount brokerage
business in 1974, is a securities broker-dealer with 236 domestic branch offices
in 43 states, as well as a branch in the Commonwealth of Puerto Rico. U.S. Trust
Corporation (USTC, and with its subsidiaries collectively referred to as
U.S. Trust), which was acquired in 2000 and is located in New York City, New
York, is a wealth management firm that through its subsidiaries also provides
fiduciary services and private banking services with 37 offices in 15 states.
Charles Schwab Bank, N.A. (Schwab Bank), is a retail bank located in Reno,
Nevada which commenced operations in April 2003.
Other subsidiaries of CSC include Charles Schwab Investment Management,
Inc. (CSIM), CyberTrader, Inc. (CyberTrader), located in Austin, Texas, and The
Charles Schwab Trust Company (CSTC). CSIM is the investment advisor for Schwab's
proprietary mutual funds. The Company refers to certain funds for which CSIM is
the investment advisor as the SchwabFunds(R). CyberTrader, which was acquired in
2000, is an electronic trading technology and brokerage firm providing services
to highly active, online traders. CSTC serves as trustee for employee benefit
plans, primarily 401(k) plans.
On October 29, 2004, the Company sold its capital markets business,
consisting of the partnership interests of Schwab Capital Markets L.P. and all
of the outstanding capital stock of SoundView Technology Group, Inc.
(collectively referred to as Schwab Soundview Capital Markets, or SSCM). In
2003, the Company substantially exited from its international operations with
the sales of its U.K. brokerage subsidiary, Charles Schwab Europe, and its
investment in Aitken Campbell, a market-making joint venture in the U.K. In
2001, USTC sold its Corporate Trust business. For further information on these
transactions, see "Item 8 - Financial Statements and Supplementary Data - Notes
to Consolidated Financial Statements - 5. Discontinued Operations, 6. Business
Acquisitions and Divestitures, and 4. Sale of Corporate Trust Business."
As of December 31, 2004, the Company had full-time, part-time and temporary
employees, and persons employed on a contract basis that represented the
equivalent of 14,200 full-time employees.
The Company provides financial services to individuals and institutional
clients through three segments - Individual Investor, Institutional Investor,
and U.S. Trust. The Individual Investor segment includes the Company's retail
brokerage and banking operations. The Institutional Investor segment provides
custodial, trading and support services to independent investment advisors
(IAs), serves company 401(k) plan sponsors and third-party administrators, and
supports company stock option plans. The U.S. Trust segment provides investment,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients. For financial information by segment for
the three years ended December 31, 2004, as well as a discussion of the
previously-reported Capital Markets segment, see "Item 8 - Financial Statements
and Supplementary Data - Notes to Consolidated Financial Statements - 26.
Segment Information."
Business Strategy and Competitive Environment
Consistent with the Company's vision of being the most useful and ethical
provider of financial services in the world, its primary strategy is to meet the
financial services needs of individual investors and the independent IAs who
serve them. In pursuit of this strategy, the Company has refocused on improving
service for these clients and building stronger relationships with them,
simplified its organizational structure and client offers, reduced its
commission rates and fees, and exited the capital markets business.
Another important element of the Company's strategy is its ongoing emphasis
on combining people and technology in ways that facilitate the delivery of a
full range of investment services at great value. People provide the client
focus and personal touch that are essential in serving investors, while
technology helps create services that are scalable and consistent. This
combination helps the Company to deliver useful, relevant, and value-priced
offerings to a broad array of clients - independent investors, individuals
investing through retirement plans, individuals seeking advice, active traders,
and independent IAs - and compete for a large percentage of the trillions of
investable wealth in the U.S. To attract and serve these clients, the Company
offers a broad and growing array of investment, banking and lending products.
The Company's competition in serving independent investors includes a wide
range of brokerage and asset management firms. In serving these investors, the
Company offers branch, telephonic and online service capabilities and
- ---------------------------
(a) Accounts with balances or activity within the preceding eight months.
- 1 -
THE CHARLES SCHWAB CORPORATION
an extensive product line. Schwab's network of branches and regional telephone
service centers is staffed with trained and experienced financial consultants
focused on building and sustaining client relationships. In addition, the
Company offers the ability to meet client trading and/or advice needs through a
single ongoing relationship, even as those needs change over time, and it also
provides access to automated online and telephonic channels to provide quick and
efficient access to an extensive array of information, research, tools, trade
execution, and administrative services. Individuals investing for retirement
through 401(k) plans can take advantage of the Company's bundled offering of
multiple investment choices, education and third-party advice.
Competition in serving investors looking for an advisory relationship
involves a variety of traditional brokerage, asset management, and wealth
advisory firms. Management believes that the Company's competitive strengths in
this arena revolve around its ability to provide clients with an individually
tailored solution - ranging from occasional consultations to an ongoing
relationship with a Schwab Consultant, IA, or U.S. Trust advisor - versus the
more fragmented offerings of other firms.
For active traders, the Company primarily competes with deep-discount,
online-focused firms as well as certain larger financial institutions.
Management believes the Company can continue to attract these clients because it
combines highly competitive pricing and expert tools with extensive service
capabilities - including experienced, knowledgeable teams of trading specialists
and integrated product offerings. The Company also offers these clients access
to all of the other tools, products, and advice available at Schwab to help them
manage their diverse and complex portfolios.
In the IA arena, the Company competes with institutional custodians,
traditional and discount brokers, banks and trust companies. Management believes
that its Schwab Institutional(R) unit can maintain its market leadership
position through a combination of superior service, scale, dedicated resources,
and extensive familiarity with the industry. Schwab Institutional also leverages
technology to provide IAs with the tools and support they need to grow and
manage their practices efficiently.
Overall, management believes that the Company's multi-channel service
delivery model of branch, phone and internet access is essential to its ability
to compete effectively with the wide variety of financial services firms
striving to attract client relationships and assets across the spectrum of
investors. Under this model, the Company can offer personalized service at
competitive prices while giving clients the choice of where, when and how they
do business with the firm. Another important aspect of the Company's ability to
compete is its ongoing focus on efficiency and productivity, as lower costs give
the Company greater pricing flexibility. Management believes that this focus
remains important in light of the recent competitive environment, in which a
number of competitors reduced online trading commission rates and account fees.
Additionally, the Company's nationwide marketing effort is an important
competitive tool because it reinforces the attributes of the Schwab(R), U.S.
Trust(R) and CyberTrader(R) brands, thereby leveraging the local marketing
endeavors of the 3,700 Company staff in the offices and service centers.
In addition to competition from other financial services firms, the Company
faces competition for quality professionals and other personnel, and its ability
to continue to compete effectively will depend upon its ability to attract new
employees and retain existing employees while managing compensation. The
Company's business can also be significantly affected by the general environment
- - economic, corporate, securities market, regulatory and geopolitical
developments all play a role in client asset valuations, trading activity,
interest rates and overall investor engagement. For a discussion of the business
environment faced by the Company in 2004, see "Item 7 - Management's Discussion
and Analysis of Financial Condition and Results of Operations - Description of
Business - Overview."
Products and Services
The Company offers a broad range of products to address its clients'
varying investment and financial needs. Examples of these product offerings
include:
o Brokerage - various asset management accounts including some with
check-writing features, individual retirement accounts, Keogh accounts, 529
college savings accounts, margin loans, and access to fixed income
securities, and equity and debt offerings;
o Banking - first mortgages, home equity lines of credit, pledged-asset
mortgages, certificates of deposit, demand deposit accounts, private
banking accounts, and credit cards; and
o Mutual funds - third-party mutual funds through Mutual Fund Marketplace(R),
including no-load mutual funds through the Mutual Fund OneSource(R)
service, proprietary mutual funds from two fund families - SchwabFunds(R)
and Excelsior(R) Funds, and mutual fund trading and clearing services to
broker-dealers.
In addition, the Company offers a wide array of services designed to meet
the needs of independent, advised, and actively trading investors.
The Company's products and services are made available through its three
segments - Individual Investor, Institutional Investor, and U.S. Trust.
Individual Investors
Clients of the Company, through the Individual Investor segment or
indirectly through the Institutional Investor segment, have access to the
services described below.
- 2 -
THE CHARLES SCHWAB CORPORATION
Independent Investors. For investors who make their own investment
decisions, the Company offers research, analytic tools, performance reports,
market analysis, and educational material. Clients looking for more guidance
have access to online portfolio planning tools, as well as professional advice
from Schwab's investment specialists who can help develop an investment strategy
and carry out investment and portfolio management decisions.
Schwab strives to demystify investing by educating and assisting clients in
the development of investment plans. Educational tools include workshops,
interactive courses, and online information about investing. Additionally,
Schwab provides various Internet-based research and analysis tools which are
designed to help clients achieve better investment outcomes. As an example of
such tools, Schwab Equity Ratings(R) is a quantitative model-based stock rating
system which provides all clients with ratings on approximately 3,000 stocks,
assigning each equity a single grade: A, B, C, D, or F. Stocks are rated based
on specific factors relating to fundamentals, valuation, momentum, and risk, and
ranked so that the number of 'buy consideration' ratings - As and Bs - equals
the number of 'sell consideration' ratings - Ds and Fs.
Advised Investors. The Company seeks to provide clients with customized
advice that is uncomplicated and not influenced by commissions on transactions.
The Company's approach to advice is based on long-term investment strategies and
guidance on portfolio diversification and asset allocation. This approach is
designed to be offered consistently across all of Schwab's delivery channels.
Schwab Private ClientTM features a face-to-face advice relationship with a
designated Schwab consultant who offers individualized service, provides ongoing
investment strategy and execution, and acts as a liaison between clients and a
team of Schwab professionals.
The Schwab Advisor Network(R) is designed for investors who want the
assistance of an independent professional in managing their financial affairs.
The IAs in the Schwab Advisor Network provide investors with personalized
portfolio management, financial planning, and wealth management solutions.
Through this program, certain Schwab clients and potential clients who desire
personalized investment management, wealth management, trust, and private
banking services can also receive referrals to U.S. Trust.
Actively Trading Investors. The Company strives to deliver information,
education, technology, service and pricing which meets the needs of active
traders. For highly active traders, CyberTrader offers integrated Web- and
software-based trading platforms, which incorporate direct access and
intelligent order routing technology, real-time market data, options trading,
and premium stock research. For active traders, Schwab also offers Web- and
software-based trading platforms with account management features, risk
management tools, multi-channel access, and dedicated personal support.
Global Dollar Services. The Company's global dollar business serves both
foreign investors and non-English-speaking U.S. clients who wish to trade or
invest in U.S. dollar-based securities. The Company has a physical presence in
the United Kingdom and Hong Kong. In the U.S., the Company serves Chinese-,
Korean-, Vietnamese- and Spanish-speaking clients through a combination of
designated branch offices and Web-based and telephonic services.
Institutional Investors
Schwab Institutional.(R) Through the Institutional Investor segment, Schwab
provides custodial, trading, technology, Web, and other support services to IAs,
whose services are integral to the Company's advice offerings. To attract and
serve advisors, Schwab Institutional has a dedicated sales force and experienced
registered representatives assigned to individual advisors.
IAs who custody client accounts at Schwab may use proprietary software
which provides IAs with up-to-date client account information, as well as
trading capabilities. Participating IAs may also utilize the Schwab
Institutional website, the core platform for IAs to conduct daily business
activities online with Schwab, including submitting client account information,
and retrieving news and market information; as well as a service which enables
IAs to provide their clients with personalized equity portfolio management by a
variety of institutional asset managers.
Corporate Services. The Company provides 401(k) recordkeeping and other
retirement plan services to corporations and professional organizations. A
dedicated sales force markets these services directly to such organizations, and
the Company also serves plan sponsors indirectly through alliances with
third-party administrators. The Company's bundled 401(k) retirement plan product
offers plan sponsors a wide array of investment options, participant education
and servicing, trustee services, and participant-level recordkeeping.
Participants in these plans have access to customized advice provided by a third
party.
- 3 -
THE CHARLES SCHWAB CORPORATION
U.S. Trust
U.S. Trust provides an array of financial services for affluent clients and
their families. These services include investment and wealth management, trust,
custody, financial and estate planning, and private banking. For clients with
less than $2 million in assets at U.S. Trust, the firm offers Wealth Advisory
Accounts, an investment advisory service that utilizes the Excelsior(R) family
of mutual funds. For clients with $2 million to $50 million in assets, U.S.
Trust provides both individually managed balanced portfolios (i.e., portfolios
that are invested in several different asset classes with the overall goal of
preserving and enhancing those assets) and specialized investment management
services. In addition to investment management services, U.S. Trust provides
specialized fiduciary, financial planning, enhanced master custody, and
philanthropic consulting services to clients that have over $50 million in
assets at U.S. Trust. U.S. Trust also offers private banking services to assist
in meeting the credit and liquidity requirements of its clients.
For institutional clients, including corporations, endowments, foundations,
and pension plans, U.S. Trust provides investment management, brokerage, and
special fiduciary services. Through these investment management services,
U.S. Trust offers a wide range of investment options, including balanced and
specialized domestic and international equity investments, structured
investments, alternative investments, fixed income securities, and short-term
cash management. Institutional clients can also utilize the Excelsior Funds.
Additionally, U.S. Trust offers investment, consulting, and fiduciary services
for employee stock ownership plans.
Regulation
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Federal Reserve Board under the
Bank Holding Company Act of 1956, as amended. CSC's depository institution
subsidiaries, including Schwab Bank and affiliates of U.S. Trust, are subject to
regulation under federal and state law, including supervision by federal and
state banking authorities. For a discussion of bank holding company
requirements, see "Item 8 - Financial Statements and Supplementary Data - Notes
to Consolidated Financial Statements - 22. Regulatory Requirements."
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. Schwab and CyberTrader are
registered as broker-dealers with the SEC, the fifty states, and the District of
Columbia and Puerto Rico. Schwab and CSIM are registered as investment advisors
with the Securities and Exchange Commission (SEC). Additionally, Schwab is
regulated by the Commodities Futures Trading Commission (CFTC) with respect to
the futures and commodities trading activities it conducts as an introducing
broker.
Much of the regulation of broker-dealers has been delegated to
self-regulatory organizations (SROs), namely the national securities exchanges
and the Municipal Securities Rulemaking Board (MSRB). Schwab is a member of a
number of national securities exchanges and is consequently subject to their
rules and regulations. The primary regulators of Schwab and CyberTrader are the
National Association of Securities Dealers (NASD) and, for municipal securities,
the MSRB. The CFTC has designated the National Futures Association (NFA) as
Schwab's primary regulator for futures and commodities trading activities. The
Company's business is also subject to oversight by regulatory bodies in other
countries in which the Company operates.
The principal purpose of regulating broker-dealers and investment advisors
is the protection of clients and the securities markets. The regulations to
which broker-dealers and investment advisors are subject cover all aspects of
the securities business, including, among other things, sales and trading
practices, publication of research, margin lending, uses and safekeeping of
clients' funds and securities, capital adequacy, recordkeeping and reporting,
fee arrangements, disclosure to clients, fiduciary duties owed to advisory
clients, and the conduct of directors, officers and employees.
New legislation, rule changes, or changes in the interpretation or
enforcement of existing federal, state and SRO rules and regulations may
directly affect the operation and profitability of the Company. The
profitability of the Company could also be affected by rules and regulations
which impact the business and financial communities generally, including changes
to the laws governing taxation, electronic commerce, and security of client
data.
The Company is subject to claims, lawsuits, regulatory examinations and
enforcement proceedings in the ordinary course of business, which can result in
settlements, awards, censures, fines, cease and desist orders, or suspension or
expulsion of an affiliate, its officers, or employees.
As registered broker-dealers, certain subsidiaries of CSC, including Schwab
are subject to SEC Rule 15c3-1 (the Net Capital Rule) and related SRO
requirements. The CFTC and NFA also impose net capital requirements. The Net
Capital Rule specifies minimum capital requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. Because CSC
itself is not a registered broker-dealer, it is not subject to the Net Capital
Rule. However, if Schwab failed to maintain specified levels of net capital,
such failure would constitute a default by CSC under certain debt covenants.
The Net Capital Rule limits broker-dealers' ability to transfer capital to
parent companies and other affiliates. Compliance with the Net Capital Rule
could limit Schwab's operations and its ability to repay subordinated debt to
CSC, which in turn could limit CSC's ability to repay debt, pay cash dividends
and purchase shares of its outstanding stock.
- 4 -
THE CHARLES SCHWAB CORPORATION
See also "Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operation - Liquidity and Capital Resources - Liquidity" and
"Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 22. Regulatory Requirements."
Sources of Revenues
For revenue information by source for the three years ended December 31,
2004, see "Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operations - Results of Operations - Revenues."
Available Information
The Company files annual, quarterly, and current reports, proxy statements
and other information with the SEC. You may read and copy any document we file
with the SEC at the SEC's public reference room at 450 Fifth Street, NW,
Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on
the public reference room. The SEC maintains an Internet website that contains
annual, quarterly and current reports, proxy and information statements and
other information that issuers (including the Company) file electronically with
the SEC. The SEC's Internet website is www.sec.gov.
On the Company's Internet website, www.aboutschwab.com, the Company posts
the following filings as soon as reasonably practicable after they are
electronically filed with or furnished to the SEC: the Company's annual reports
on Form 10-K, the Company's quarterly reports on Form 10-Q, the Company's
current reports on Form 8-K, and any amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934. All such filings on the Company's website are available free of charge.
Item 2. Properties
A summary of the Company's significant locations at December 31, 2004 is
presented in the following table. All locations are leased, except as noted
below. The square footage amounts (in thousands) are presented net of space that
has been subleased to third parties.
- --------------------------------------------------------------------------------
Square Footage
Location Leased Owned
- --------------------------------------------------------------------------------
Corporate office space:
San Francisco, CA (1) 1,607 -
New York, NY (2) 436 -
Service centers:
Phoenix, AZ (3,4) 107 1,009
Denver, CO (3) 274 -
Orlando, FL (3) 106 -
Indianapolis, IN (3) - 113
- --------------------------------------------------------------------------------
(1) Includes Schwab headquarters.
(2) Includes U.S. Trust headquarters.
(3) Includes a regional telephone service center.
(4) Includes two data centers and an administrative support center.
Substantially all of the Company's branch offices are located in leased
premises. The corporate headquarters, data centers, offices, and service centers
generally support all of the Company's segments.
From 2001 to 2004, the Company initiated restructuring initiatives that
included reductions in facilities. For a discussion of such initiatives, see
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operation - Description of Business" and "Item 8 - Financial
Statements and Supplementary Data - Notes to Consolidated Financial Statements -
3. Restructuring Charges." Properties that are included in the Company's
restructuring initiatives are excluded from the table above.
Item 3. Legal Proceedings
CSC and its subsidiaries have been named as parties in various legal
actions, which include the matters described below. It is inherently difficult
to predict the ultimate outcome of these matters, particularly in cases in which
claimants seek substantial or unspecified damages, and a substantial judgment,
settlement or penalty could be material to the Company's operating results for a
particular future period, depending on the Company's results for that period.
However, based on current information, it is the opinion of management, after
consultation with counsel, that the resolution of these matters will not have a
material adverse impact on the financial condition, results of operations or
cash flows of the Company.
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THE CHARLES SCHWAB CORPORATION
Mutual Funds Litigation: Since November 2003, multiple purported class
action and derivative lawsuits have been filed against the Company and certain
affiliates, officers and directors in connection with alleged improper and
illegal mutual fund trading practices.
Two stockholders' derivative actions were filed in California Superior
Court in San Francisco in March and April 2004 against CSC and sixteen current
or former CSC directors. These actions allege that the directors breached their
fiduciary duties to Schwab and its stockholders by allegedly failing to maintain
adequate controls to prevent improper mutual fund trading practices. The
lawsuits seek the recovery of unspecified compensatory damages and attorneys'
fees from the named individuals, along with the return of all salaries and other
remuneration they received as directors. CSC is named as a nominal defendant,
although no damages are sought against CSC.
Several lawsuits filed in federal court relating to mutual fund trading
practices have been consolidated in U.S. District Court in Maryland for the
purpose of consolidated and coordinated pre-trial proceedings. Lead plaintiffs
and lead counsel have been appointed, and lead plaintiffs have filed
consolidated and amended complaints in such actions as follows:
During September 2004, purported Excelsior(R) Fund shareholders filed a
consolidated amended class action complaint against USTC, United States Trust
Company of New York (U.S. Trust NY), Schwab and the Excelsior Funds. Plaintiffs
allege that the defendants breached fiduciary duties and violated various
federal securities laws by permitting market timing and late trading in the
Excelsior Funds and by failing to disclose such timing in the fund prospectuses.
Plaintiffs seek unspecified compensatory and punitive damages, and disgorgement
of investment advisory fees.
During September 2004, certain Excelsior Fund shareholders also filed a
consolidated amended derivative action on behalf of nominal defendants Excelsior
Funds Inc., Excelsior Funds Trust, and Excelsior Tax Exempt Funds Inc. (the Fund
Companies), against CSC, USTC, U.S. Trust NY, U.S. Trust Company, N.A.
(U.S. Trust NA), various current and former officers, directors and trustees of
the Excelsior Funds (the U.S. Trust and Excelsior Defendants) and various
third-party defendants. Plaintiffs allege that the U.S. Trust and Excelsior
Defendants breached fiduciary duties and violated federal securities laws by
permitting market timing in the Excelsior Funds and by failing to disclose such
timing in the fund prospectuses. Plaintiffs seek, on behalf of the Fund
Companies, unspecified monetary damages, as well as removal of the Excelsior
Fund directors, removal of U.S. Trust as advisor to the funds, rescission of
U.S. Trust's investment advisory contracts with the funds, and disgorgement of
management fees and compensation relating to the funds.
During October 2004, certain CSC shareholders filed a consolidated amended
class action complaint on behalf of purchasers of CSC stock, against CSC,
Schwab, U.S. Trust NA, U.S. Trust NY and current and former CSC and U.S. Trust
officers and directors Charles Schwab, Alan Weber, David Pottruck, and Jeffrey
Maurer. Plaintiffs allege that the defendants violated federal securities laws
by failing to disclose alleged improper mutual fund trading practices.
Plaintiffs seek unspecified compensatory damages.
During October 2004, Schwab was named in three additional class action
lawsuits brought on behalf of shareholders in the Invesco, MFS, and
Pilgrim-Baxter mutual fund families. The lawsuits, which were filed in U.S.
District Court in Maryland, allege that Schwab and more than 38 other
broker-dealers, banks, and other financial intermediaries acted as conduits for
market-timing and late-trading activity by disregarding excessive trading on
their platforms and facilitating such activity. Plaintiffs seek unspecified
compensatory and punitive damages.
The Company believes it has strong defenses and is vigorously contesting
each of the above mentioned claims.
Mutual Funds Regulatory Matters: The Company has been responding to
inquiries and subpoenas from federal and state authorities relating to
circumstances in which a small number of parties were permitted to engage in
short-term trading of certain Excelsior Funds through U.S. Trust. Although the
Company is unable to predict the ultimate outcome of these matters, any
enforcement actions instituted as a result of the investigations may subject the
Company to fines, penalties or other administrative remedies. The Company is
cooperating with regulators, and has taken steps to enhance its existing
policies and procedures to further discourage, detect, and prevent market timing
and late trading.
SoundView Technology Group, Inc. (SoundView) Litigation: As part of the
sale of SoundView to UBS Securities LLC and UBS Americas Inc. (collectively
referred to as UBS), the Company agreed to indemnify UBS for any expenses
associated with certain litigation, including the following matters:
SoundView and certain of its subsidiaries are among the numerous financial
institutions named as defendants in multiple purported securities class actions
filed in the United District Court for the Southern District of New York (the
IPO Allocation Litigation) between June and December 2001. The IPO Allocation
Litigation was brought on behalf of persons who either directly or in the
aftermarket purchased IPO securities between March 1997 and December 2000. The
plaintiffs allege that SoundView and the other underwriters named as defendants
required customers receiving allocations of IPO shares to pay excessive and
undisclosed commissions on unrelated trades and to purchase shares in the
aftermarket at prices higher than the IPO price, in violation of the federal
securities laws. SoundView has been named in 31 of the actions - each involving
a different company's IPO - which
- 6 -
THE CHARLES SCHWAB CORPORATION
have been consolidated with 280 other actions in which SoundView is not named as
a defendant. The parties, with the assent of the Court, have selected 17 of
these cases as focus cases for the purpose of case-specific discovery, and the
Court has certified the existence of a class in the focus cases. Wit Capital, a
SoundView predecessor, is a defendant in one of the focus cases. Additionally,
SoundView and/or related entities had underwriting commitments in approximately
11 other focus cases; SoundView entities are not named as defendants in these
cases, but may have indemnification obligations to the lead underwriters
depending on the outcome of these actions. The Company is vigorously contesting
such claims on behalf of SoundView pursuant to the above-mentioned indemnity.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of 2004.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
The Company's common stock is listed on the New York Stock Exchange and the
Nasdaq Stock Market under the ticker symbol SCH. The number of common
stockholders of record as of February 15, 2005 was 11,666. The closing market
price per share on that date was $10.95.
The other information required to be furnished pursuant to this item is
included in "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 29. Quarterly Financial Information
(Unaudited)."
(c) Issuer Purchases of Equity Securities
The following table summarizes purchases made by or on behalf of CSC of its
common stock for each calendar month in the fourth quarter of 2004.
- --------------------------------------------------------------------------------
(In millions, except Total Number Approximate
per share amounts) of Shares Dollar Value of
Purchased as Shares that
Total Number Average Part of Publicly May Yet be
of Shares Price Paid Announced Purchased under
Month Purchased (1) per Share Program (1) the Program
- --------------------------------------------------------------------------------
October 7 $ 8.95 7 $109
November 11 9.94 11 -
December 5 11.94 5 234
- --------------------------------------------------------------------------------
Total 23 $10.13 23 $234
================================================================================
(1) All shares were repurchased under authorizations by CSC's Board of
Directors of $300 million, $250 million, and $500 million of common stock
publicly announced by the Company on December 9, 2004, March 17, 2003, and
September 20, 2001, respectively. Both the March 17, 2003 and September 20,
2001 authorizations have been exhausted. Unless modified or revoked by the
Board of Directors, the remaining authorization does not have an expiration
date.
The Company may receive shares to pay the exercise price and/or to satisfy
tax withholding obligations by employees who exercise stock options (granted
under employee stock incentive plans), which are commonly referred to as stock
swap exercises. Such exercises represented less than 500,000 per month for each
of the months presented in the above table.
- 7 -
THE CHARLES SCHWAB CORPORATION
Item 6. Selected Financial Data
Selected Financial and Operating Data
(In Millions, Except Per Share Amounts, Ratios, Number of Domestic Offices,
Average Revenue Per Revenue Trade, and as Noted)
- ------------------------------------------------------------------------------------------------------------------------------------
Growth Rates
-------------------
Compounded Annual
4-Year 1-Year
2000-2004 2003-2004 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Results of Operations
Revenues (1) (5%) 8% $ 4,202 $ 3,896 $ 3,944 $ 4,068 $ 5,199
Expenses excluding interest (1) (4%) 12% $ 3,557 $ 3,179 $ 3,695 $ 3,941 $ 4,183
Income from continuing operations before
extraordinary gain (1) (8%) (13%) $ 414 $ 476 $ 149 $ 75 $ 583
Net income (21%) (39%) $ 286 $ 472 $ 109 $ 199 $ 718
Income from continuing operations per share - basic (1) (8%) (11%) $ .31 $ .35 $ .11 $ .05 $ .43
Income from continuing operations per share - diluted (1) (8%) (14%) $ .30 $ .35 $ .11 $ .05 $ .41
Basic earnings per share (2) (21%) (40%) $ .21 $ .35 $ .08 $ .14 $ .53
Diluted earnings per share (2) (20%) (40%) $ .21 $ .35 $ .08 $ .14 $ .51
Dividends declared per common share 16% 48% $ .074 $ .050 $ .044 $ .044 $ .041
Weighted-average common shares outstanding - diluted 1,365 1,364 1,375 1,399 1,404
Non-trading revenues as a percentage of revenues (1,3) 76% 69% 69% 66% 55%
Trading revenues as a percentage of revenues (1,3) 24% 31% 31% 34% 45%
Effective income tax rate on income from continuing
operations (1) 35.8% 33.6% 40.2% 41.4% 42.6%
Capital expenditures - cash purchases of equipment,
office facilities, property, and internal-use
software development costs, net (4) (27%) 32% $ 194 $ 147 $ 154 $ 295 $ 689
Capital expenditures as a percentage of revenues (4) 5% 4% 4% 7% 13%
====================================================================================================================================
Performance Measures
Pre-tax profit margin (1) 15.3% 18.4% 6.3% 3.1% 19.5%
After-tax profit margin (1) 6.8% 12.1% 2.8% 4.9% 13.8%
Return on stockholders' equity 6% 11% 3% 5% 21%
====================================================================================================================================
Financial Condition (at year end)
Total assets 5% 3% $ 47,133 $ 45,866 $ 39,705 $ 40,464 $ 38,154
Long-term debt (7%) (24%) $ 585 $ 772 $ 642 $ 730 $ 770
Stockholders' equity 1% (2%) $ 4,386 $ 4,461 $ 4,011 $ 4,163 $ 4,230
Assets to stockholders' equity ratio 11 10 10 10 9
Long-term debt to total financial capital
(long-term debt plus stockholders' equity) 12% 15% 14% 15% 15%
====================================================================================================================================
Client Information (at year end)
Client assets (in billions) 6% 12% $1,081.2 $ 966.7 $ 764.8 $ 845.9 $ 871.7
Active client accounts (5) (1%) (3%) 7.3 7.5 8.0 7.8 7.5
Total mutual fund assets (in billions) 8% 14% $ 441.3 $ 386.8 $ 323.8 $ 342.8 $ 330.3
Independent investment advisor client
assets (in billions) (6) 11% 21% $ 348.2 $ 287.1 $ 222.4 $ 235.0 $ 231.3
Independent investment advisor client
accounts (in thousands) (6) 7% 6% 1,316.3 1,238.8 $1,182.4 $1,081.7 $ 986.5
Number of domestic offices (10%) (27%) 273 376 422 429 415
====================================================================================================================================
Employee Information (4)
Full-time equivalent employees
(at year end, in thousands) (14%) (11%) 14.2 16.0 16.4 19.2 25.9
Revenues per average full-time equivalent
employee (in thousands) 5% 10% $ 269 $ 245 $ 214 $ 183 $ 218
Compensation and benefits expense as a
percentage of revenues 45% 43% 44% 44% 44%
====================================================================================================================================
(1) Amounts have been adjusted to summarize the impact of The Charles Schwab Corporation's (the Company's) sales of its capital
markets business, Schwab Soundview Capital Markets, and its United Kingdom (U.K.) brokerage susidiary, Charles Schwab Europe,
in loss from discontinued operations.
(2) Both basic and diluted earnings per share include discontinued operations and extraordinary gains.
(3) Non-trading revenues include asset management and administration fees, net interest revenue, and other revenues. Trading
revenues include commission and principal transaction revenues.
(4) Amounts have been adjusted to reflect the sale of Schwab Soundview Capital Markets.
(5) Reflects the removal of 192,000 accounts in 2003 related to the Company's withdrawal from the Employee Stock Purchase Plan
business and the transfer of those accounts to other providers. Active accounts are defined as accounts with balances or
activity within the preceding eight months.
(6) Represents amounts related to the Schwab Institutional(R) unit.
- 8 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
DESCRIPTION OF BUSINESS
Overview
Securities market returns were mixed for much of 2004 due to the cumulative
effects of ongoing geopolitical, economic and energy market uncertainties,
concerns about rising interest rates, and a close presidential election. While
this environment weighed on client engagement, the Company actively pursued its
strategy of refocusing on its core client base, improving product and service
offerings for those clients, lowering pricing, and streamlining its overall
infrastructure. In addition, the Company embarked on a firm-wide cost reduction
effort designed to mitigate the effects of its price reductions and to improve
overall efficiency and productivity.
During the fourth quarter of 2004, the election was decided and market
returns turned positive. In this improved environment, client asset valuations
recovered and daily average revenue trades rose by 39% over third quarter lows.
The Dow Jones Industrial Average, the Standard and Poor's 500 Index, and the
Nasdaq Composite Index ended 2004 up 3%, 9%, and 9%, respectively. Total client
assets housed at the Company rose by 12% during 2004 to $1.08 trillion; net new
client assets brought to the Company totaled $50.3 billion for the year,
including $16.8 billion in the fourth quarter, the highest in 13 quarters.
Overall, the Company's price cuts contributed to a 14% decline in trading
revenues for 2004, yet continued success in attracting client assets and
building stronger client relationships led to a 17% increase in non-trading
revenues and total revenue growth of 8%. Expenses rose by 12% over 2003 levels,
reflecting the reinstatement of the Company's 401(k) match and the payment of
higher discretionary bonuses, an increased marketing communications investment,
and the recognition of $261 million in after-tax charges relating to the
Company's exit from the capital markets business and its cost reduction effort.
As a result, net income declined by 39% from 2003, and the Company's 2004 profit
margin was 6.8%, compared with 12.1% in the prior year. The Company's 2004 cost
reduction effort enabled the firm to steadily reduce its operating expense base
throughout 2004, and about $300 million in annualized cost savings were
identified and implemented by year end.
The Company generates cash primarily through the revenues of its brokerage
and banking subsidiaries. These revenues are classified into non-trading and
trading categories. The Company earns non-trading revenues primarily through:
o Asset management and administration fees earned through its proprietary and
third-party mutual fund offerings, as well as fee-based investment
management and advisory services; and
o Interest revenue earned on margin loans, loans to banking clients, and
investments.
Non-trading revenues are impacted by securities valuations, interest rates,
the Company's ability to attract new clients, and client activity levels. The
Company earns trading revenues through:
o Commissions earned for executing trades for clients; and
o Principal transaction revenues for trading activity in fixed income
securities.
Trading revenues are impacted by trading volumes, the volatility of equity
prices in the securities markets and commission rates.
Management of the Company focuses on several key financial and
non-financial metrics (as shown in the following table) in evaluating the
Company's financial position and operating performance:
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets
(in billions) (1) (10%) $ 50.3 $ 56.2 $ 47.6
Client assets
(in billions, at year end) 12% $1,081.2 $ 966.7 $ 764.8
Daily average revenue trades
(in thousands) 11% 156.4 140.8 134.1
Company Financial Metrics:
Revenue growth (decline)
from prior year (2) 8% (1%) (3%)
Pre-tax profit margin (2) 15.3% 18.4% 6.3%
Return on stockholders' equity 6% 11% 3%
Revenue per average full-time
equivalent employee
(in thousands) (2) 10% $ 269 $ 245 $ 214
Revenue on client assets (9%) 42 46 49
- --------------------------------------------------------------------------------
(1) Includes an individual outflow of $6.0 billion in 2004 related to a mutual
fund clearing client. Includes inflows of $12.1 billion in 2003 at
U.S. Trust related to the acquisition of State Street Corporation's Private
Asset Management group.
(2) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
o Net new client assets is defined as the total inflows of client cash and
securities to the firm less client outflows. Management believes that this
metric depicts how well
- 9 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
the Company's products and services appeal to new and existing clients.
o Client assets is the market value of all client assets housed at the
Company. Management considers client assets to be indicative of the
Company's appeal in the marketplace. Additionally, growth in certain
components of client assets (e.g., money market funds) directly impacts
asset management and administration fee revenues.
o Schwab's daily average revenue trades (DART) is deemed by management to be
a key indicator of client engagement with securities markets and the most
prominent driver of commission revenues.
o Management believes that revenue growth, pre-tax profit margin, and return
on stockholders' equity provide broad indicators of the Company's overall
financial health, operating efficiency, and ability to generate acceptable
returns.
o Revenue per average full-time equivalent employee (revenue per FTE) is
considered by management to be the Company's broadest measure of
productivity. With the Company's restructuring initiatives over the past
four years, revenue per FTE has steadily improved to $269,000 in 2004.
o Revenue on client assets is defined as annualized basis points of revenue
per dollar of average client assets. Management believes that this metric
is a key measure of the Company's ability to broaden the number of services
utilized by clients.
Restructuring
The Company recorded pre-tax restructuring charges as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
2004 Cost Reduction Effort:
Workforce reduction $ 129 - -
Facilities reduction 82 - -
- --------------------------------------------------------------------------------
Total 211 - -
- --------------------------------------------------------------------------------
2003, 2002, and 2001 Initiatives:
Workforce reduction (1) $ 27 $ 140
Facilities reduction 4 49 202
Systems removal - - 1
- --------------------------------------------------------------------------------
Total 3 76 343
- --------------------------------------------------------------------------------
Total $ 214 $ 76 $ 343
================================================================================
2004 Cost Reduction Effort
In the second quarter of 2004, the Company commenced a firm-wide cost
reduction effort designed to mitigate the financial impact of its pricing
changes (see Results of Operations - Financial Overview - Revenues -
Commissions) and to strengthen its productivity and efficiency. The goals of
this effort include eliminating work that is not essential to meeting client
service standards or the Company's ongoing operating needs, reengineering work
processes to maximize productivity, minimizing organizational complexity through
functional streamlining, and addressing business unit performance across the
Company. During 2004, the Company reallocated certain client service functions
from its Orlando regional telephone service center to other centers. The Company
also closed or consolidated 111 branch offices, began opening smaller satellite
offices in selected locations, and took steps to streamline its technology
organization. Additionally, the Company reduced its operating facilities,
primarily by exiting certain administrative office space in California.
The Company recorded pre-tax restructuring charges of $211 million in 2004
related to the 2004 cost reduction effort, primarily reflecting severance costs
for approximately 1,600 employees and facilities reduction charges.
The Company's 2004 cost reduction effort enabled the firm to steadily
reduce its operating expense base throughout 2004, and about $300 million in
annualized cost savings were identified and implemented by year end. The Company
estimates that its 2004 cost reduction effort will result in approximately
$16 million, or $10 million after-tax, of restructuring charges in the first
quarter of 2005. Estimated additional charges for, or expense savings from, cost
reduction efforts to be implemented during 2005 have not yet been determined.
2003, 2002, and 2001 Initiatives
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software, and equipment from service, and the withdrawal from
certain international operations. These initiatives reduced operating expenses
and adjusted the Company's organizational structure to help improve
productivity, enhance efficiency, and increase profitability. During 2004, the
Company recorded pre-tax restructuring charges of $3 million related to its
2003, 2002, and 2001 restructuring initiatives, primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities.
For further information on the Company's restructuring initiatives, see
"Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 3. Restructuring Charges." The actual costs of these
restructuring initiatives could differ from the estimated costs, depending
primarily on the Company's ability to sublease properties. For further
information on the
- 10 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Company's facilities restructuring reserves, see "Critical Accounting Policies."
Corporate Development
Discontinued Operations: On October 29, 2004, the Company completed the sale of
its capital markets business to UBS. Pursuant to the purchase agreement, UBS
acquired all of the partnership interests of Schwab Capital Markets L.P. and all
of the outstanding capital stock of SoundView Technology Group, Inc.
(collectively referred to as Schwab Soundview Capital Markets, or SSCM) for $265
million in cash. At closing, the Company and Schwab entered into eight-year
order routing and execution services agreements with UBS for the handling of
Schwab's equity and listed options order flow. SSCM comprised substantially all
of the previously-reported Capital Markets segment.
The results of operations, net of income taxes, and cash flows of SSCM have
been presented as discontinued operations on the consolidated statements of
income and of cash flows, respectively, and the assets and liabilities of SSCM
prior to the sale have each been combined and presented as assets and
liabilities of discontinued operations on the consolidated balance sheet. The
Company's consolidated prior period revenues, expenses, taxes on income, assets,
liabilities, and cash flows have been adjusted to reflect this presentation.
In January 2003, the Company sold its U.K. brokerage subsidiary, Charles
Schwab Europe (CSE), to Barclays PLC. The results of operations of CSE, net of
income taxes, have been summarized as discontinued operations on the Company's
consolidated statement of income. The Company's consolidated prior period
revenues, expenses, and taxes on income have been adjusted to reflect this
presentation.
For further information on the Company's discontinued operations, see "Item
8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 5. Discontinued Operations."
Divestiture of Investment: In June 2003, the Company sold its investment in
Aitken Campbell, a market-making joint venture in the U.K., to the Company's
joint venture partner, TD Waterhouse Group, Inc. In 2003, the Company recorded
an impairment charge to reduce the carrying value of its investment and an
income tax benefit. The Company's share of Aitken Campbell's historical
earnings, which was accounted for under the equity method, was not material to
the Company's results of operations, EPS, or cash flows. For further
information, see "Item 8 - Financial Statements and Supplementary Data Notes
to Consolidated Financial Statements 6. Business Acquisitions and
Divestitures."
Sale of Corporate Trust Business: In June 2001, USTC sold its Corporate Trust
business to The Bank of New York Company, Inc. The Company recognized an
extraordinary gain in 2002 related to this sale, primarily for amounts
recognized upon satisfaction of certain client retention requirements. For
further information, see "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 4. Sale of Corporate Trust
Business."
RESULTS OF OPERATIONS
Financial Overview
Total revenues were $4.2 billion in 2004, up $306 million, or 8%, from
2003. The Company's non-trading revenues totaled $3.2 billion in 2004, up $471
million, or 17%, from 2003. This increase was primarily due to an increase in
asset management and administration fees resulting primarily from higher levels
of client assets and an increase in net interest revenue resulting primarily
from higher levels of and changes in the composition of interest-earning assets.
Trading revenues totaled $1.0 billion in 2004, down $165 million, or 14%, from
2003. This decrease was primarily due to lower average revenue earned per
revenue trade resulting from reductions in the Company's commission pricing,
partially offset by higher client trading activity.
Total expenses excluding interest for 2004 were $3.6 billion, up $378
million, or 12%, from 2003. This increase was primarily due to a $212 million,
or 13%, increase in compensation and benefits expense resulting from higher
levels of discretionary bonuses to employees, employee benefits, and incentive
compensation, as well as a $138 million, or 182%, increase in restructuring
charges.
Income from continuing operations before taxes on income and extraordinary
gain for 2004 was $645 million, down $72 million, or 10% from 2003, primarily
due to the combination of factors discussed above - higher compensation and
benefits expense and restructuring charges, partially offset by higher levels of
non-trading revenues. Loss from discontinued operations, net of tax, was
$128 million for 2004, compared to $4 million for 2003. Net income for 2004 was
$286 million, or $.21 per share, down 39% from 2003, primarily due to a higher
loss from discontinued operations, net of tax, as well as lower income from
continuing operations before taxes on income and extraordinary gain. The
Company's after-tax profit margin for 2004 was 6.8%, down from 12.1% for 2003.
Return on stockholders' equity was 6% for 2004, down from 11% in 2003.
- 11 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Certain reclassifications have been made to prior year amounts to conform
to the current presentation. All references to earnings per share (EPS)
information in this Management's Discussion and Analysis of Results of
Operations and Financial Condition reflect diluted earnings per share unless
otherwise noted.
Segment Information: In evaluating the Company's financial performance,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes items described below.
Management believes that adjusted operating income is a useful indicator of the
ongoing financial performance of the Company's segments, and a tool that can
provide meaningful insight into financial performance without the effects of
certain material items that are not expected to be an ongoing part of operations
(e.g., extraordinary items, non-operating revenues, restructuring charges,
impairment charges, acquisition- and merger-related charges, and discontinued
operations).
In 2004, net income of $286 million included the following items which in
total had the effect of decreasing after-tax income by $252 million: $133
million of after-tax restructuring charges, a $128 million after-tax loss from
discontinued operations, and a $9 million after-tax gain on an investment. In
2003, net income of $472 million included the following items which in total had
the effect of decreasing after-tax income by $19 million: $48 million of
after-tax restructuring charges, a $5 million investment write-down related to
the Company's U.K. market-making operation, a $4 million after-tax loss from
discontinued operations, a $16 million tax benefit associated with the Company's
sale of its U.K. market-making operation, an $11 million after-tax gain on the
sale of an investment, and an $11 million tax benefit associated with the
Company's merger with U.S. Trust. In 2002, net income of $109 million included
the following items which in total had the effect of decreasing after-tax income
by $304 million: $211 million of after-tax restructuring charges, a $52 million
after-tax loss from discontinued operations, a $37 million investment write-down
related to the Company's U.K. market-making operation, $16 million of after-tax
acquisition-related charges, and a $12 million after-tax extraordinary gain on
the sale of U.S. Trust's Corporate Trust business.
As detailed in "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 26. Segment Information," the
Company's adjusted operating income before taxes was $845 million for 2004, up
$64 million, or 8%, from 2003 due to increases of $58 million, or 13%, in the
Individual Investor segment, and $9 million, or 23%, in the U.S. Trust segment,
partially offset by a decrease of $21 million, or 7%, in the Institutional
Investor segment. The increase in the Individual Investor segment was primarily
due to higher revenues resulting from increased client trading activity and
levels of client assets. The decrease in the Institutional Investor segment was
primarily due to growth in expenses outpacing growth in revenues primarily as a
result of higher client acquisition and servicing costs.
Revenues
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table, non-trading and total revenues increased, while
trading revenues decreased from 2003.
- 12 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
====================================================================================================================================
Sources of Revenues
Year Ended December 31,
- ------------------------------------------------------------------------------------------------------------------------------------
Growth Rate 2004 2003 2002
1-year --------------------------------------------------------------
2003-2004 Amount Percent Amount Percent Amount Percent
----------------------------------------------------------------------------
Non-Trading Revenues
Asset management and administration fees
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) (1%) $ 870 21% $ 883 23% $ 874 22%
Mutual Fund OneSource(R) 33% 376 9% 283 7% 264 7%
Other 18% 59 1% 50 1% 41 1%
Asset management and related services 28% 786 19% 616 16% 574 15%
- ------------------------------------------------------------------------------------------------------------------------------------
Asset management and administration fees 14% 2,091 50% 1,832 47% 1,753 45%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue
Interest revenue:
Margin loans to clients 31% 454 11% 347 9% 459 12%
Investments, client-related 3% 293 7% 284 7% 337 8%
Loans to banking clients 20% 275 7% 230 6% 236 6%
Securities available for sale 88% 139 3% 74 2% 76 2%
Other 58% 52 1% 33 1% 48 1%
- ------------------------------------------------------------------------------------------------------------------------------------
Interest revenue 25% 1,213 29% 968 25% 1,156 29%
Interest expense:
Brokerage client cash balances 49% 113 3% 76 2% 164 4%
Deposits from banking clients 9% 105 3% 96 3% 94 2%
Long-term debt (9%) 32 1% 35 1% 46 1%
Short-term borrowings 38% 18 - 13 - 20 1%
Other (55%) 9 - 20 - 7 -
- ------------------------------------------------------------------------------------------------------------------------------------
Interest expense 15% 277 7% 240 6% 331 8%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue 29% 936 22% 728 19% 825 21%
- ------------------------------------------------------------------------------------------------------------------------------------
Other 3% 150 4% 146 3% 129 3%
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-trading revenues 17% 3,177 76% 2,706 69% 2,707 69%
- ------------------------------------------------------------------------------------------------------------------------------------
Trading Revenues
Commissions
Equity and other securities (18%) 731 17% 892 23% 925 24%
Mutual funds 2% 112 3% 110 3% 111 3%
Options (2%) 93 2% 95 3% 99 2%
- ------------------------------------------------------------------------------------------------------------------------------------
Commissions (15%) 936 22% 1,097 29% 1,135 29%
- ------------------------------------------------------------------------------------------------------------------------------------
Principal transactions (4%) 89 2% 93 2% 102 2%
- ------------------------------------------------------------------------------------------------------------------------------------
Total trading revenues (14%) 1,025 24% 1,190 31% 1,237 31%
- ------------------------------------------------------------------------------------------------------------------------------------
Total revenues 8% $ 4,202 100% $ 3,896 100% $ 3,944 100%
====================================================================================================================================
- 13 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the U.S. Trust segment generates
primarily non-trading revenues. Revenues by segment are as shown in the
following table:
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Individual Investor 3% $ 2,444 $ 2,365 $ 2,375
Institutional Investor 9% 897 821 855
U.S. Trust 23% 773 629 651
Unallocated 16% 74 64 63
- --------------------------------------------------------------------------------
Operating revenues 8% 4,188 3,879 3,944
Non-operating revenues (1) (18%) 14 17 -
- --------------------------------------------------------------------------------
Total revenues 8% $ 4,202 $ 3,896 $ 3,944
================================================================================
(1) Primarily consists of pre-tax gains on investments.
The increase in revenues in the U.S. Trust segment was primarily due to the
acquisition of State Street Corporation's Private Asset Management group in
October 2003 and higher levels of client assets. See "Item 8 - Financial
Statements and Supplementary Data - Notes to Consolidated Financial Statements -
26. Segment Information" for financial information by segment for the last three
years.
Asset Management and Administration Fees
Asset management and administration fees include mutual fund service fees,
as well as fees for other asset-based financial services provided to individual
and institutional clients. The Company earns mutual fund service fees for
transfer agent services, shareholder services, administration, and investment
management provided to its proprietary funds, and recordkeeping and shareholder
services provided to third-party funds. These fees are based upon the daily
balances of client assets invested in third-party funds and upon the average
daily net assets of the Company's proprietary funds. Mutual fund service fees
are earned through each of the Company's segments. The Company also earns asset
management and administration fees for financial services provided to individual
and institutional clients, including investment management and consulting, trust
and fiduciary services, custody services, financial and estate planning, and
private banking services. These fees are primarily based on the value and
composition of assets under management and are earned through each of the
Company's segments.
The increase in asset management and related service fees from 2003 to 2004
was primarily due to higher levels of client assets and higher asset-based fees
from certain client relationships. The increase in mutual fund service fees from
2003 to 2004 was primarily due to higher average assets in and service fees
earned on Schwab's Mutual Fund OneSource(R) service. The increase in asset
management and related service fees from 2002 to 2003 was primarily due to
higher asset-based fees from certain client relationships, partially offset by a
decrease in account fees. The increase in mutual fund service fees from 2002 to
2003 was due to higher service fees earned on and average assets in Schwab's
Mutual Fund OneSource service, and higher service fees earned on SchwabFunds(R).
Commissions
The Company earns commission revenues by executing client trades primarily
through the Individual Investor and Institutional Investor segments. These
revenues are affected by the number of client accounts that trade, the average
number of revenue-generating trades per account, and the average revenue earned
per revenue trade.
The decrease in commission revenues from 2003 to 2004 was primarily due to
lower average revenue earned per revenue trade as a result of significant
reductions in commission pricing for a wide range of clients in 2004, partially
offset by higher daily average revenue trades. The increase in commission
revenues from 2002 to 2003 was primarily due to higher daily average trades,
partially offset by lower revenue per revenue trade.
Effective in June 2004, the Company lowered its online equity pricing to
$9.95 for clients with more than $1 million in assets at Schwab and also lowered
commission pricing for a wide range of other clients. Additionally, effective in
November 2004, the Company lowered its base online equity commission pricing to
$19.95, expanded access to $9.95 online equity commissions, and lowered
commissions on online and broker-assisted trades of options contracts. Primarily
as a result of these pricing changes, the Company's average revenue earned per
revenue trade declined from $30.97 in May 2004 to $18.82 in December 2004.
- 14 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
As illustrated in the following table, daily average revenue trades
executed by the Company increased 11% in 2004. Average revenue earned per
revenue trade decreased 23% from 2003 to 2004, primarily due to the pricing
changes discussed above. Average revenue earned per revenue trade decreased 7%
from 2002 to 2003, primarily due to decreased pricing of certain equity trades
made through online channels as well as decreased pricing of fixed income
securities trades.
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 156.4 140.8 134.1
Accounts that traded
(in thousands) 2,749 2,734 2,871
Average revenue trades
per account that traded 14.3 12.9 11.8
Trading frequency proxy (2) 3.4 3.8 3.8
Number of trading days (3) 251.5 250.0 252.0
Average revenue earned
per revenue trade (4) $ 26.34 $ 34.06 $ 36.46
Online trades as a percentage of
total trades 89% 87% 83%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents revenue trades per $100,000 in total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
(4) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position. The Company
continues to actively evaluate commission rates and fee structures for certain
clients.
Net Interest Revenue
Net interest revenue is the difference between interest earned on certain
assets (mainly margin loans to clients, investments of segregated client cash
balances, loans to banking clients, and securities available for sale) and
interest paid on supporting liabilities (mainly deposits from banking clients
and brokerage client cash balances). Net interest revenue is affected by changes
in the volume and mix of these assets and liabilities, as well as by
fluctuations in interest rates and hedging strategies.
The Company's net interest revenue is earned through each of its segments.
In clearing its clients' trades, Schwab holds cash balances payable to clients.
In most cases, Schwab pays its clients interest on cash balances awaiting
investment, and may invest these funds and earn interest revenue. Margin loans
arise when Schwab lends funds to clients on a secured basis to purchase
securities. Pursuant to SEC regulations, client cash balances that are not used
for margin lending are generally segregated into investment accounts that are
maintained for the exclusive benefit of clients.
When investing segregated client cash balances, Schwab must adhere to SEC
regulations that restrict investments to U.S. government securities,
participation certificates, mortgage-backed securities guaranteed by the
Government National Mortgage Association, certificates of deposit issued by U.S.
banks and thrifts, and resale agreements collateralized by qualified securities.
Schwab's policies for credit quality and maximum maturity requirements are more
restrictive than these SEC regulations. In each of the last three years, resale
agreements accounted for over 65% of Schwab's investments of segregated client
cash balances. The average maturities of Schwab's total investments of
segregated client cash balances were 142 days for 2004, 161 days for 2003, and
66 days for 2002. U.S. Trust and Schwab Bank lend funds to banking clients
primarily in the form of mortgage loans. These loans are largely funded by
interest-bearing deposits from banking clients.
- 15 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
The Company's interest-earning assets are financed primarily by
interest-bearing brokerage client cash balances and deposits from banking
clients. Other funding sources include noninterest-bearing brokerage client cash
balances, proceeds from stock-lending activities, short-term borrowings and
long-term debt, as well as stockholders' equity. Client-related daily average
balances, interest rates, and average net interest spread are summarized as
follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $20,159 $21,826 $17,869
Average interest rate 1.45% 1.30% 1.89%
Margin loans to clients:
Average balance outstanding $ 9,074 $ 7,025 $ 8,017
Average interest rate 4.99% 4.94% 5.72%
Loans to banking clients:
Average balance outstanding $ 6,453 $ 5,034 $ 4,204
Average interest rate 4.24% 4.56% 5.62%
Securities available for sale:
Average balance outstanding $ 4,031 $ 1,904 $ 1,508
Average interest rate 3.45% 3.91% 5.02%
Average yield on interest-earning assets 2.94% 2.62% 3.51%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $23,788 $23,140 $22,432
Average interest rate .47% .33% .73%
Interest-bearing banking deposits:
Average balance outstanding $ 9,077 $ 5,395 $ 4,046
Average interest rate 1.15% 1.79% 2.33%
Other interest-bearing sources:
Average balance outstanding $ 2,519 $ 2,843 $ 1,094
Average interest rate 1.07% 1.05% 2.03%
Average noninterest-bearing portion $ 4,333 $ 4,411 $ 4,026
Average interest rate on funding sources .61% .57% .89%
Summary:
Average yield on interest-earning assets 2.94% 2.62% 3.51%
Average interest rate on funding sources .61% .57% .89%
- --------------------------------------------------------------------------------
Average net interest spread 2.33% 2.05% 2.62%
- --------------------------------------------------------------------------------
The increase in net interest revenue from 2003 to 2004 was primarily due to
higher levels of and changes in the composition of interest-earning assets,
including increases in margin loan balances, loans to banking clients and
securities available for sale, partially offset by higher interest rates on
brokerage client cash balances due to changes in the interest rate environment.
The decrease in net interest revenue from 2002 to 2003 was primarily due to
changes in the composition of interest-earning assets, including the decline in
margin loan balances and the corresponding increase in client-related
investments. Additionally, the decline in yields on interest-earning assets due
to changes in the interest rate environment from 2002 to 2003 was only partially
offset by lower yields on funding sources.
Since the Company establishes the rates paid on brokerage client cash
balances and certain banking deposits and the rates charged on margin loans, it
manages a substantial portion of its net interest spread. However, the spread is
influenced by external factors such as the interest rate environment and
competition. The Company's average net interest spread increased from 2003 to
2004 as the average yield on interest-earning assets, primarily client-related
investments, increased more than the average interest rate on funding sources.
The Company's average net interest spread decreased from 2002 to 2003 as the
average yield on interest-earning assets, primarily client-related investments,
declined more than the average interest rate on funding sources.
Principal Transactions
Principal transaction revenues are primarily comprised of revenues from
client fixed income securities trading activity, which are included in the
Individual Investor and Institutional Investor segments. Factors that influence
principal transaction revenues include the volume of client trades, market price
volatility, and changes in regulations and industry practices.
Other Revenues
Other revenues include net gains and losses on certain investments, fees
for services (such as transfer of assets), account service fees, and software
maintenance fees. Other revenues are earned through each of the Company's
segments.
- 16 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Expenses Excluding Interest
As shown in the table below, total expenses excluding interest increased in
2004 primarily due to higher compensation and benefits expense and restructuring
charges. Additionally, increases in professional services expense and
advertising and market development expense were substantially offset by
decreases in depreciation and amortization expense and occupancy and equipment
expense.
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Compensation and benefits 13% $ 1,877 $ 1,665 $ 1,755
Occupancy and equipment (10%) 389 430 446
Professional services 40% 245 175 168
Depreciation and amortization (18%) 226 277 309
Communications (2%) 223 228 245
Advertising and market
development 32% 184 139 207
Commissions, clearance and
floor brokerage (3%) 39 40 46
Restructuring charges 182% 214 76 343
Impairment charges (100%) - 5 37
Other 11% 160 144 139
- --------------------------------------------------------------------------------
Total expenses 12% $ 3,557 $ 3,179 $ 3,695
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 85% 82% 94%
Compensation and benefits 45% 43% 44%
Advertising and market development 4% 4% 5%
- --------------------------------------------------------------------------------
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive
and variable compensation, related employee benefits and taxes, and retention
program costs arising from certain acquisitions and mergers. Employees receive
variable compensation that is tied to the achievement of specified objectives,
primarily related to revenue growth and profit margin. Therefore, a significant
portion of compensation and benefits expense will fluctuate with these measures.
The increase in compensation and benefits expense from 2003 to 2004 was
primarily due to higher levels of discretionary bonuses to employees, employee
benefits, and incentive compensation. The decrease in compensation and benefits
expense from 2002 to 2003 was primarily due to a reduction in full-time
equivalent employees through the Company's expense reduction measures and lower
levels of employee benefits, partially offset by higher levels of incentive
compensation and discretionary bonuses to employees. The following table shows a
comparison of certain compensation and benefits components and employee data:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Salaries and wages $ 1,199 $ 1,150 $ 1,229
Incentive and variable compensation 376 270 233
Employee benefits and other 302 245 293
- --------------------------------------------------------------------------------
Total $ 1,877 $ 1,665 $ 1,755
================================================================================
Full-time equivalent employees (1)
(in thousands)
At year end 14.2 16.0 16.4
Average 15.6 15.9 18.4
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis. All amounts have been adjusted to reflect the sale of
the Company's capital markets business.
Employee benefits and other expense increased from 2003 to 2004 primarily
due to the reinstatement of the Company's 401(k) employee contribution match,
which was suspended in 2003 (except for a discretionary award to certain
non-officer employees made in the fourth quarter of 2003). Employee benefits and
other expense decreased from 2002 to 2003 primarily due to the suspension of the
Company's 401(k) employer contribution in 2003 as discussed above. Additionally,
employee benefits and other expense includes net pension expense of $7 million
in 2004 and $8 million in 2003 related to U.S. Trust's defined benefit pension
plan, compared to net pension income of less than $1 million for 2002. The
increase in pension expense in 2003 was primarily due to changes in certain
assumptions used to calculate pension expense, including the expected rate of
return on pension plan assets and the discount rate, both effective in 2003.
See "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 2. Significant Accounting Policies - New
Accounting Standards" for a discussion of future compensation expense related to
stock option awards.
Expenses Excluding Compensation and Benefits
The decreases in occupancy and equipment expense from 2002 to 2004 were
primarily due to the Company's restructuring initiatives and other expense
reduction measures (see Description of Business - Restructuring).
The increases in professional services expense from 2002 to 2004 were
primarily due to higher levels of consulting fees in several areas, including
new and expanded products and services, and information technology projects.
The decreases in depreciation and amortization expense from 2002 to 2004
were primarily due to increases in fully-
- 17 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
amortized assets and the Company's restructuring initiatives and other expense
reduction measures.
The increase in advertising and market development expense from 2003 to
2004 was primarily due to the Company's increased print and other media
spending. The decrease in advertising and market development expense from 2002
to 2003 was primarily due to reductions, as part of the Company's expense
reduction measures, in brand-focused television and other media spending.
Taxes on Income
The Company's effective income tax rate on income from continuing
operations was 35.8% in 2004, 33.6% in 2003 and 40.2% in 2002. The increase in
the effective income tax rate from 2003 to 2004 was primarily due to tax
benefits in 2003 related to the deductibility of certain costs associated with
the Company's merger with U.S. Trust and the Company's sale of its U.K.
market-making operation. The decrease in the effective income tax rate from 2002
to 2003 was primarily due to the tax benefits in 2003 discussed above, as well
as an impairment charge in 2002 related to the Company's U.K. market-making
operation which was not deductible for tax purposes. Management expects the
Company's effective income tax rate in 2005 to be approximately 38%.
LIQUIDITY AND CAPITAL RESOURCES
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended. CSC conducts virtually all business through its wholly owned
subsidiaries. The capital structure among CSC and its subsidiaries is designed
to provide each entity with capital and liquidity to meet its operational needs
and regulatory requirements. See "Item 8 - Financial Statements and
Supplementary Data - Notes to Consolidated Financial Statements - 22. Regulatory
Requirements."
Liquidity
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
below, Schwab and CSC's depository institution subsidiaries are subject to
regulatory requirements that may restrict them from certain transactions with
CSC. Management believes that funds generated by the operations of CSC's
subsidiaries will continue to be the primary funding source in meeting CSC's
liquidity needs, providing adequate liquidity to meet CSC's depository
institution subsidiaries' capital guidelines, and maintaining Schwab's net
capital. Based on their respective regulatory capital ratios at December 31,
2004 and 2003, the Company and its depository institution subsidiaries are
considered well capitalized.
CSC has liquidity needs that arise from its Senior Medium-Term Notes,
Series A (Medium-Term Notes), as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes, of which
$386 million was issued and outstanding at December 31, 2004, have maturities
ranging from 2005 to 2010 and fixed interest rates ranging from 6.21% to 8.05%
with interest payable semiannually. CSC has entered into interest rate swap
agreements (Swaps) that effectively convert the interest rate characteristics of
a portion of the Medium-Term Notes from fixed to variable. For a complete
discussion of the Swaps, see "Item 8 - Financial Statements and Supplementary
Data - Notes to Consolidated Financial Statements - 24. Financial Instruments
Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk." The Medium-Term
Notes are rated A2 by Moody's Investors Service (Moody's), A- by Standard &
Poor's Ratings Group (S&P), and A by Fitch IBCA, Inc. (Fitch).
CSC has a prospectus supplement on file with the SEC enabling CSC to issue
up to $750 million in Senior or Senior Subordinated Medium-Term Notes, Series A.
At December 31, 2004, all of these notes remained unissued.
In the second quarter of 2004, the SEC declared effective CSC's
Registration Statement under the Securities Act of 1933 on Form S-3 relating to
a universal shelf registration for the issuance of up to $1.0 billion aggregate
amount of various securities, including common stock, preferred stock, debt
securities, and warrants. The Company currently intends to use any proceeds from
the issuance of these securities for general corporate purposes, including, but
not limited to, working capital and possible acquisitions. At December 31, 2004,
all of these securities remained unissued.
CSC has authorization from its Board of Directors (Board) to issue
commercial paper up to the amount of CSC's committed, unsecured credit facility
(see below), not to exceed $1.5 billion. At December 31, 2004, no commercial
paper has been issued. CSC's ratings for these short-term borrowings are P-1 by
Moody's, A-2 by S&P, and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a
group of nineteen banks which is scheduled to expire in June 2005. This facility
replaced a facility that expired in June 2004. These facilities were unused in
2004. Any issuances under CSC's commercial paper program (see above) will reduce
the amount available under this facility. The funds under this facility are
available
- 18 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
for general corporate purposes and CSC pays a commitment fee on the unused
balance of this facility. The financial covenants in this facility require CSC
to maintain a minimum level of stockholders' equity, Schwab to maintain minimum
net capital ratios, as defined, and CSC's depository institution subsidiaries to
be well capitalized, as defined. Management believes that these restrictions
will not have a material effect on its ability to meet foreseeable dividend or
funding requirements.
CSC also has direct access to $781 million of the $831 million uncommitted,
unsecured bank credit lines, provided by eight banks, that are primarily
utilized by Schwab to manage short-term liquidity. The amount available to CSC
under these lines is lower than the amount available to Schwab because the
credit line provided by one of these banks is only available to Schwab. These
lines were not used by CSC in 2004.
Schwab
Most of Schwab's assets are readily convertible to cash, consisting
primarily of short-term (i.e., less than 150 days) investment-grade,
interest-earning investments (the majority of which are segregated for the
exclusive benefit of clients pursuant to regulatory requirements), receivables
from brokerage clients, and receivables from brokers, dealers and clearing
organizations. Client margin loans are demand loan obligations secured by
readily marketable securities. Receivables from and payables to brokers, dealers
and clearing organizations primarily represent current open transactions, which
usually settle, or can be closed out, within a few business days.
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$27.0 billion, $25.6 billion, and $24.9 billion at December 31, 2004, 2003, and
2002, respectively. Management believes that brokerage client cash balances and
operating earnings will continue to be the primary sources of liquidity for
Schwab in the future.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements in the
first quarter of 2003, the Company consolidated a special purpose trust (Trust)
and recorded a note payable of $235 million. This Trust was formed in 2000 to
finance the acquisition and renovation of an office building and land. In
June 2004, the Company exercised its option to purchase this property from the
Trust and repaid $99 million of the note payable. Simultaneously, the Company
completed a transaction on this property with American Financial Realty Trust, a
publicly-traded real estate investment trust, resulting in proceeds of
$136 million, which was used to repay the remainder of the note payable, and a
20-year lease. This transaction was accounted for as a financing. The remaining
lease financing liability of $134 million is being reduced by a portion of the
lease payments over the 20-year term.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of eight banks totaling $831 million at
December 31, 2004 (as noted previously, $781 million of these lines are also
available for CSC to use). The need for short-term borrowings arises primarily
from timing differences between cash flow requirements and the scheduled
liquidation of interest-bearing investments. Schwab used such borrowings for 15
days in 2004, with the daily amounts borrowed averaging $46 million. There were
no borrowings outstanding under these lines at December 31, 2004.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2004. Schwab pays a fee to maintain these arrangements. In
connection with its securities lending activities, Schwab is required to provide
collateral to certain brokerage clients. Schwab satisfies the collateral
requirements by arranging letters of credit (LOCs), in favor of these brokerage
clients, that are guaranteed by multiple banks. At December 31, 2004, the
outstanding value of these LOCs totaled $52 million. No funds were drawn under
these LOCs at December 31, 2004.
Schwab is subject to regulatory requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. These
regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying
cash dividends, or making unsecured advances or loans to its parent or employees
if such payment would result in net capital of less than 5% of aggregate debit
balances or less than 120% of its minimum dollar requirement of $1 million. At
December 31, 2004, Schwab's net capital was $1.2 billion (12% of aggregate debit
balances), which was $1.0 billion in excess of its minimum required net capital
and $723 million in excess of 5% of aggregate debit balances. Schwab has
historically targeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2005. The amount outstanding under this facility at
December 31, 2004 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
- 19 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
U.S. Trust
U.S. Trust's liquidity needs are generally met through deposits from
banking clients, equity capital, and borrowings.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at U.S. Trust. At December 31,
2004, these balances totaled $577 million.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At December 31, 2004, U.S.
Trust had $52 million in Trust Preferred Capital Securities outstanding with a
fixed interest rate of 8.41%. Certain of USTC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $1.7 billion. At December 31, 2004, $625 million was
outstanding under these facilities. Additionally, at December 31, 2004, U.S.
Trust had $38 million of federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Schwab
Bank and Schwab. At December 31, 2004, U.S. Trust had $400 million and $200
million in repurchase agreements outstanding with Schwab Bank and Schwab,
respectively.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $30 million at December 31, 2004.
U.S. Trust uses Swaps with CSC and third parties to hedge the interest rate
risk associated with its variable rate deposits from banking clients. These
Swaps are structured for U.S. Trust to receive a variable rate of interest and
pay a fixed rate of interest. At December 31, 2004, the Swaps with CSC have a
notional value of $650 million and a fair value of $9 million. For a complete
discussion of the Swaps with third parties, see "Item 8 - Financial Statements
and Supplementary Data - Notes to Consolidated Financial Statements - 24.
Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market
Risk."
U.S. Trust is subject to the Federal Reserve Board's risk-based and
leverage capital guidelines. These regulations require banks and bank holding
companies to maintain minimum levels of capital. In addition, USTC's depository
institution subsidiaries are subject to limitations on the amount of dividends
they can pay to USTC.
Schwab Bank
Schwab Bank's current liquidity needs are generally met through deposits
from banking clients and equity capital.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at Schwab Bank. At December 31,
2004, these balances totaled $4.0 billion.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility maturing in December
2005. Borrowings under this facility do not qualify as regulatory capital for
Schwab Bank. No funds were drawn under this facility at December 31, 2004.
In May 2004, Schwab Bank established a credit facility with the FHLB. At
December 31, 2004, $266 million was available, and no funds were drawn under
this facility.
Schwab Bank is subject to the same risk-based and leverage capital
guidelines as U.S. Trust (see discussion above), except that Schwab Bank is
subject to a minimum tier 1 leverage ratio of 8% for its first three years of
operations. In addition, Schwab Bank is subject to limitations on the amount of
dividends it can pay to CSC.
Liquidity Risk Factors
The Company manages risk by maintaining sufficient liquid financial
resources to fund its balance sheet and meet its obligations. The Company's
liquidity needs are met primarily through cash generated by operations, as well
as cash provided by external financing. Risks in meeting these needs may arise
with fluctuations in client cash or deposit balances, as well as changes in
market conditions.
Specific risk factors which may affect the Company's liquidity position
include:
o a dramatic increase in the Company's client lending activities (including
margin, mortgage, and personal lending) which may reduce the Company's
liquid resources and capital position;
o a reduction in cash held in banking or brokerage client accounts which may
affect the amount of the Company's liquid assets; and
o a significant downgrade in the Company's credit ratings which could
increase its borrowing costs and limit its access to the capital markets.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on the
Company's consolidated balance sheet) and cash flows are affected by changes in
brokerage client cash balances and the associated amounts required to be
segregated under federal or other regulatory guidelines. Timing differences
between cash and investments actually segregated on a given date and the amount
required to be segregated for that date may arise in the ordinary course of
business and are addressed by the Company in accordance with applicable
regulations. Other factors which affect the Company's cash position and cash
flows include investment
- 20 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
activity in securities owned, levels of capital expenditures, acquisition
activity, banking client deposit and loan activity, financing activity in
short-term borrowings and long-term debt, payments of dividends, and repurchases
of CSC's common stock.
In 2004, cash and cash equivalents decreased $7 million to $2.8 billion
primarily due to higher levels of securities available for sale and increases in
loans to banking clients, substantially offset by increases in deposits from
banking clients, including sweep deposit accounts. Certain Schwab brokerage
clients can sweep the excess cash held in their brokerage accounts into these
money market deposit accounts at Schwab Bank or U.S. Trust. At December 31,
2004, these sweep deposit balances totaled $4.6 billion, up $3.0 billion from
December 31, 2003. This sweep deposit activity is reflected on the Consolidated
Statement of Cash Flows as a cash outflow from payables to brokerage clients
(classified as an operating activity) and a cash inflow to deposits from banking
clients (classified as a financing activity).
The Company's capital expenditures were $194 million in 2004 and
$147 million in 2003, or 5% and 4% of revenues in 2004 and 2003, respectively.
In 2004, 86% of capital expenditures were for information technology and 14% for
facilities expansion and improvements. Capital expenditures include capitalized
costs for developing internal-use software of $79 million in 2004 and
$64 million in 2003.
Management currently anticipates that 2005 capital expenditures will be
approximately 15% lower than 2004 spending. As has been the case in recent
years, the Company may adjust its capital expenditures from period to period as
business conditions change. Management believes that funds generated by its
operations will continue to be the primary funding source of its capital
expenditures.
Certain cash flows from financing activities by the Company in 2004
include:
o Net repayment of $179 million of long-term debt;
o Receipt of cash proceeds of $51 million on the exercise of 11 million of
the Company's stock options, with a weighted-average exercise price of
$4.88, and a related tax benefit of $18 million; and
o Payment of common stock dividends of $101 million.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (long-term debt
plus stockholders' equity) at December 31, 2004 was $5.0 billion, down
$262 million, or 5%, from a year ago, due to lower stockholders' equity,
primarily resulting from stock repurchases and a net decrease in long-term debt.
At December 31, 2004, the Company had long-term debt of $585 million, or 12% of
total financial capital, bearing interest at a weighted-average rate of 7.08%.
At December 31, 2004, the Company's stockholders' equity was $4.4 billion, or
88% of total financial capital.
Off-Balance-Sheet Arrangements
The Company enters into various off-balance-sheet arrangements in the
ordinary course of business, primarily to meet the needs of its clients and to
reduce its own exposure to interest rate risk. These arrangements include firm
commitments to extend credit and letters of credit. Additionally, the Company
enters into guarantees and other similar arrangements as part of transactions in
the ordinary course of business. For additional information on each of these
arrangements, see "Item 8 - Financial Statements and Supplementary Data - Notes
to Consolidated Financial Statements - 23. Commitments and Contingent
Liabilities."
- 21 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Commitments
A summary of the Company's principal contractual obligations and other
commitments as of December 31, 2004 is shown in the following table. Excluded
from this table are liabilities recorded on the consolidated balance sheet that
are generally short-term in nature (e.g., drafts payable and short-term
borrowings) or without contractual payment terms (e.g., deposits from banking
clients, payables to brokerage clients, and deferred compensation). Management
believes that funds generated by its operations, as well as cash provided by
external financing, will continue to be the primary funding sources in meeting
these obligations and commitments.
- --------------------------------------------------------------------------------
Less than 1-3 3-5 After 5
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
Operating leases (1) $ 188 $ 323 $ 270 $ 621 $1,402
Long-term debt (2) 56 106 24 252 438
Credit-related financial
instruments (3) 775 264 - 1,194 2,233
Purchase obligations (4) 206 125 32 5 368
Workforce restructuring
reserves (5) 70 4 - - 74
- --------------------------------------------------------------------------------
Total $1,295 $ 822 $ 326 $2,072 $4,515
================================================================================
(1) Represents minimum rental commitments, net of sublease commitments, and
includes facilities under the Company's restructuring initiatives. See
"Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 3. Restructuring Charges and 23.
Commitments and Contingent Liabilities."
(2) Excludes maturities under a lease financing liability and the effect of
interest swaps. See "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 16. Long-term Debt."
(3) Includes U.S. Trust and Schwab Bank firm commitments to extend credit
primarily for loans to banking clients and standby letters of credit. See
"Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 24. Financial Instruments Subject to
Off-Balance Sheet Risk, Credit Risk or Market Risk."
(4) Consists of purchase obligations for services such as advertising and
marketing, telecommunications, professional services, and hardware- and
software-related agreements. Includes purchase obligations of $126 million
at December 31, 2004 which can be canceled by the Company without penalty.
(5) Includes workforce restructuring reserves of $51 million and $23 million
related to the Company's restructuring initiatives and discontinued
operations, respectively. See "Item 8 - Financial Statements and
Supplementary Data - Notes to Consolidated Financial Statements - 3.
Restructuring Charges and 5. Discontinued Operations."
Share Repurchases
CSC repurchased 39 million shares of its common stock for $383 million in
2004 and 4 million shares of its common stock for $32 million in 2003. On
December 9, 2004, the Board authorized the repurchase of up to an additional
$300 million of CSC's common stock. As of December 31, 2004, CSC has authority
to repurchase up to $234 million of its common stock.
Dividend Policy
Since the initial dividend in 1989, CSC has paid 63 consecutive quarterly
dividends and has increased the dividend 14 times, including a 43% increase in
the second quarter of 2004. Since 1989, dividends have increased by a 27%
compounded annual growth rate. CSC paid common stock dividends of $.074, $.050,
and $.044 per share in 2004, 2003, and 2002, respectively. While the payment and
amount of dividends are at the discretion of the Board, subject to certain
regulatory and other restrictions, the Company currently targets its cash
dividend at approximately 10% to 20% of net income.
RISK MANAGEMENT
Overview
The Company's business activities expose it to a variety of risks
including, but not limited to, those discussed below. Identification, assessment
and management of these risks are essential to the success and financial
soundness of the Company.
Senior management takes an active role in the Company's risk management
process and has developed policies and procedures under which specific business
and control units are responsible for identifying, measuring, and controlling
various risks. Oversight of risk management has been delegated to the Global
Risk Steering Committee, which is comprised of managers who lead major business
and control functions. The Global Risk Steering Committee is responsible for
reviewing and monitoring the Company's risk exposures, leading in the continued
development of the Company's risk management policies and practices, and
reviewing changes in regulation and other risk-related developments. The Global
Risk Steering Committee regularly reports on risk management to the Audit
Committee of the Board of Directors, which reviews major risk exposures and the
steps management has taken to monitor and control such exposures.
The Company also has a number of functional risk sub-committees, which
report into the Global Risk Steering Committee on a frequent basis. These
sub-committees include:
o Technology and Operations Risk Committee, which focuses on the integrity of
operational controls and operating capacity of the Company's technology and
operations systems;
o Financial Risk Oversight Committee, which focuses on the credit exposures
resulting from client activity (e.g., margin lending activities and loans
to banking clients), the investing activities of certain of the Company's
proprietary funds, corporate credit activities (e.g.,
- 22 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
counterparty and corporate investing activities), the Company's liquidity,
capital resources, interest rate risk, and the market risk resulting from
securities positioning activities;
o Fiduciary Risk Committee, which focuses on overseeing the activities of the
Company that are deemed to have a fiduciary component; and
o Disclosure Committee, which focuses on the oversight of disclosure and
internal controls.
Additionally, the Company's compliance, finance, internal audit, legal, and
risk and credit management departments assist management and the various risk
committees in evaluating, testing and monitoring the Company's risk management.
Risk is inherent in the Company's business. Consequently, despite the
Company's efforts to identify areas of risk, oversee operational areas involving
risk, and implement policies and procedures designed to mitigate risk, there can
be no assurance that the Company will not suffer unexpected losses due to
operating or other risks.
The following discussion highlights the Company's principal risks and some
of the policies and procedures for risk identification, assessment, and
mitigation. See Liquidity and Capital Resources for a discussion on liquidity
risk and "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 24. Financial Instruments Subject to
Off-Balance Sheet Risk, Credit Risk or Market Risk" for additional discussion on
credit risk and market risk.
Technology and Operating Risk
Technology and operating risk is the potential for loss due to deficiencies
in control processes or technology systems that constrain the Company's ability
to gather, process and communicate information efficiently and securely, without
interruptions. The Company's operations are highly dependent on the integrity of
its technology systems and the Company's success depends, in part, on its
ability to make timely enhancements and additions to its technology in
anticipation of evolving client needs. To the extent the Company experiences
system interruptions, errors or downtime (which could result from a variety of
causes, including changes in client use patterns, technological failure, changes
to its systems, linkages with third-party systems, and power failures), the
Company's business and operations could be significantly negatively impacted.
Additionally, rapid increases in client demand may strain the Company's ability
to enhance its technology and expand its operating capacity. To minimize
business interruptions, Schwab has two data centers intended, in part, to
further improve the recovery of business processing in the event of an
emergency. The Company is committed to an ongoing process of upgrading,
enhancing, and testing its technology systems. This effort is focused on meeting
client needs, meeting market and regulatory changes, and deploying standardized
technology platforms.
Technology and operating risk also includes the risk of human error,
employee misconduct, external fraud, computer viruses, terrorist attack, and
natural disaster. Employee misconduct could include fraud and misappropriation
of client or Company assets, improper use or disclosure of confidential client
or Company information, and unauthorized activities, such as transactions
exceeding acceptable risks or authorized limits. External fraud includes
misappropriation of client or Company assets by third parties, including through
unauthorized access to Company systems and data and client accounts. The
frequency and sophistication of such fraud attempts continue to increase.
The Company has specific policies and procedures to identify and manage
operational risk, and uses periodic risk self-assessments and internal audit
reviews to evaluate the effectiveness of these internal controls. The Company
maintains backup and recovery functions, including facilities for backup and
communications, and conducts periodic testing of disaster recovery plans. The
Company also maintains policies and procedures and technology to protect against
fraud and unauthorized access to systems and data.
Despite the Company's risk mitigation efforts, it is not always possible to
deter or prevent technological or operational failure, or fraud or other
misconduct, and the precautions taken by the Company may not be effective in all
cases. The Company may be subject to litigation, losses, and regulatory actions
in such cases, and may be required to expend significant additional resources to
remediate vulnerabilities or other exposures.
The Company also faces technology and operating risk when it employs the
services of various external vendors, including domestic and international
outsourcing of certain technology, processing and support functions. The Company
manages its exposure to such outsourcing risks through contractual agreements
and ongoing monitoring of vendor performance.
The Company is actively engaged in the research and development of new
technologies, services, and products. The Company endeavors to protect its
research and development efforts, and its brands, through the use of copyrights,
patents, trade secrets, and contracts. From time to time, the Company may be
subject to litigation claims from third parties alleging infringement of their
intellectual property rights (e.g., patents). Such litigation can require the
expenditure of significant Company resources. If the Company were found to have
infringed a third-party patent, or other intellectual property rights, it could
incur substantial liability, and in some circumstances could be enjoined from
- 23 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
using certain technology, or providing certain products or services.
Credit Risk
Credit risk is the potential for loss due to a client or counterparty
failing to perform its contractual obligations, or the value of collateral held
to secure obligations proving to be inadequate. The Company's direct exposure to
credit risk mainly results from margin lending activities, securities lending
activities, its role as a counterparty in financial contracts, and investing
activities, and indirectly from the investing activities of certain of the
Company's proprietary funds. To mitigate the risks of such losses, the Company
has established policies and procedures which include: establishing and
reviewing credit limits, monitoring of credit limits and quality of
counterparties, and adjusting margin requirements for certain securities. In
addition, most of the Company's credit extensions, such as margin loans to
clients, securities lending agreements, and resale agreements, are supported by
collateral arrangements. These arrangements are subject to requirements to
provide additional collateral in the event that market fluctuations result in
declines in the value of collateral received.
Additionally, the Company has exposure to credit risk associated with the
Company's banking loan portfolios held at U.S. Trust and Schwab Bank. This
client credit exposure is actively managed through individual and portfolio
reviews performed by account officers and senior line management. Periodic
assessment of the validity of credit ratings, credit quality and the credit
management process is conducted by a credit review department which is separate
from the loan origination and monitoring department. Management regularly
reviews asset quality including concentrations, delinquencies, non-performing
loans to banking clients, losses and recoveries. All are factors in the
determination of an appropriate allowance for credit losses, which is reviewed
quarterly by senior management. See "Item 8 - Financial Statements and
Supplementary Data - Notes to Consolidated Financial Statements - 9. Loans to
Banking Clients and Related Allowance for Credit Losses and 24. Financial
Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" for
an analysis of the Company's loan portfolios and allowance for credit losses,
and for an additional discussion on credit risk, respectively.
Schwab performs clearing services for all securities transactions in its
client accounts. Schwab has exposure to credit risk due to its obligation to
settle transactions with clearing corporations, mutual funds and other financial
institutions even if Schwab's client or a counterparty fails to meet its
obligations to Schwab. See "Item 8 - Financial Statements and Supplementary Data
- - Notes to Consolidated Financial Statements - 24. Financial Instruments Subject
to Off-Balance Sheet Risk, Credit Risk or Market Risk."
There were no troubled debt restructurings at December 31, 2004 or 2003. As
of December 31, 2004, management is not aware of any significant potential
problem loans other than the amounts disclosed in "Item 8 - Financial Statements
and Supplementary Data - Notes to Consolidated Financial Statements - 9. Loans
to Banking Clients and Related Allowance for Credit Losses."
Fiduciary Risk
Fiduciary risk is the potential for financial or reputational loss through
the breaching of fiduciary duties to a client. Fiduciary activities include, but
are not limited to, individual and institutional trust, investment management,
custody, and cash and securities processing. The Company attempts to mitigate
this risk by establishing procedures to ensure that obligations to clients are
discharged faithfully and in compliance with applicable legal and regulatory
requirements. Business units have the primary responsibility for adherence to
the procedures applicable to their business. Guidance and control are provided
through the creation, approval, and ongoing review of applicable policies by
business units and various fiduciary risk committees.
Market Risk
See discussion of market risk at "Item 7A - Quantitative and Qualitative
Disclosures About Market Risk."
Legal and Regulatory Risk
The Company faces significant legal and compliance risk in its business,
and the volume of litigation and regulatory proceedings against financial
services firms and the amount of damages claimed have been increasing. Among
other things, these risks relate to the suitability of client investments,
disclosure obligations and performance expectations for Company products and
services, supervision of employees, and the adequacy of the Company's controls.
Claims against the Company may increase due to a variety of factors, such as if
clients suffer losses during a period of deteriorating equity market conditions,
as the Company increases the level of advice it provides to clients, and as the
Company enhances the services it provides to IAs. In addition, the Company and
its affiliates are subject to extensive regulation by federal, state and foreign
regulatory authorities, and self-regulatory organizations, and such regulation
is becoming increasingly extensive and complex.
The Company attempts to mitigate legal and compliance risk through policies
and procedures reasonably designed to avoid litigation claims and prevent or
detect violations of applicable legal and regulatory requirements. These
procedures address issues such as business conduct and
- 24 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
ethics, sales and trading practices, marketing and communications, extension of
credit, client funds and securities, books and records, anti-money laundering,
client privacy, employment policies, and contracts management. Despite the
Company's efforts to maintain an effective compliance program and internal
controls, legal breaches and rule violations, even if unintentional, could
result in reputational harm, significant losses and disciplinary sanctions,
including limitations on the Company's business activities.
Potential Strategic Transactions
The Company from time to time engages in the evaluation, consideration and
negotiation of a wide array of potential strategic transactions, including
business combinations, acquisitions and dispositions. Any such transaction could
have a material impact on the Company's financial position, results of
operations, EPS, or cash flows.
The process of integrating any acquisition may create unforeseen challenges
for the Company's operational, financial and management information systems, as
well as unforeseen expenditures and other risks, including diversion of
management's attention from other business concerns, the potential loss of key
clients, employees and business partners, and difficulties in managing
facilities and employees in different geographic areas. In addition, an
acquisition may cause the Company to assume liabilities or become subject to
litigation. Further, there can be no assurance that the Company will realize a
positive return on any acquisition or that future acquisitions will not be
dilutive to the Company's current stockholders' percentage ownership or to EPS.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the U.S. While the
majority of the Company's revenues, expenses, assets and liabilities are not
based on estimates, there are certain critical accounting policies that require
management to make estimates regarding matters that are uncertain and
susceptible to change where such change may result in a material adverse impact
on the Company's financial position and reported financial results. These
critical accounting policies are described below. Management regularly reviews
the estimates and assumptions used in the preparation of the Company's financial
statements for reasonableness and adequacy.
Valuation of Goodwill: Under the provisions of Statement of Financial Accounting
Standards (SFAS) No. 142 - Goodwill and Other Intangible Assets, goodwill is
required to be tested for impairment at least annually, or whenever indications
of impairment exist. An impairment exists when the carrying amount of goodwill
exceeds its implied fair value, resulting in an impairment charge for this
excess. The Company's goodwill balances, net of accumulated amortization, were
$811 million and $810 million at December 31, 2004 and 2003, respectively.
The Company has elected April 1 as its annual goodwill impairment testing
date. In testing for a potential impairment of goodwill on April 1, 2004,
management estimated the fair value of each of the Company's reporting units
(generally defined as the Company's businesses for which financial information
is available and reviewed regularly by management) and compared this value to
the carrying value of the reporting unit. The estimated fair value of each
reporting unit was greater than its carrying value, and therefore management
concluded that no amount of goodwill was impaired. The estimated fair value of
the reporting units was established using a discounted cash flow model that
includes significant assumptions about the future operating results and cash
flows of each reporting unit. Adverse changes in the Company's planned business
operations such as unanticipated competition, a loss of key personnel, the sale
of a reporting unit or a significant portion of a reporting unit, or other
unforeseen developments could result in an impairment of the Company's recorded
goodwill.
Valuation and Estimated Useful Lives of Intangible Assets Other than Goodwill:
The Company's intangible assets represent purchased assets that lack physical
substance but can be distinguished from goodwill, principally the value of
client relationships. Management generally obtains independent valuations to
estimate the initial valuation and expected amortization period for
client-related intangible assets. These valuations are primarily based on the
present value of the estimated net cash flows expected to be derived from the
client relationships, and assumptions about future client attrition. At each
balance sheet date, management compares the actual and estimated attrition for
client-related intangible assets to evaluate whether revisions to the
amortization period are necessary. Also, management evaluates the client-related
intangible assets for impairment whenever events or changes in circumstances
indicate that the carrying amount of the asset may not be recoverable.
Therefore, higher than expected client attrition may result in higher future
amortization charges or an impairment charge for client-related intangible
assets. The Company's intangible asset balances, net of accumulated
amortization, were $153 million and $141 million at December 31, 2004 and 2003,
respectively.
- 25 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Restructuring Reserves: A portion of the reserves under the Company's
restructuring initiatives are based on assumptions, including the Company's
ability to successfully sublease certain real estate properties. The initial
restructuring reserves and any subsequent changes in estimates of such reserves
are recorded in restructuring charges on the Company's consolidated statement of
income. Factors and uncertainties which may adversely affect the estimates of
sublease income include deterioration in the respective properties' real estate
markets, including Northern California, Texas, and New Jersey, and prolonged
vacancy periods prior to execution of tenant subleases. The Company's total
facilities reserves related to its restructuring initiatives were $248 million
and $213 million at December 31, 2004 and 2003, respectively.
As of December 31, 2004, the remaining facilities restructuring reserve is
net of estimated future sublease income of approximately $310 million. This
estimated future sublease income amount is determined based upon a number of
factors, including current and expected commercial real estate lease rates in
the respective properties' real estate markets, and estimated vacancy periods
prior to execution of tenant subleases. At year end, approximately 80% of the
total square footage targeted for sublease under the restructuring initiatives
has been subleased, up from approximately 65% at December 31, 2003. The increase
in subleased square footage is primarily due to the subleasing of certain
property in New Jersey to a real estate investment trust in the second quarter
of 2004, partially offset by the addition of properties as part of the 2004 cost
reduction effort. For a further discussion on the Company's restructuring
reserves, see "Description of Business - Restructuring."
Pension and Other Postretirement Benefits: Under U.S. Trust's trusteed,
noncontributory, qualified defined benefit pension plan, the benefit obligation
and related plan assets are based on certain estimates - years of employee
service, rate of increase in salary, discount rate and expected rate of return
on plan assets - which are made by management with recommendations by actuaries.
In addition to the years of employee service, rate of increase in salary, and
discount rate, U.S. Trust's postretirement medical and life insurance benefit
obligation is based on the health care cost trend rate which is an actuarial
estimated rate of future increases in per capita cost of health care benefits.
The Company's benefit obligation at December 31, 2004 and 2003 was $312 million
and $283 million, respectively. The related pension expense (credit) is included
in compensation and benefits on the Company's consolidated statement of income
and was $7 million, $8 million, and less than $(1) million for 2004, 2003, and
2002, respectively.
Derivative Instruments and Hedging Activities: As part of its asset and
liability management process, the Company uses Swaps to manage interest rate
risk.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with U.S. Trust's variable rate deposits from banking clients. The
Company has designated these Swaps as cash flow hedges, as allowed by
SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities.
Therefore, principally all of the cumulative change in the fair value of these
Swaps from inception, totaling a net $6 million and $33 million liability at
December 31, 2004 and 2003, respectively, has been recorded in accumulated other
comprehensive loss, which is a component of stockholders' equity that is not
recognized in current earnings. Any actual hedge ineffectiveness, which was
immaterial for 2004, is recorded in interest expense on the Company's
consolidated statement of income. In order to maintain hedge accounting
treatment, management performs a quarterly assessment of its expectation that
these Swaps are effective in achieving the desired hedging results.
Additionally, the Company has entered into Swaps that effectively convert
the interest rate characteristics of a portion of the Company's Senior
Medium-Term Notes, Series A (Medium-Term Notes) from fixed to variable. The
Company has designated such Swaps as fair value hedges, as allowed by
SFAS No. 133. Since the notional amount, fixed interest rate, and maturity of
these Swaps exactly match the terms of the corresponding Medium-Term Notes, the
Company has concluded that these Swaps are completely effective in achieving the
desired hedging results, as permitted under SFAS No. 133. Consequently, changes
in the fair value of these Swaps, totaling an aggregate $13 million and
$19 million asset at December 31, 2004 and 2003, respectively, are completely
offset by changes in the fair value of the hedged Medium-Term Notes.
Accordingly, there has not been any impact on earnings as a result of this
hedging program except for the conversion from a fixed to a floating rate of
interest on a portion of the Medium-Term Notes.
Allowance for Credit Losses: The Company regularly evaluates its portfolio of
loans to banking clients and provides allowances for the portion management
believes may be uncollectible. Several factors are taken into consideration in
this evaluation including current economic conditions, the composition of the
loan portfolio, past loss experience, and risks inherent in the loan portfolio.
For Schwab Bank and U.S. Trust portfolios, which primarily consist of mortgage
loans, a risk-based methodology is used to determine the allowance for credit
losses. Mortgage loans are categorized into portfolios by loan type and risk
characteristics. A probable loss rate, based on company and
- 26 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
industry experience, is used to determine the credit allowance for each
portfolio of loans. At both December 31, 2004 and 2003, the Company's allowance
for credit losses was $27 million on loan portfolios of $6.8 billion and $5.8
billion, respectively.
Legal Reserve: The Company is subject to legal, regulatory and other proceedings
and claims arising from the conduct of its business. The Company establishes a
reserve for potential losses that may arise out of these proceedings to the
extent that such losses are probable and can be estimated. The amount of the
reserve, which is determined on a case-by-case basis, represents the Company's
best estimate of probable losses after considering, among other factors, the
progress of each case, experience in similar cases, available defenses,
insurance coverage, and the opinions and views of legal counsel. However,
significant judgment is required in making this estimate and the actual cost of
resolving a claim may be higher or lower than the amount of the recorded
reserve.
The Company's management has discussed the development and selection of
these critical accounting estimates with the Audit Committee. Additionally, the
Audit Committee has reviewed the Company's disclosures relating to the estimates
discussed in this Management's Discussion and Analysis of Results of Operations
and Financial Condition.
For further information on the Company's accounting policies, see "Item 8 -
Financial Statements and Supplementary Data - Notes to Consolidated Financial
Statements - 2. Significant Accounting Policies."
FORWARD-LOOKING STATEMENTS
In addition to historical information, this Annual Report on Form 10-K
contains "forward-looking statements" within the meaning of Section 27A of the
Securities Act, and Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements are identified by words such as "believe,"
"anticipate," "expect," "intend," "plan," "will," "may," and other similar
expressions. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances are forward-looking
statements. These forward-looking statements, which reflect management's
beliefs, objectives and expectations as of the date hereof, are necessarily
estimates based on the best judgment of the Company's senior management. These
statements relate to, among other things, the Company's ability to pursue its
business strategy (see "Item 1 - Business - Business Strategy and Competitive
Environment"); the impact of legal proceedings and regulatory matters (see "Item
3 - Legal Proceedings" and "Item 8 - Financial Statements and Supplementary Data
- - Notes to Consolidated Financial Statements - 23. Commitments and Contingent
Liabilities - Legal Contingencies"); the impact of the firm-wide cost reduction
effort on the Company's results of operations and the Company's ability to
realize the estimated cost savings (see Description of Business - Overview and -
Restructuring); management's expected effective income tax rate (see Results of
Operations - Expenses Excluding Interest); capital expenditures (see Liquidity
and Capital Resources - Cash and Capital Resources); sources of liquidity and
capital (see Liquidity and Capital Resources - Liquidity and - Commitments); the
potential impact of future strategic transactions (see Risk Management -
Potential Strategic Transactions); the impact of changes in management's
estimates on the Company's results of operations (see Critical Accounting
Policies); the impact on the Company's results of operations of recording stock
option expense (see "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 2. Significant Accounting
Policies"); and net interest expense under interest rate swaps (see "Item 8 -
Financial Statements and Supplementary Data - Notes to Consolidated Financial
Statements - 24. Financial Instruments Subject to Off-Balance Sheet Risk, Credit
Risk or Market Risk"). Achievement of the expressed beliefs, objectives and
expectations described in these statements is subject to certain risks and
uncertainties that could cause actual results to differ materially from the
expressed beliefs, objectives, and expectations. Readers are cautioned not to
place undue reliance on these forward-looking statements, which speak only as of
the date of this Annual Report on Form 10-K or, in the case of documents
incorporated by reference, as of the date of those documents.
Important factors that may cause such differences include, but are not
limited to: the Company's success in building fee-based relationships with its
clients; the effect of client trading patterns on Company revenues and earnings;
changes in revenues and profit margin due to cyclical securities markets and
fluctuations in interest rates; the level and continuing volatility of equity
prices; a significant downturn in the securities markets over a short period of
time or a sustained decline in securities prices, trading volumes, and investor
confidence; geopolitical developments affecting the securities markets, the
economy, and investor sentiment; the effects of the Company's or its
competitors' pricing, product and service decisions; the Company's ability to
recognize the expected benefits of acquisitions or dispositions; the effects of
changes in taxation laws and regulations (including tax rate changes, new tax
laws and revised tax law interpretations), as well as the effect of strategic
transactions (including business combinations,
- 27 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
acquisitions, and dispositions) on the Company's effective income tax rate; the
size and number of the Company's insurance claims; a significant decline in the
real estate market, including the Company's ability to sublease certain
properties; and the scope of severance payments related to workforce reductions.
Other more general factors that may cause such differences include, but are not
limited to: the Company's inability to attract and retain key personnel; the
timing and impact of changes in the Company's level of investments in personnel,
technology, or advertising; changes in technology; computer system failures and
security breaches; evolving legislation, regulation and changing industry
practices adversely affecting the Company; adverse results of litigation or
regulatory matters; the inability to obtain external financing at acceptable
rates; and intensified industry competition and consolidation. Certain of these
factors are discussed in greater detail in this Annual Report on Form 10-K.
- 28 -
THE CHARLES SCHWAB CORPORATION
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the potential for loss due to a change in the value of a
financial instrument held by the Company as a result of fluctuations in interest
rates, equity prices, or currency exchange rates.
The Company is exposed to interest rate risk primarily from changes in the
interest rates on its interest-earning assets (mainly margin loans to clients,
investments, loans to banking clients, mortgage-backed securities, and other
fixed-rate investments) and its funding sources (including brokerage client cash
balances, banking deposits, proceeds from stock-lending activities, and
long-term debt) which finance these assets. To mitigate the risk of loss, the
Company has established policies and procedures which include setting guidelines
on the amount of net interest revenue at risk, and by monitoring the net
interest margin and average maturity of its interest-earning assets and funding
sources. The Company also has the ability to adjust the rates paid on certain
brokerage client cash balances and certain banking deposits and the rates
charged on margin loans. Additionally, the Company uses Swaps to mitigate
interest rate exposure associated with short-term floating interest-rate
deposits. The Company's exposure to equity price and currency exchange risks is
not material.
Additional qualitative and quantitative disclosures about market risk are
summarized in the following paragraphs. See "Item 8 - Financial Statements and
Supplementary Data - Notes to Consolidated Financial Statements - 24. Financial
Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" for
an additional discussion on market risk.
Financial Instruments Held For Trading Purposes
The Company holds fixed income securities, which include municipal and
government securities, and corporate bonds, in inventory to meet clients'
trading needs. The fair value of such inventory was approximately $54 million
and $74 million at December 31, 2004 and 2003, respectively. These securities,
and the associated interest rate risk, are not material to the Company's
financial position, results of operations, or cash flows.
Financial Instruments Held For Purposes Other Than Trading
Debt Issuances
At December 31, 2004, CSC had $386 million aggregate principal amount of
Medium-Term Notes outstanding, with fixed interest rates ranging from 6.21% to
8.05%. At December 31, 2003, CSC had $466 million aggregate principal amount of
Medium-Term Notes outstanding, with fixed interest rates ranging from 6.04% to
8.05%. At December 31, 2004 and 2003, U.S. Trust had $52 million Trust Preferred
Capital Securities outstanding, with a fixed interest rate of 8.41%.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The fair value of these
obligations at December 31, 2004 and 2003, based on estimates of market rates
for debt with similar terms and remaining maturities, was $485 million and
$584 million, respectively, which approximated their carrying amounts of
$451 million and $537 million, respectively.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes Swaps to manage interest rate risk. For a discussion of such
Swaps, see "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 24. Financial Instruments Subject to
Off-Balance Sheet Risk, Credit Risk or Market Risk."
Loans Held for Sale
Schwab Bank's loans held for sale portfolio consists of fixed- and
adjustable-rate mortgages, which are subject to a loss in value when market
interest rates rise. Schwab Bank uses forward sale commitments to manage this
risk. At December 31, 2004, the forward sale commitments were designated as cash
flow hedging instruments of the loans held for sale. Accordingly, the fair
values of the forward sale commitments are recorded on the Company's
consolidated balance sheet, with gains or losses recorded in other comprehensive
income (loss). At December 31, 2004 and 2003, the derivative liability recorded
by Schwab Bank for these forward sale commitments was immaterial.
Net Interest Revenue Simulation
The Company uses net interest revenue simulation modeling techniques to
evaluate and manage the effect of changing interest rates. The simulation model
(the model) includes all interest-sensitive assets and liabilities, as well as
Swaps utilized by the Company to hedge its interest rate risk. Key variables in
the model include assumed balance growth or decline for client loans, deposits,
and brokerage client cash, changes in the level and term structure of interest
rates, the repricing of financial instruments, prepayment and reinvestment
assumptions, and product pricing assumptions. The simulations involve
assumptions that are inherently uncertain and, as a result, cannot precisely
estimate net
- 29 -
THE CHARLES SCHWAB CORPORATION
interest revenue or precisely predict the impact of changes in interest rates on
net interest revenue. Actual results may differ from simulated results due to
the timing, magnitude, and frequency of interest rate changes as well as changes
in market conditions and management strategies, including changes in asset and
liability mix.
As demonstrated by the simulations presented below, the Company is
positioned so that the consolidated balance sheet produces an increase in net
interest revenue when interest rates rise and, conversely, a decrease in net
interest revenue when interest rates fall (i.e., interest-earning assets are
repricing more quickly than interest-bearing liabilities).
The simulations in the following table assume that the asset and liability
structure of the consolidated balance sheet would not be changed as a result of
the simulated changes in interest rates. As the Company actively manages its
consolidated balance sheet and interest rate exposure, in all likelihood the
Company would take steps to manage any additional interest rate exposure that
could result from changes in the interest rate environment. The following table
shows the results of a gradual 100 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at December 31, 2004 and 2003. The
following table also shows the results of a gradual 200 basis point increase or
decrease in interest rates relative to the Company's current forecast of net
interest revenue over the twelve months ending December 31, 2005. Historically,
the Company had used a gradual 200 basis point change when evaluating its
sensitivity; however, the Company changed to a 100 basis point simulation in
December 2001 due to low levels of interest rates. Given the recent increase in
interest rates, the Company will again report its interest rate sensitivity
using a gradual 200 basis point change.
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Increase of 100 basis points 2.9% 1.7%
Decrease of 100 basis points (2.8%) (6.4%)
Increase of 200 basis points 5.7% n/a
Decrease of 200 basis points (5.9%) n/a
- --------------------------------------------------------------------------------
n/a - Not applicable.
The down 100 basis point simulation shows reduced exposure to falling
interest rates at December 31, 2004 compared to December 31, 2003. This reduced
sensitivity results from higher interest rates and an expectation of interest
rates continuing to increase, both of which lessen the impact of spread
compression between interest-earning assets and brokerage client cash balances
and banking deposits.
- 30 -
THE CHARLES SCHWAB CORPORATION
Item 8. Financial Statements and Supplementary Data
TABLE OF CONTENTS
Consolidated Statement of Income ------------------------------------- 32
Consolidated Balance Sheet ------------------------------------------- 33
Consolidated Statement of Cash Flows --------------------------------- 34
Consolidated Statement of Stockholders' Equity ----------------------- 35
Notes to Consolidated Financial Statements --------------------------- 36
Note 1. Introduction and Basis of Presentation -------------- 36
Note 2. Significant Accounting Policies --------------------- 36
Note 3. Restructuring Charges ------------------------------- 39
Note 4. Sale of Corporate Trust Business -------------------- 41
Note 5. Discontinued Operations ----------------------------- 41
Note 6. Business Acquisitions and Divestitures --------------- 43
Note 7. Securities Owned ------------------------------------ 43
Note 8. Receivables from Brokerage Clients ------------------ 44
Note 9. Loans to Banking Clients and Related
Allowance for Credit Losses ------------------------- 44
Note 10. Loan Securitizations -------------------------------- 45
Note 11. Equipment, Office Facilities and Property ----------- 46
Note 12. Deposits from Banking Clients ----------------------- 46
Note 13. Payables to Brokers, Dealers and Clearing
Organizations --------------------------------------- 46
Note 14. Payables to Brokerage Clients ----------------------- 46
Note 15. Short-term Borrowings ------------------------------- 46
Note 16. Long-term Debt -------------------------------------- 47
Note 17. Taxes on Income ------------------------------------- 47
Note 18. Employee Incentive and Deferred
Compensation Plans ---------------------------------- 48
Note 19. Retirement and Other Employee Benefit Plans --------- 49
Note 20. Accumulated Other Comprehensive Income (Loss) ------- 52
Note 21. Earnings Per Share ---------------------------------- 52
Note 22. Regulatory Requirements ----------------------------- 52
Note 23. Commitments and Contingent Liabilities -------------- 54
Note 24. Financial Instruments Subject to Off-Balance
Sheet Risk, Credit Risk or Market Risk -------------- 55
Note 25. Fair Value of Financial Instruments ----------------- 58
Note 26. Segment Information --------------------------------- 58
Note 27. Supplemental Cash Flow Information ------------------ 60
Note 28. The Charles Schwab Corporation - Parent
Company Only Financial Statements ------------------- 60
Note 29. Quarterly Financial Information (Unaudited) --------- 62
Management's Report on Internal Control Over Financial Reporting ----- 63
Report of Independent Registered Public Accounting Firm -------------- 64
- 31 -
THE CHARLES SCHWAB CORPORATION
Consolidated Statement of Income
(In Millions, Except Per Share Amounts)
Year Ended December 31, 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 2,091 $ 1,832 $ 1,753
Commissions 936 1,097 1,135
Interest revenue 1,213 968 1,156
Interest expense (277) (240) (331)
--------- --------- ---------
Net interest revenue 936 728 825
Principal transactions 89 93 102
Other 150 146 129
- ------------------------------------------------------------------------------------------------------------------------------------
Total 4,202 3,896 3,944
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 1,877 1,665 1,755
Occupancy and equipment 389 430 446
Professional services 245 175 168
Depreciation and amortization 226 277 309
Communications 223 228 245
Advertising and market development 184 139 207
Commissions, clearance and floor brokerage 39 40 46
Restructuring charges 214 76 343
Impairment charges - 5 37
Other 160 144 139
- ------------------------------------------------------------------------------------------------------------------------------------
Total 3,557 3,179 3,695
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income and extraordinary gain 645 717 249
Taxes on income 231 241 100
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before extraordinary gain 414 476 149
Loss from discontinued operations, net of tax (128) (4) (52)
Extraordinary gain on sale of corporate trust business, net of tax - - 12
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 286 $ 472 $ 109
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,365 1,364 1,375
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income from continuing operations before extraordinary gain $ .31 $ .35 $ .11
Loss from discontinued operations, net of tax $ (.10) - $ (.04)
Extraordinary gain, net of tax - - $ .01
Net income $ .21 $ .35 $ .08
Earnings Per Share - Diluted
Income from continuing operations before extraordinary gain $ .30 $ .35 $ .11
Loss from discontinued operations, net of tax $ (.09) - $ (.04)
Extraordinary gain, net of tax - - $ .01
Net income $ .21 $ .35 $ .08
- ------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .074 $ .050 $ .044
- ------------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
- 32 -
THE CHARLES SCHWAB CORPORATION
Consolidated Balance Sheet
(In Millions, Except Share and Per Share Amounts)
December 31, 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,778 $ 2,785
Cash and investments segregated and on deposit for federal or other regulatory
purposes (1) (including resale agreements of $12,901 in 2004 and $16,824 in 2003) 19,019 21,341
Securities owned - at market value (including securities pledged of $8 in 2004
and $131 in 2003) 5,335 3,934
Receivables from brokers, dealers and clearing organizations 482 476
Receivables from brokerage clients - net 9,841 8,581
Loans to banking clients - net 6,822 5,736
Loans held for sale 20 29
Equipment, office facilities and property - net 903 943
Goodwill - net 811 810
Intangible assets - net 153 141
Other assets 969 829
Assets of discontinued operations - 261
- ------------------------------------------------------------------------------------------------------------------------------------
Total $47,133 $45,866
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $11,118 $ 8,308
Drafts payable 363 152
Payables to brokers, dealers and clearing organizations 1,468 2,633
Payables to brokerage clients 27,154 27,184
Accrued expenses and other liabilities 1,396 1,216
Short-term borrowings 663 996
Long-term debt 585 772
Liabilities of discontinued operations - 144
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 42,747 41,405
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share; none issued - -
Common stock - 3 billion shares authorized; $.01 par value per share;
1,392,091,544 shares issued 14 14
Additional paid-in capital 1,769 1,749
Retained earnings 3,258 3,125
Treasury stock - 61,434,850 and 34,452,710 shares in 2004 and 2003, respectively, at cost (591) (319)
Unamortized stock-based compensation (59) (95)
Accumulated other comprehensive loss (5) (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,386 4,461
- ------------------------------------------------------------------------------------------------------------------------------------
Total $47,133 $45,866
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $19,004 million at December 31, 2004, excluding $200 million of intercompany repurchase
agreements, and $21,004 million at December 31, 2003. On January 4, 2005 and January 5, 2004, the Company deposited $426
million and $221 million, respectively, into its segregated reserve bank accounts.
See Notes to Consolidated Financial Statements.
- 33 -
THE CHARLES SCHWAB CORPORATION
Consolidated Statement of Cash Flows
(In Millions)
Year Ended December 31, 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 286 $ 472 $ 109
Adjustments to reconcile net income to net cash provided by
operating activities:
Loss from discontinued operations, net of tax 128 4 52
Depreciation and amortization 226 277 309
Impairment charges - 5 37
Tax benefits from, and amortization of, stock-based awards 64 29 31
Deferred income taxes (4) 5 19
Non-cash restructuring charges 16 12 37
Extraordinary gain on sale of corporate trust business, net of tax - - (12)
Other 2 (26) 27
Originations of loans held for sale (856) (1,606) -
Proceeds from sales of loans held for sale 870 1,585 -
Net change in:
Cash and investments segregated and on deposit for federal
or other regulatory purposes 2,321 (1,065) (3,302)
Securities owned (excluding securities available for sale) 32 (117) 87
Receivables from brokers, dealers and clearing organizations (7) (278) 218
Receivables from brokerage clients (1,261) (1,741) 2,745
Other assets (51) (72) (5)
Drafts payable 210 19 (259)
Payables to brokers, dealers and clearing organizations (1,165) 1,184 646
Payables to brokerage clients (31) 1,479 (527)
Accrued expenses and other liabilities 111 (110) (18)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 891 56 194
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (3,387) (3,264) (1,147)
Proceeds from sales of securities available for sale 686 397 636
Proceeds from maturities, calls and mandatory redemptions of
securities available for sale 1,154 819 415
Net increase in loans to banking clients (2,112) (1,538) (705)
Proceeds from sales of banking client loans 1,026 355 196
Purchase of equipment, office facilities and property - net (194) (147) (154)
Cash payments for business combinations and investments,
net of cash received (2) (374) -
Proceeds from sales of subsidiaries and investments 271 70 26
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (2,558) (3,682) (733)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients 2,810 3,077 (217)
Net change in short-term borrowings (333) 488 (55)
Proceeds from long-term debt 136 - 100
Repayment of long-term debt (315) (100) (214)
Dividends paid (101) (68) (60)
Purchase of treasury stock (383) (32) (299)
Proceeds from stock options exercised and other 51 34 34
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities 1,865 3,399 (711)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash (used for) provided by discontinued operations (205) 33 (142)
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (7) (194) (1,392)
Cash and Cash Equivalents at Beginning of Year 2,785 2,979 4,371
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 2,778 $ 2,785 $ 2,979
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 34 -
THE CHARLES SCHWAB CORPORATION
Consolidated Statement of Stockholders' Equity
(In Millions)
Accumulated
Additional Unamortized Other
Common Paid-In Retained Treasury Stock-based Comprehensive
Stock Capital Earnings Stock Compensation Income(Loss) Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 $ 14 $ 1,726 $ 2,794 $ (295) $ (39) $ (37) $ 4,163
====================================================================================================================================
Comprehensive income:
Net income - - 109 - - - 109
Net loss on cash flow hedging instruments,
net of tax of $3 - - - - - (6) (6)
Net unrealized gain on securities available for sale,
net of reclassification adjustment, and tax of $11 - - - - - 17 17
Foreign currency translation adjustment - - - - - 8 8
--------
Total comprehensive income 128
Dividends declared on common stock - - (60) - - - (60)
Purchase of treasury stock - - - (299) - - (299)
Stock options exercised, and shares and stock options
issued under stock-based compensation plans - 5 (74) 129 (22) - 38
Non-cash stock-based compensation expense
related to restructuring - 9 - - 1 - 10
Issuance of shares for acquisitions - 4 - - - - 4
Amortization of stock-based compensation awards - - - - 27 - 27
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 14 1,744 2,769 (465) (33) (18) 4,011
====================================================================================================================================
Comprehensive income:
Net income - - 472 - - - 472
Net gain on cash flow hedging instruments,
net of tax of $13 - - - - - 19 19
Net unrealized loss on securities available for sale,
net of reclassification adjustment, and tax of $13 - - - - - (19) (19)
Foreign currency translation adjustment - - - - - 5 5
--------
Total comprehensive income 477
Dividends declared on common stock - - (68) - - - (68)
Purchase of treasury stock - - - (32) - - (32)
Stock options exercised, and shares and stock options
issued under stock-based compensation plans - (4) (47) 174 (97) - 26
Non-cash stock-based compensation expense
related to restructuring - 8 - - 1 - 9
Issuance of shares for acquisitions - 1 (1) 4 - - 4
Amortization of stock-based compensation awards - - - - 34 - 34
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 14 1,749 3,125 (319) (95) (13) 4,461
====================================================================================================================================
Comprehensive income:
Net income - - 286 - - - 286
Net gain on cash flow hedging instruments,
net of tax of $10 - - - - - 15 15
Net unrealized loss on securities available for sale,
net of reclassification adjustment, and tax of $5 - - - - - (8) (8)
Foreign currency translation adjustment - - - - - 1 1
--------
Total comprehensive income 294
Dividends declared on common stock - - (101) - - - (101)
Purchase of treasury stock - - - (383) - - (383)
Stock options exercised, and shares and stock options
issued under stock-based compensation plans - 17 (52) 111 (47) - 29
Non-cash stock-based compensation expense
related to restructuring - 3 - - 3 - 6
Amortization of stock-based compensation awards - - - - 80 - 80
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2004 $ 14 $ 1,769 $ 3,258 $ (591) $ (59) $ (5) $ 4,386
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 35 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
1. Introduction and Basis of Presentation
The Charles Schwab Corporation (CSC) is a financial holding company
engaged, through its subsidiaries, in securities brokerage, banking, and related
financial services. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 236 domestic branch offices in 43 states, as well as a branch
in the Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 37 offices in 15 states. Other subsidiaries include
Charles Schwab Investment Management, Inc., the investment advisor for Schwab's
proprietary mutual funds, CyberTrader, Inc. (CyberTrader), an electronic trading
technology and brokerage firm providing services to highly active, online
traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail bank.
The consolidated financial statements include CSC and its majority-owned
subsidiaries (collectively referred to as the Company). These consolidated
financial statements have been prepared in conformity with accounting principles
generally accepted in the U.S., which require management to make certain
estimates and assumptions that affect the reported amounts in the accompanying
financial statements. Such estimates relate to capitalized development costs for
internal-use software; useful lives of intangible assets, equipment, office
facilities, and property; valuation of goodwill, intangible assets, and equity
investments; valuation of employee stock options; fair value of financial
instruments and investments; allowance for credit losses on banking loans;
allowance for doubtful accounts of brokerage clients; retirement and
postretirement benefits; future tax benefits; restructuring reserves; and legal
reserves. Actual results could differ from such estimates. Certain prior-year
amounts have been reclassified to conform to the 2004 presentation. All material
intercompany balances and transactions have been eliminated.
The Company completed the sale of its capital markets business in 2004 and
the sale of its U.K. brokerage business in 2003. These financial statements have
been adjusted to reflect these businesses as discontinued operations. See note
"5 - Discontinued Operations" for further discussion of these sales.
2. Significant Accounting Policies
Securities transactions: Clients' securities transactions are recorded on the
date that they settle, while the related commission revenues and expenses are
recorded on the date that the trade occurs. Principal transactions are recorded
on a trade date basis.
Cash and cash equivalents: The Company considers all highly liquid investments,
including money market funds, interest-bearing deposits with banks, federal
funds sold, commercial paper and treasury securities, with original maturities
of three months or less that are not segregated and on deposit for federal or
other regulatory purposes to be cash equivalents.
Cash and investments segregated and on deposit for federal or other regulatory
purposes consist primarily of securities purchased under agreements to resell
(resale agreements), which are collateralized by U.S. government securities, and
certificates of deposit. Resale agreements are collateralized investing
transactions that are recorded at their contractual amounts plus accrued
interest. The Company obtains possession of collateral (U.S. government
securities) with a market value equal to or in excess of the principal amount
loaned and accrued interest under resale agreements. Collateral is valued daily
by the Company, with additional collateral obtained when necessary. Certificates
of deposit are recorded at market value.
Securities borrowed, securities loaned, and securities sold under agreements to
repurchase (repurchase agreements): Securities borrowed require the Company to
deliver cash to the lender in exchange for securities and are included in
receivables from brokers, dealers and clearing organizations. For securities
loaned, the Company receives collateral in the form of cash in an amount
generally equal to the market value of securities loaned. Securities loaned are
included in payables to brokers, dealers and clearing organizations. The Company
monitors the market value of securities borrowed and loaned, with additional
collateral obtained or refunded when necessary. Repurchase agreements are
recorded at their contractual amounts plus accrued interest and are included in
short-term borrowings.
Securities owned include securities available for sale that are recorded at
estimated fair value using quoted market prices, where available, or third-party
pricing services. Unrealized gains and losses are reported, net of taxes, in
accumulated other comprehensive income (loss) included in stockholders' equity.
Realized gains and losses from sales of securities
- 36 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
available for sale are determined on a specific identification basis and are
included in other revenues.
Securities owned also include equity, fixed income and other securities,
SchwabFunds(R) money market funds, and equity and bond mutual funds and are
recorded at estimated fair value. Unrealized gains and losses are included in
principal transaction revenues.
Receivables from brokerage clients are stated net of allowance for doubtful
accounts of $1 million and $2 million at December 31, 2004 and 2003,
respectively. Cash receivables from brokerage clients that remain unsecured or
partially secured for more than 30 days are fully reserved.
Nonperforming assets included in the loan portfolio consist of financial
instruments where the Company has stopped accruing interest (non-accrual
financial instruments). Interest accruals are discontinued when principal or
interest is contractually past due 90 days or more unless collectibility of the
loan is reasonably assured. Non-accrual financial instruments are generally
returned to accrual status only when all delinquent principal and interest
payments become current and the collectibility of future principal and interest
on a timely basis is reasonably assured.
Loans to banking clients are stated net of allowance for credit losses of
$27 million at both December 31, 2004 and 2003. The allowance is established
through charges to income based on management's evaluation of the adequacy of
the allowance for credit losses in the existing portfolio.
The adequacy of the allowance is reviewed regularly by management, taking
into consideration current economic conditions, the existing loan portfolio
composition, past loss experience and risks inherent in the portfolio, including
the value of impaired loans.
Loans held for sale consist of fixed-rate and adjustable-rate mortgage loans
intended for sale. Loans held for sale are stated at lower of cost or market
value. Market value is determined using quoted market prices.
Equipment, office facilities and property: Equipment and office facilities are
depreciated on a straight-line basis over the estimated useful life of the asset
of three to ten years. Buildings are depreciated on a straight-line basis over
twenty years. Leasehold improvements are amortized on a straight-line basis over
the lesser of the estimated useful life of the asset or the term of the lease.
Software and certain costs incurred for purchasing or developing software for
internal use are amortized on a straight-line basis over an estimated useful
life of three or five years. Equipment, office facilities and property are
stated at cost net of accumulated depreciation and amortization, except for
land, which is stated at cost. Equipment, office facilities and property are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of such assets may not be recoverable.
Derivative financial instruments are recorded on the balance sheet at fair value
based upon dealer quotes and third-party pricing services. As part of its
consolidated asset and liability management process, the Company utilizes
interest rate swap agreements (Swaps) to manage interest rate risk of both
fixed-rate and variable-rate financial instruments. The Company applies hedge
accounting to these swaps and therefore gains and losses are generally deferred
and recognized in interest expense to offset the impact of changing interest
rates on the hedged financial instruments. For further discussion on these
derivative financial instruments, see note "24 - Financial Instruments Subject
to Off-Balance Sheet Risk, Credit Risk or Market Risk."
Income taxes: The Company files a consolidated U.S. federal income tax return
and uses the asset and liability method in recording income tax expense. Under
this method, deferred tax assets and liabilities are recorded for temporary
differences between the tax basis of assets and liabilities and their recorded
amounts for financial reporting purposes, using currently enacted tax law.
Stock-based compensation: The Company applies Accounting Principles Board
Opinion (APB) No. 25 - Accounting for Stock Issued to Employees, and related
interpretations, for its stock-based employee compensation plans. Because the
Company grants stock option awards at market value, there is no compensation
expense recorded when the awards are granted. Expense is recognized if the
original terms of an award are subsequently modified, which has occurred in
connection with restructuring and severance activities. Compensation expense for
restricted stock awards is based on the market value of the shares awarded at
the date of grant and is amortized on a straight-line basis over the vesting
period. The unamortized portion of the award is recorded as unamortized
stock-based compensation in stockholders' equity.
The Company changed its option pricing model from the Black-Scholes model
to a binomial model for all options granted on or after January 1, 2004. The
fair values of stock options granted prior to January 1, 2004 were determined
using the Black-Scholes model. The Company believes that the binomial model
offers greater flexibility in reflecting the characteristics of employee stock
options. The binomial model takes into account similar inputs to a Black-Scholes
model such as volatility, dividend yield rate, and risk-free
- 37 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
interest rate. In addition to these assumptions, the binomial model considers
the contractual term of the option, the probability that the option will be
exercised prior to the end of its contractual life, and the probability of
termination or retirement of the option holder in computing the value of the
option. The Company determines these probabilities generally based on analysis
of historical trends of such events. The weighted-average of the assumptions
used in the respective option pricing models were as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Expected dividend yield .48% .30% .30%
Expected volatility 35% 49% 51%
Risk-free interest rate 3.9% 2.7% 3.5%
Expected life (in years) (1) 3.4 5.0 5.0
- --------------------------------------------------------------------------------
(1) Reflects a decrease in the contractual term and vesting period for 2004
stock option grants.
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes or binomial fair value, as described
above, at the grant dates for awards under those plans consistent with the fair
value method of Statement of Financial Accounting Standards (SFAS) No. 123 -
Accounting for Stock-Based Compensation, the Company would have recorded
additional compensation expense and its net income and earnings per share (EPS)
would have been reduced to the pro forma amounts presented in the following
table:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Expense for stock-based
compensation (after tax) (1):
As reported $ 39 $ 23 $ 20
Pro forma (2) $ 127 $ 124 $ 162
- --------------------------------------------------------------------------------
Net income (loss):
As reported $ 286 $ 472 $ 109
Pro forma $ 198 $ 371 $ (33)
- --------------------------------------------------------------------------------
Basic EPS:
As reported $ .21 $ .35 $ .08
Pro forma $ .15 $ .28 $ (.02)
Diluted EPS:
As reported $ .21 $ .35 $ .08
Pro forma $ .15 $ .27 $ (.02)
- --------------------------------------------------------------------------------
(1) Includes compensation expense related to restricted stock awards of
$37 million, $18 million, and $14 million in 2004, 2003, and 2002,
respectively.
(2) Includes pro forma compensation expense related to stock options granted in
both current and prior years. Pro forma stock option compensation is
amortized on a basis consistent with the vesting terms over the vesting
period beginning with the month in which the option was granted.
Goodwill represents the cost of acquired businesses in excess of the fair value
of the related net assets acquired. Goodwill is tested for impairment at least
annually or whenever indications of impairment exist. In testing for a potential
impairment of goodwill, management estimates the fair value of each of the
Company's reporting units (generally defined as the Company's businesses for
which financial information is available and reviewed regularly by management),
and compares it to their carrying value. If the estimated fair value of a
reporting unit is less than its carrying value, management is required to
estimate the fair value of all assets and liabilities of the reporting unit,
including goodwill. If the carrying value of the reporting unit's goodwill is
greater than the estimated fair value, an impairment charge is recognized for
the excess. The Company has elected April 1 as its annual impairment testing
date.
The carrying amount of goodwill attributable to each of the Company's
reportable segments is presented in the following table:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Individual Investor $ 416 $ 416
Institutional Investor 3 3
U.S. Trust 392 391
- --------------------------------------------------------------------------------
Total $ 811 $ 810
================================================================================
Changes in the carrying amount of goodwill associated with the capital
markets business, which was sold in 2004, are discussed in note "5 -
Discontinued Operations" and note "6 - Business Acquisitions and Divestitures."
Intangible assets consist primarily of purchased client accounts. These
intangible assets have finite lives and are amortized over their estimated
useful lives and subject to impairment testing whenever events or changes in
circumstances indicate that their carrying amount may not be recoverable. In
testing for a potential impairment of intangible assets, management assesses
whether the future cash flows related to the asset will be greater than its
carrying value at the time of the test. Accordingly, the process of evaluating a
potential impairment is based on estimates and is subjective.
The Company's gross amortizing intangible asset balances were $145 million
and $138 million at December 31, 2004 and 2003, respectively. Accumulated
amortization relating to these intangible assets was $11 million and $2 million
at December 31, 2004 and 2003, respectively. These intangible assets have a
weighted-average estimated useful life of 20 years. The Company recorded
amortization expense of $9 million, $2 million, and $4 million in 2004, 2003,
and 2002, respectively, related to these intangible assets. Estimated future
amortization expense for these intangible assets is approximately $10 million in
each of 2005
- 38 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
and 2006, and approximately $7 million in each of 2007, 2008, and 2009.
Additionally, the Company has certain intangible assets which are
non-amortizing but are subject to impairment testing as described above. The
Company's non-amortizing intangible asset balances were $19 million and
$5 million at December 31, 2004 and 2003, respectively, and are primarily
comprised of the value of contracts acquired in 2004 to manage investments of
mutual funds.
Variable interest entities: Upon adoption of Financial Accounting Standards
Board Interpretation (FIN) No. 46 - Consolidation of Variable Interest Entities,
an Interpretation of Accounting Research Bulletin No. 51 - Consolidated
Financial Statements, in the first quarter of 2003, the Company consolidated a
special purpose trust (Trust) and recorded a note payable of $235 million. This
Trust was formed in 2000 to finance the acquisition and renovation of an office
building and land. In June 2004, the Company exercised its option to purchase
this property from the Trust and repaid $99 million of the note payable.
Simultaneously, the Company completed a transaction on this property with
American Financial Realty Trust, a publicly-traded real estate investment trust,
resulting in proceeds of $136 million, which was used to repay the remainder of
the note payable, and a 20-year lease. This transaction was accounted for as a
financing. The remaining lease financing liability of $134 million at
December 31, 2004 is being reduced by a portion of the lease payments over the
20-year term.
New accounting standards: SEC Staff Accounting Bulletin (SAB) No. 105
"Application of Accounting Principles to Loan Commitments" was released in March
2004. This release summarizes the SEC staff position regarding the application
of GAAP to loan commitments accounted for as derivative instruments. The Company
accounts for interest rate lock commitments issued on mortgage loans that will
be held for sale as derivative instruments. Consistent with SAB No. 105, the
Company considers the fair value of these commitments to be zero at the
commitment date, with subsequent changes in fair value determined solely on
changes in market interest rates. As of December 31, 2004, the Company had
interest rate lock commitments on mortgage loans to be held for sale with
principal balances totaling approximately $110 million, the fair value of which
was immaterial.
Emerging Issues Task Force Issue (EITF) No. 03-01 "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments" was
ratified by the Financial Accounting Standards Board (FASB) in March 2004. This
EITF addresses how to determine the meaning of other-than-temporary impairment
and its application to investments classified as either available-for-sale or
held-to-maturity under Statement of Financial Accounting Standards
(SFAS) No. 115 - Accounting for Certain Investments in Debt and Equity
Securities (including individual securities and investments in mutual funds),
and investments accounted for under the cost method or the equity method. In
September 2004, the FASB delayed the effective date of the portion of this EITF
that relates to measuring and recognizing other-than-temporary impairment until
implementation guidance is finalized. This delay does not suspend the
requirement to recognize other-than-temporary impairment required by existing
accounting literature.
A revision to SFAS No. 123, Share-Based Payment, which supersedes APB No.
25 (SFAS No. 123R) and was issued in December 2004, requires that the cost
resulting from all share-based payments be recognized as an expense in the
consolidated financial statements, and also changes the classification of
certain tax benefits in the consolidated statement of cash flows. The Company is
required to adopt SFAS No. 123R on July 1, 2005. The Company has historically
recorded compensation expense for all restricted stock awards. Beginning in the
third quarter of 2005, the Company will record compensation expense for unvested
stock option awards over the future periods in which the awards vest. Based upon
stock options outstanding at December 31, 2004, pre-tax compensation expense
related to stock option awards would be approximately $22 million, $23 million,
and $10 million in the second half of 2005 and full-year 2006 and 2007,
respectively, which equates to a decrease in EPS of $.01 in the second half of
2005 and full-year 2006. The amount and timing of total future compensation
expense related to stock option grants will vary based upon additional awards,
if any, cancellations, forfeitures, or modifications of existing awards, and
employee severance terms.
3. Restructuring Charges
The Company recorded pre-tax restructuring charges as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
2004 Cost Reduction Effort $ 211 - -
2003, 2002, and 2001 Initiatives 3 $ 76 $ 343
- --------------------------------------------------------------------------------
Total restructuring charges $ 214 $ 76 $ 343
================================================================================
- 39 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
A summary of restructuring reserve liabilities is as follows:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
2004 Cost Reduction Effort $ 118 -
2003, 2002, and 2001 Initiatives 143 $ 220
- --------------------------------------------------------------------------------
Total restructuring reserves $ 261 $ 220
================================================================================
In addition to these restructuring reserves, see note "5 - Discontinued
Operations" for a discussion of the Company's restructuring reserves related to
discontinued operations. All restructuring reserve liabilities are included in
accrued expenses and other liabilities on the Company's consolidated balance
sheet.
2004 Cost Reduction Effort
In the second quarter of 2004, the Company commenced a firm-wide cost
reduction effort designed to mitigate the financial impact of its pricing
changes and to strengthen its productivity and efficiency. The goals of this
effort include eliminating work that is not essential to meeting client service
standards or the Company's ongoing operating needs, reengineering work processes
to maximize productivity, minimizing organizational complexity through
functional streamlining, and addressing business unit performance across the
Company. During 2004, the Company reallocated certain client service functions
from its Orlando regional telephone service center to other centers. The Company
also closed or consolidated 111 branch offices, began opening smaller satellite
offices in selected locations, and took steps to streamline its technology
organization. Additionally, the Company reduced its operating facilities,
primarily by exiting certain administrative office space in California.
The Company recorded pre-tax restructuring charges of $211 million in 2004
related to the 2004 cost reduction effort, primarily reflecting severance costs
for approximately 1,600 employees and facilities reduction charges.
A summary of pre-tax restructuring charges related to the Company's 2004
cost reduction effort is as follows:
- --------------------------------------------------------------------------------
2004
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 122
Charges for officers' stock-based compensation 7
- --------------------------------------------------------------------------------
Total workforce reduction 129
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated sublease income 75
Write-downs of fixed assets 7
- --------------------------------------------------------------------------------
Total facilities reduction 82
- --------------------------------------------------------------------------------
Total restructuring charges $ 211
================================================================================
A summary of the activity in the restructuring reserve related to the
Company's 2004 cost reduction effort is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities
Reduction Reduction Total
- --------------------------------------------------------------------------------
Restructuring charges $ 129 $ 82 $ 211
Cash payments (72) (8) (80)
Non-cash charges (1) (7) (7) (14)
Other (2) - 1 1
- --------------------------------------------------------------------------------
Balance at December 31, 2004 $ 50 (3) $ 68 (4) $ 118
================================================================================
(1) Primarily includes charges for officers' stock-based compensation and
write-downs of fixed assets.
(2) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's consolidated
statement of income.
(3) The Company expects to substantially utilize the remaining workforce
reduction reserve through cash payments for severance pay and benefits over
the respective severance periods through 2006.
(4) The Company expects to substantially utilize the remaining facilities
reduction reserve through cash payments for the net lease expense over the
respective lease terms through 2014.
2003, 2002, and 2001 Initiatives
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software and equipment from service, and the withdrawal from
certain international operations. These initiatives reduced operating expenses
and adjusted the Company's organizational structure to help improve
productivity, enhance efficiency, and increase profitability. In 2004, the
Company recorded pre-tax restructuring charges of $3 million related to its
2003, 2002, and 2001 restructuring initiatives, primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities. In 2003, the Company recorded pre-tax restructuring
charges of $76 million related to these
- 40 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
restructuring initiatives, primarily due to adjustments to the Company's
workforce and facilities levels in response to the market environment, as well
as changes in estimates of sublease income associated with previously announced
efforts to sublease excess facilities.
A summary of the activity in the restructuring reserve related to the
Company's 2003, 2002, and 2001 restructuring initiatives for the years ended
December 31, 2004, 2003, and 2002 is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $ 71 $ 97 $ 4 $ 172
Restructuring charges 140 202 1 343
Cash payments (144) (49) (3) (196)
Non-cash charges (1) (9) (26) (2) (37)
- --------------------------------------------------------------------------------
Balance at
December 31, 2002 $ 58 $ 224 $ - $ 282
Restructuring charges 27 49 - 76
Cash payments (58) (75) - (133)
Non-cash charges (1) (8) (4) - (12)
Other (2) - 7 - 7
- --------------------------------------------------------------------------------
Balance at
December 31, 2003 $ 19 $ 201 $ - $ 220
Restructuring charges (1) 4 - 3
Cash payments (15) (71) - (86)
Non-cash charges (1) (2) - - (2)
Other (2) - 8 - 8
- --------------------------------------------------------------------------------
Balance at
December 31, 2004 $ 1 (3) $ 142 (4) $ - $ 143
================================================================================
(1) Primarily includes charges for officers' stock-based compensation and
write-downs of fixed assets.
(2) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's consolidated
statement of income.
(3) Relates to the Company's 2003 restructuring initiative. The Company expects
to substantially utilize the remaining workforce reduction reserve through
cash payments for severance pay and benefits over the respective severance
periods through 2005.
(4) Includes $5 million, $62 million, and $75 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining facilities reduction reserve
through cash payments for the net lease expense over the respective lease
terms through 2017.
The actual costs of these restructuring initiatives could differ from the
estimated costs, depending primarily on the Company's ability to sublease
properties.
4. Sale of Corporate Trust Business
In 2001, U.S. Trust sold its Corporate Trust business to The Bank of New
York Company, Inc. In 2002, the Company recorded a pre-tax extraordinary gain of
$22 million, or $12 million after tax, which represented the remaining proceeds
from this sale that were realized upon satisfaction of certain client retention
requirements.
5. Discontinued Operations
On October 29, 2004, the Company completed the sale of its capital markets
business to UBS Securities LLC and UBS Americas Inc. (collectively referred to
as UBS). Pursuant to the purchase agreement, UBS acquired all of the partnership
interests of Schwab Capital Markets L.P. and all of the outstanding capital
stock of SoundView Technology Group, Inc. (collectively referred to as Schwab
Soundview Capital Markets, or SSCM) for $265 million in cash. At closing, the
Company and Schwab entered into eight-year order routing and execution services
agreements with UBS for the handling of Schwab's equity and listed options order
flow. The Company has deferred $28 million of the purchase price, representing
the fair value of these services agreements, to be recognized as revenue over
the eight-year term on a straight-line basis. SSCM comprised substantially all
of the previously-reported Capital Markets segment.
The results of operations, net of income taxes, and cash flows of SSCM have
been presented as discontinued operations on the consolidated statements of
income and of cash flows, respectively, and the assets and liabilities of SSCM
prior to the sale have each been combined and presented as assets and
liabilities of discontinued operations on the consolidated balance sheet. The
Company's consolidated prior period revenues, expenses, taxes on income, assets,
liabilities, and cash flows have been adjusted to reflect this presentation.
The carrying amounts of SSCM assets and liabilities included as part of the
sale are as follows:
- --------------------------------------------------------------------------------
October 29, 2004
- --------------------------------------------------------------------------------
Assets
Cash $ 43
Securities owned 87
Goodwill 123
Other assets 53
- --------------------------------------------------------------------------------
Total assets $ 306
- --------------------------------------------------------------------------------
Liabilities
Accrued expenses and other liabilities $ 88
- --------------------------------------------------------------------------------
Total liabilities $ 88
- --------------------------------------------------------------------------------
- 41 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
On January 31, 2003, the Company sold its U.K. brokerage subsidiary,
Charles Schwab Europe (CSE), to Barclays PLC. The results of the operations of
CSE, net of income taxes, have been presented as discontinued operations on the
Company's consolidated statement of income.
A summary of revenues and losses for discontinued operations is as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Revenues (1) $ 226 $ 202 $ 195
Loss on sale (2) $ 88 $ 3 $ 24
Total pre-tax loss (3) $ 199 $ 6 $ 80
After-tax losses $ 128 $ 4 $ 52
- --------------------------------------------------------------------------------
(1) Includes revenues of $4 million and $44 million in 2003 and 2002,
respectively, related to CSE.
(2) Includes goodwill impairment charges of $95 million in 2004 for SSCM, based
upon the negotiated terms of the sale, and $24 million in 2002 for CSE.
(3) Includes restructuring charges of $113 million, $17 million, and
$30 million in 2004, 2003, and 2002, respectively.
In addition to the restructuring reserves discussed in note "3 -
Restructuring Charges," the Company retained certain restructuring-related
obligations following the sales of SSCM and CSE, and recorded reserves for
severance, facilities leases and systems. A summary of the activity in these
reserves for the years ended December 31, 2004, 2003, and 2002 is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $ 3 $ - $ - $ 3
Restructuring charges (1) 20 6 4 30
Cash payments (12) (1) (2) (15)
Non-cash charges (2) (1) (2) (2) (5)
- --------------------------------------------------------------------------------
Balance at
December 31, 2002 $ 10 $ 3 $ - $ 13
Restructuring charges (1) 5 12 - 17
Cash payments (10) - - (10)
Non-cash charges (2) (1) (3) - (4)
- --------------------------------------------------------------------------------
Balance at
December 31, 2003 $ 4 $ 12 $ - $ 16
Restructuring charges (1) 75 38 - 113
Cash payments (55) (5) - (60)
Non-cash charges (2) (1) (7) - (8)
- --------------------------------------------------------------------------------
Balance at
December 31, 2004 $ 23(3) $ 38(4) $ - $ 61
================================================================================
(1) Included in loss from discontinued operations.
(2) Primarily includes charges for officers' stock-based compensation and
write-downs of fixed assets.
(3) The Company expects to substantially utilize the remaining workforce
reduction reserve through cash payments for severance pay and benefits over
the respective severance periods through 2006.
(4) The Company expects to substantially utilize the remaining facilities
reduction reserve through cash payments for the net lease expense over the
respective lease terms through 2015.
In January 2004, as part of the Company's purchase accounting for the
acquisition of SoundView Technology Group, Inc. (SoundView), the Company
recorded a $29 million liability for above-market lease rates for certain
facilities leases expiring through 2011. At December 31, 2004, the remaining
liability was $23 million.
- 42 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
6. Business Acquisitions and Divestitures
In January 2004, the Company completed its acquisition of SoundView
Technology Group, Inc. (SoundView) for approximately $340 million, or
$289 million net of SoundView's cash and cash equivalents acquired.
Additionally, the Company recorded securities owned of $93 million related to
this acquisition. As a result of a purchase price allocation, the Company
recorded goodwill of $194 million and intangible assets of $21 million related
to this acquisition. On October 29, 2004, the Company completed the sale of
SSCM, including all outstanding capital stock of SoundView. See note "5 -
Discontinued Operations" for further discussion.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In 2003 and 2002, the Company recorded pre-tax
impairment charges of $5 million and $37 million, respectively, to reduce the
carrying value of its investment. In 2003, the Company also recorded an income
tax benefit of $16 million. The Company's share of Aitken Campbell's historical
earnings, which was accounted for under the equity method, has not been material
to the Company's results of operations, EPS, or cash flows.
7. Securities Owned
A summary of securities owned is as follows:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Securities available for sale $4,870 $3,437
SchwabFunds(R) money market funds 285 306
Equity, fixed income, and other securities 161 167
Equity and bond mutual funds 19 24
- --------------------------------------------------------------------------------
Total $5,335 $3,934
================================================================================
The amortized cost, estimated fair value, and gross unrealized gains and
losses on securities available for sale are as follows:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
U.S. treasury securities:
Amortized cost $ 263 $ 301
Aggregate fair value $ 262 $ 302
Gross unrealized gains - $ 1
Gross unrealized losses $ 1 -
U.S. government sponsored agencies
and corporations:
Amortized cost 1,534 1,421
Aggregate fair value 1,534 1,421
Gross unrealized gains 5 5
Gross unrealized losses 5 5
State and municipal obligations:
Amortized cost 1 148
Aggregate fair value 1 155
Gross unrealized gains - 7
Gross unrealized losses - -
Collateralized mortgage obligations:
Amortized cost 3,062 1,508
Aggregate fair value 3,051 1,508
Gross unrealized gains 5 4
Gross unrealized losses 16 4
Other securities:
Amortized cost 22 51
Aggregate fair value 22 51
Gross unrealized gains - -
Gross unrealized losses - -
- --------------------------------------------------------------------------------
Total securities available for sale:
Amortized cost $ 4,882 $ 3,429
Aggregate fair value $ 4,870 $ 3,437
Gross unrealized gains $ 10 $ 17
Gross unrealized losses $ 22 $ 9
================================================================================
A summary of investments with unrealized losses, aggregated by category and
period of continuous unrealized loss, at December 31, 2004, is as follows:
- --------------------------------------------------------------------------------
Less than 12 months
12 months or longer Total
---------------- ---------------- ----------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
- --------------------------------------------------------------------------------
U.S. treasury
securities $ 236 $ 1 - - $ 236 $ 1
U.S. government
sponsored agencies
and corporations 601 4 $ 53 $ 1 654 5
Collateralized
mortgage
obligations 1,557 15 58 1 1,615 16
Other securities 13 - 1 - 14 -
- --------------------------------------------------------------------------------
Total temporarily
impaired securities $2,407 $ 20 $ 112 $ 2 $2,519 $ 22
================================================================================
Management views the unrealized losses noted above as temporary as the
decline in market value is attributable to changes in interest rates and not
credit quality. The determination of whether or not other-than-temporary
- 43 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
impairment exists is a matter of judgment. Factors considered in evaluating
whether a decline in value is other than temporary include: the financial
conditions and near-term prospects of the issuer; the Company's intent and
ability to retain the investment for a period of time sufficient to allow for
any anticipated recovery; and the length of time and the extent to which the
fair value has been less than cost.
The maturities and related weighted-average yields of debt securities
available for sale at December 31, 2004 are as follows:
- --------------------------------------------------------------------------------
Within 1 - 5 5 - 10 Over 10
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
U.S. treasury securities $ 259 $ 4 - - $ 263
U.S. government sponsored
agencies and corporations - 16 - $1,518 1,534
State and municipal obligations - 1 - - 1
Collateralized mortgage
obligations (1) - - - 3,062 3,062
Other debt securities 13 9 - - 22
- --------------------------------------------------------------------------------
Total at amortized cost 272 30 - 4,580 4,882
Estimated fair value 271 29 - 4,570 4,870
- --------------------------------------------------------------------------------
Net unrealized losses $ 1 $ 1 - $ 10 $ 12
================================================================================
Weighted-average yield (2) 1.77% 3.31% - 4.08% 3.94%
- --------------------------------------------------------------------------------
(1) Collateralized mortgage obligations have been allocated over maturity
groupings based on contractual maturities. Expected maturities may differ
from contractual maturities because borrowers have the right to prepay
obligations with or without prepayment penalties.
(2) Yields have been computed by dividing annualized interest revenue, on a
taxable equivalent basis, by the amortized cost of the respective
securities at December 31, 2004.
Gross proceeds and gross realized gains and losses related to sales of
securities available for sale are as follows. Realized gains and losses of
securities available for sale are included in other income on the Company's
consolidated income statement.
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Gross proceeds $ 686 $ 397 $ 636
Gross realized gains $ 9 $ 12 $ 12
Gross realized losses $ (2) - -
- --------------------------------------------------------------------------------
The Company's positions in SchwabFunds(R) money market funds arise from
certain overnight funding of clients' redemption, check-writing, and debit card
activities. Fixed income securities are held to meet clients' trading
activities. Equity and bond mutual funds include investments made by the Company
relating to its deferred compensation plan and inventory maintained to
facilitate certain SchwabFunds and third-party mutual fund clients'
transactions.
Securities sold, but not yet purchased, of $16 million and $20 million at
December 31, 2004 and 2003, respectively, consist primarily of mutual fund
shares that are distributed to clients to satisfy their dividend reinvestment
requests. These securities are recorded at market value in accrued expenses and
other liabilities.
8. Receivables from Brokerage Clients
Receivables from brokerage clients consist primarily of margin loans to
brokerage clients of $9.8 billion and $8.5 billion at December 31, 2004 and
2003, respectively. Securities owned by brokerage clients are held as collateral
for margin loans. Such collateral is not reflected in the consolidated financial
statements.
9. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Residential real estate mortgages $ 5,342 $ 4,624
Consumer loans 971 735
Other 536 404
- --------------------------------------------------------------------------------
Total loans 6,849 5,763
Less: allowance for credit losses (27) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $ 6,822 $ 5,736
================================================================================
Included in the loan portfolio are non-accrual loans totaling $1 million at
both December 31, 2004 and 2003, respectively. Non-accrual loans are considered
impaired by the Company, and represent all the Company's nonperforming assets at
both December 31, 2004 and 2003. For 2004 and 2003, the impact of interest
revenue which would have been earned on non-accrual loans versus interest
revenue recognized on these loans was not material to the Company's results of
operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was $4 million and $1 million at December 31, 2004 and 2003,
respectively.
- 44 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
A summary of activity in the allowance for credit losses related to loans
to banking clients is as follows. Recoveries and charge-offs were immaterial for
each of 2004, 2003, and 2002.
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Balance at beginning of year $ 27 $ 24 $ 21
Provision 2 4 3
Release of allowance on loans sold (2) (1) -
- --------------------------------------------------------------------------------
Balance at end of year $ 27 $ 27 $ 24
================================================================================
10. Loan Securitizations
In the fourth quarters of 2004 and 2003, U.S. Trust sold $1.0 billion and
$354 million, respectively, of residential mortgage loans originated through its
private banking business in securitization transactions. In these
securitizations, U.S. Trust retained a portion of the senior mortgage
pass-through certificates and all subordinated pass-through certificates that
were created by the securitization process (the retained securities), and the
servicing rights. U.S. Trust received proceeds of $1.0 billion and $355 million
from these securitizations in 2004 and 2003, respectively, reacquired the
retained securities of $820 million and $7 million, respectively, and recognized
immaterial net gains after payment of transaction expenses. These securitization
transactions are accounted for as sales under the requirements of SFAS No. 140 -
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities.
The fair values of the retained securities at the date of securitization
were primarily determined based on the following key economic assumptions:
- --------------------------------------------------------------------------------
2004 2003
- --------------------------------------------------------------------------------
Average discount rate 4.5% 6.4%
Constant prepayment rate (1) 25% n/a
Prepayment speed assumption (2) n/a 300%
Expected weighted average life (in years) 2.4 6.0
Expected credit losses 0% 0%
- --------------------------------------------------------------------------------
(1) Constant prepayment rate and constant prepayment rate to balloon
methodologies were used.
(2) Based upon the Public Securities Association convention, a 300% prepayment
speed assumption equates to an increasing constant prepayment rate from 0%
to 18% over the initial 30 month loan term and 18% thereafter.
n/a Not applicable.
The estimated fair values of the retained securities were $805 million and
$12 million at December 31, 2004 and 2003, respectively, and were included in
securities owned on the Company's consolidated balance sheet. The fair values of
the servicing rights were immaterial. Key economic assumptions, and the
sensitivities of the current fair value of retained securities related to these
securitizations to immediate adverse changes in those assumptions, are presented
in the table below.
- --------------------------------------------------------------------------------
December 31, 2004
- --------------------------------------------------------------------------------
Fair value of retained securities $ 805
Expected weighted-average life (in years) 1.3 - 6.0
Prepayment speed assumption (1) 9.4 - 25.0%
Impact on fair value of:
50 basis point adverse change $ -
100 basis point adverse change $ -
Discount rate assumption 4.9 - 11.3%
Impact on fair value of:
50 basis point adverse change $ (9)
100 basis point adverse change $ (18)
- --------------------------------------------------------------------------------
(1) Constant prepayment rate and constant prepayment rate to balloon
methodologies were used.
The sensitivity analysis above is hypothetical and should be used with
caution. Changes in fair value based on a variation in assumptions generally
cannot be extrapolated because the relationship of the change in the assumption
to the change in fair value may not be linear. Also, in the table above, the
effect of a variation in a particular assumption on the fair value of the
retained interest is calculated independently without changing any other
assumption. In practice, changes in one factor may result in changes in another,
which might magnify or counteract the sensitivities.
Cash flows received from the retained securities were $28 million and
$1 million in 2004 and 2003, respectively. Cash flows received from servicing
fees were immaterial in both 2004 and 2003.
Any credit losses on the securitized loans are assigned to U.S. Trust, as
holder of the subordinated securities, up to the par value. There were no
delinquencies in the securitized mortgage loans at December 31, 2004 and 2003,
and there were no losses for either 2004 or 2003. U.S. Trust has not guaranteed
the mortgage loans as these transactions are structured without recourse to
U.S. Trust or the Company.
- 45 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
The following table presents information about the principal balances of
managed and securitized loans.
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Residential real estate mortgages $ 6,628 $ 5,012
Consumer loans 971 735
Other 536 404
- --------------------------------------------------------------------------------
Total loans managed and securitized 8,135 6,151
Less:
Sold or securitized loans 1,266 359
Loans held for sale 20 29
Allowance for credit losses 27 27
- --------------------------------------------------------------------------------
Total loans to banking clients - net $ 6,822 $ 5,736
================================================================================
11. Equipment, Office Facilities and Property
Equipment, office facilities and property are detailed below:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Land (1) $ 55 $ 55
Buildings (1) 472 479
Leasehold improvements 358 348
Furniture and equipment 218 217
Telecommunications equipment 145 156
Information technology equipment 426 413
Software 667 552
Software development and construction in progress 61 83
- --------------------------------------------------------------------------------
Subtotal 2,402 2,303
Accumulated depreciation and amortization (1,499) (1,360)
- --------------------------------------------------------------------------------
Total $ 903 $ 943
================================================================================
(1) See note "2 - Significant Accounting Policies" for discussion on the
consolidation of a Trust.
12. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, certificates of deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Interest-bearing deposits (1) $10,280 $ 7,585
Noninterest-bearing deposits 838 723
- --------------------------------------------------------------------------------
Total $11,118 $ 8,308
================================================================================
(1) Includes certificates of deposit of $100,000 or more totaling $340 million
and $886 million at December 31, 2004 and 2003, respectively.
During the years ended December 31, 2004 and 2003, the Company paid an
average rate of 1.15% and 1.79%, respectively, on its interest-bearing deposits
from banking clients.
13. Payables to Brokers, Dealers and Clearing Organizations
Payables to brokers, dealers and clearing organizations consist primarily
of securities loaned of $1.4 billion and $2.6 billion at December 31, 2004 and
2003, respectively. The cash collateral received from counterparties under
securities lending transactions was equal to or greater than the market value of
the securities loaned.
14. Payables to Brokerage Clients
The principal source of funding for Schwab's margin lending is cash
balances in brokerage client accounts. At December 31, 2004, Schwab was paying
interest at 1.2% on $23.9 billion of cash balances in brokerage client accounts,
which were included in payables to brokerage clients. At December 31, 2003,
Schwab was paying interest at .2% on $23.8 billion of such cash balances.
15. Short-term Borrowings
CSC may borrow up to $800 million under a committed, unsecured credit
facility with a group of nineteen banks which is scheduled to expire in
June 2005. CSC plans to establish a similar facility to replace this one when it
expires. This facility replaced a facility that expired in June 2004. The funds
under this facility are available for general corporate purposes and CSC pays a
commitment fee on the unused balance of this facility. The financial covenants
in this facility require CSC to maintain a minimum level of stockholders'
equity, Schwab to maintain minimum net capital ratios, as defined, and CSC's
depository institution subsidiaries to be well capitalized, as defined. These
facilities were unused at December 31, 2004 and 2003.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of eight banks totaling $831 million at
December 31, 2004. CSC has access to $781 million of these credit lines. The
amount available to CSC under these lines is lower than the amount available to
Schwab because the credit line provided by one of these banks is only available
to Schwab. There were no borrowings outstanding under these lines at
December 31, 2004 and 2003.
- 46 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2004. Schwab pays a fee to maintain these arrangements. In
connection with its securities lending activities, Schwab is required to provide
collateral to certain brokerage clients. Schwab satisfies the collateral
requirements by arranging letters of credit (LOCs), in favor of these brokerage
clients, that are guaranteed by multiple banks. At December 31, 2004, the
outstanding value of these LOCs totaled $52 million. No funds were drawn under
these LOCs at December 31, 2004 and 2003.
Other short-term borrowings include Federal Home Loan Bank System
borrowings, federal funds purchased, repurchase agreements, and other borrowed
funds. At December 31, 2004 and 2003, these other short-term borrowings totaled
$663 million and $996 million, respectively, with weighted-average interest
rates ranging from 2.13% to 2.50% and .87% to 1.22%, respectively.
16. Long-term Debt
Long-term debt consists of the following:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 386 $ 466
Lease financing liability 134 -
Note payable - 235
8.41% Trust Preferred Capital Securities 52 52
Fair value adjustment (1) 13 19
- --------------------------------------------------------------------------------
Total $ 585 $ 772
================================================================================
(1) Represents the fair value adjustment related to hedged Medium-Term Notes.
See note "24 - Financial Instruments Subject to Off-Balance Sheet Risk,
Credit Risk or Market Risk."
The aggregate principal amount of Senior Medium-Term Notes, Series A
(Medium-Term Notes) outstanding at December 31, 2004 had maturities ranging from
2005 to 2010. The aggregate principal amount of Medium-Term Notes outstanding at
December 31, 2004 and 2003 had fixed interest rates ranging from 6.21% to 8.05%,
and 6.04% to 8.05%, respectively. At December 31, 2004 and 2003, the Medium-Term
Notes carried a weighted-average interest rate of 7.46% and 7.31%, respectively.
Upon adoption of FIN No. 46 in the first quarter of 2003, the Company
consolidated a Trust and recorded a note payable of $235 million. This Trust was
formed in 2000 to finance the acquisition and renovation of an office building
and land. In June 2004, the Company exercised its option to purchase this
property from the Trust and repaid $99 million of the note payable.
Simultaneously, the Company completed a transaction on this property with
American Financial Realty Trust, a publicly-traded real estate investment trust,
resulting in proceeds of $136 million, which was used to repay the remainder of
the note payable, and a 20-year lease. This transaction was accounted for as a
financing. The remaining lease financing liability of $134 million at
December 31, 2004 is being reduced by a portion of the lease payments over the
20-year term.
The Trust Preferred Capital Securities qualify as tier 1 capital under
guidelines of the Board of Governors of the Federal Reserve System (Federal
Reserve Board) and have no voting rights. Holders of the Trust Preferred Capital
Securities are entitled to receive cumulative cash distributions semi-annually.
The Company has the right to redeem the Trust Preferred Capital Securities prior
to their stated maturity of February 1, 2027, on or after February 1, 2007, upon
approval (if then required) of the Federal Reserve Board.
Annual maturities on long-term debt outstanding at December 31, 2004 are as
follows:
- --------------------------------------------------------------------------------
2005 $ 60
2006 72
2007 43
2008 20
2009 14
Thereafter 363
- --------------------------------------------------------------------------------
Total maturities 572
Fair value adjustment 13
- --------------------------------------------------------------------------------
Total $ 585
================================================================================
17. Taxes on Income
Income tax expense on income from continuing operations is as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Current:
Federal $ 196 $ 215 $ 92
State 39 21 (1)
- --------------------------------------------------------------------------------
Total current 235 236 91
- --------------------------------------------------------------------------------
Deferred:
Federal 15 8 4
State (19) (3) 15
- --------------------------------------------------------------------------------
Total deferred (4) 5 19
- --------------------------------------------------------------------------------
Taxes on income 231 241 110
Current tax expense on
extraordinary gain - - (10)
- --------------------------------------------------------------------------------
Taxes on income before
extraordinary gain $ 231 $ 241 $ 100
================================================================================
- 47 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
The above amounts do not include tax benefits or expense from the exercise
of stock options and the vesting of restricted stock awards, which for
accounting purposes are recorded in additional paid-in capital. Such tax amounts
totaled a net tax benefit of $16 million in 2004, compared to net tax expense of
$3 million in 2003 and a net tax benefit of $4 million in 2002.
The income tax benefit related to loss from discontinued operations was
$71 million, $2 million, and $28 million in 2004, 2003, and 2002, respectively.
The temporary differences that created deferred tax assets and liabilities,
included in other assets, are detailed below:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Deferred tax assets:
Reserves and allowances $ 164 $ 125
Deferred compensation and employee benefits 99 103
Property and equipment leasing 28 26
State loss carryforwards (1) 25 16
Net loss on cash flow hedging instruments 3 12
Other 7 14
- --------------------------------------------------------------------------------
Total deferred assets 326 296
- --------------------------------------------------------------------------------
Deferred tax liabilities:
Capitalized internal-use software development
costs (65) (55)
Depreciation and amortization (38) (14)
Net unrealized gains (losses) on securities
available for sale 5 (3)
- --------------------------------------------------------------------------------
Total deferred liabilities (98) (72)
- --------------------------------------------------------------------------------
Net deferred tax asset $ 228 $ 224
================================================================================
(1) Consists primarily of net operating losses in New York State that will
expire in 2022 through 2024. Realization is dependent on generating
sufficient taxable income in New York State prior to the expiration of such
losses.
The Company determined that no valuation allowance against deferred tax
assets at December 31, 2004 and 2003 was necessary.
The effective income tax rate on income from continuing operations differs
from the amount computed by applying the federal statutory income tax rate as
follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Federal statutory income tax rate 35.0% 35.0% 35.0%
State income taxes, net of
federal tax benefit 2.4 1.6 1.1
(Gain) write-down on investment
in Aitken Campbell - (1.9) 5.2
Merger-related costs - (1.5) -
Other charges (1.6) .4 (1.1)
- --------------------------------------------------------------------------------
Effective income tax rate 35.8% 33.6% 40.2%
================================================================================
The effective income tax rate including loss from discontinued operations
and extraordinary gain was 35.9% in 2004, 33.6% in 2003, and 42.9% in 2002.
18. Employee Incentive and Deferred Compensation Plans
Stock Option Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within seven or ten years from the date of grant.
Options generally vest over a three- to four-year period from the date of grant.
A summary of option activity follows:
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
-------------------------- ---------------------------- ---------------------------
Weighted- Weighted- Weighted-
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Options Price Options Price Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 136 $ 15.25 156 $ 15.38 153 $ 16.20
Granted 22 $ 9.39 2 $ 9.39 26 $ 11.32
Exercised (11) $ 4.88 (6) $ 6.21 (6) $ 6.59
Canceled (1) (14) $ 17.77 (16) $ 18.84 (17) $ 19.39
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
end of year 133 $ 14.88 136 $ 15.25 156 $ 15.38
====================================================================================================================================
Exercisable at
end of year 101 $ 15.97 90 $ 15.03 77 $ 12.93
- ------------------------------------------------------------------------------------------------------------------------------------
Available for
future grant at
end of year 37 44 41
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted-average
fair value of
options granted
during the year (2) $ 2.75 $ 4.20 $ 5.35
- ------------------------------------------------------------------------------------------------------------------------------------
(1) In 2002, 5 million options were voluntarily rescinded by the then Chief Executive Officer and the Chairman of the Board. The
weighted-average exercise price of these options is $17.04 and the weighted-average fair value is $8.03.
(2) The fair value of options granted is estimated as of the grant date using the Black-Scholes option pricing model for grants
made prior to January 1, 2004, and a binomial option pricing model for grants made on or after January 1, 2004. See discussion
in note "2 - Significant Accounting Policies - Stock-based Compensation."
- 48 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
Options outstanding and exercisable are as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Options Outstanding Options Exercisable
--------------------------------------------- -------------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices of Options Life (in years) Price of Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
$ .11 to $ 7.00 8 1.5 $ 4.76 8 $ 4.76
$ 7.01 to $ 10.00 40 5.5 $ 8.88 23 $ 8.62
$ 10.01 to $ 15.00 29 6.5 $ 11.99 19 $ 12.03
$ 15.01 to $ 19.00 22 5.8 $ 15.44 19 $ 15.45
$ 19.01 to $ 26.00 15 4.5 $ 22.02 13 $ 22.15
$ 26.01 to $ 38.29 19 4.7 $ 29.63 19 $ 29.64
- ------------------------------------------------------------------------------------------------------------------------------------
$ .11 to $ 38.29 133 5.3 $ 14.88 101 $ 15.97
====================================================================================================================================
Restricted Stock and Long-term Incentive Plans
The Company's stock incentive plans provide for granting restricted stock
awards to employees and officers. Restricted stock awards are restricted from
transfer or sale and generally vest over a four-year period, but some vest based
upon the Company achieving certain financial or other measures.
The Company also awards eligible officers long-term incentive plan (LTIP)
units and restricted stock under a long-term incentive program. These awards are
restricted from transfer or sale and generally vest over a three- to four-year
period. The cash payout of the LTIP units at the end of the vesting period is
based upon the Company achieving certain cumulative EPS levels. The LTIP
liability was $24 million and $9 million at December 31, 2004 and 2003,
respectively.
Restricted stock and LTIP unit information is as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Restricted stock awards (shares) 4 11 2
Average market price of awarded shares $ 11.93 $ 8.75 $ 10.44
Restricted shares outstanding (at year end) 9 13 4
Restricted stock amortization $ 27 $ 28 $ 23
LTIP unit compensation expense $ 15 $ 9 -
- --------------------------------------------------------------------------------
Other Deferred Compensation Plans
The Company sponsors deferred compensation plans for both officers and
non-employee directors. The Company's deferred compensation plan for officers
permits participants to defer the payment of certain cash compensation. The
deferred compensation liability was $221 million and $207 million at
December 31, 2004 and 2003, respectively. The Company's deferred compensation
plan for non-employee directors permits participants to defer receipt of all or
a portion of their directors' fees and to receive either a grant of stock
options, or upon ceasing to serve as a director, the number of shares of CSC's
common stock that would have resulted from investing the deferred fee amount
into CSC's common stock.
19. Retirement and Other Employee Benefit Plans
The Company's retirement and other employee benefit plans consist of CSC's
and U.S. Trust's plans that were in effect prior to the merger with USTC in
2000. The following summarizes such plans.
Retirement Plans
Eligible employees of the Company who have met certain service requirements
may participate in the Company's qualified retirement plan, the SchwabPlan(R)
401(k) Retirement Savings and Investment Plan (SchwabPlan). The Company may
match certain employee contributions or make additional contributions to this
plan at its discretion. Total company contribution expense was $48 million in
2004, $3 million in 2003, and $47 million in 2002. In 2004, the Company
reinstated its 401(k) employee contribution match, which was suspended in 2003
(except for a discretionary award to certain non-officer employees made in the
fourth quarter of 2003).
U.S. Trust previously sponsored a 401(k) Plan and ESOP covering all
eligible U.S. Trust employees. U.S. Trust terminated this plan, effective
December 2003, and merged the plan assets into the SchwabPlan. Total
contribution expense under this plan was $9 million in 2002. There was no
contribution expense in 2003 as U.S. Trust suspended contributions beginning in
the first quarter of 2003.
Pension and Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan for the benefit of eligible U.S. Trust employees, the
U.S. Trust Corporation Employees' Retirement Plan (the Pension Plan).
U.S. Trust provides certain health care and life insurance benefits for
active employees and certain qualifying retired employees and their dependents.
Postretirement medical and life insurance benefits are accrued during the years
that the employee renders service to reflect the expected cost of providing
health care and life insurance and other benefits to an employee upon
retirement.
The following table summarizes the components of retirement and
postretirement benefit expenses (credits), the funded status of U.S. Trust's
qualified retirement plan, changes in the benefit obligations related to these
plans and the major assumptions used to determine these amounts.
- 49 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
2004 2003 2002
----------------------------- ----------------------------- -----------------------------
Pension Health Pension Health Pension Health
Plan & Life Total Plan & Life Total Plan & Life Total
- ------------------------------------------------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning
of year $ 283 $ 21 $ 304 $ 281 $ 21 $ 302 $ 248 $ 20 $ 268
Service cost, including expenses 11 - 11 13 - 13 13 - 13
Interest cost 17 1 18 19 1 20 18 2 20
Amendments (1) - - - (49) - (49) (1) - (1)
Actuarial loss 15 2 17 31 - 31 13 1 14
Benefits and expenses paid (14) (2) (16) (12) (1) (13) (10) (2) (12)
- ------------------------------------------------------------------------------------------------------------------------------------
Pension benefit obligation at
end of year $ 312 $ 22 $ 334 $ 283 $ 21 $ 304 $ 281 $ 21 $ 302
====================================================================================================================================
Change in plan assets:
Fair value of plan assets at
beginning of year $ 284 - $ 284 $ 252 - $ 252 $ 281 - $ 281
Actual gain (loss) on plan
assets 35 - 35 44 - 44 (19) - (19)
Employer contribution 40 2 42 - $ 1 1 - $ 1 1
Benefits and expenses paid (13) (2) (15) (12) (1) (13) (10) (1) (11)
- ------------------------------------------------------------------------------------------------------------------------------------
Fair value of plan assets at end
of year $ 346 - $ 346 $ 284 - $ 284 $ 252 - $ 252
====================================================================================================================================
Funded Status $ 34 $ (22) $ 12 $ 1 $ (21) $ (20) $ (29) $ (21) $ (50)
Unrecognized net actuarial loss
(gain) 81 1 82 85 (1) 84 74 - 74
Unrecognized prior service cost
(benefit) (41) - (41) (45) - (45) 4 (1) 3
- ------------------------------------------------------------------------------------------------------------------------------------
Net amount recognized $ 74 $ (21) $ 53 $ 41 $ (22) $ 19 $ 49 $ (22) $ 27
====================================================================================================================================
Amount recognized in the balance
sheet consists of:
Prepaid benefit cost $ 74 - $ 74 $ 41 - $ 41 $ 49 - $ 49
Accrued benefit costs - $ (21) (21) - $ (22) (22) - $ (22) (22)
- ------------------------------------------------------------------------------------------------------------------------------------
Net amount recognized $ 74 $ (21) $ 53 $ 41 $ (22) $ 19 $ 49 $ (22) $ 27
====================================================================================================================================
Components of net periodic
benefit cost:
Service cost and expenses $ 11 - $ 11 $ 13 - $ 13 $ 13 - $ 13
Interest cost 17 $ 1 18 19 $ 1 20 18 $ 1 19
Expected return on plan assets (22) - (22) (24) - (24) (30) - (30)
Amortization of prior service cost (4) - (4) - - - - - -
Amortization of net loss (gain) 5 - 5 - - - (1) - (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit expense (2) $ 7 $ 1 $ 8 $ 8 $ 1 $ 9 $ - $ 1 $ 1
====================================================================================================================================
Additional information
Increase in additional minimum
liability included in other
comprehensive income - n/a - n/a - n/a
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted-average assumptions
used to determine benefit
obligations
Discount rate 5.88% 5.88% 6.00% 6.00% 6.75% 6.75%
Rate of increase in
compensation (3) 5.10% 5.10% 5.25% 5.25% 5.30% 5.30%
Measurement date Sept. 30, Sept. 30, Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2004 2004 2003 2003 2002 2002
Weighted-average assumptions
used to determine net
periodic benefit cost
Discount rate 6.00% 6.00% 6.75% 6.75% 7.50% 7.50%
Rate of increase in
compensation (3) 5.25% 5.25% 5.30% 5.30% 6.18% 6.18%
Expected rate of return on plan
assets 8.25% n/a 8.25% n/a 9.00% n/a
- ------------------------------------------------------------------------------------------------------------------------------------
(1) In 2003, U.S. Trust amended the Pension Plan with respect to the computation of retirement benefits earned by qualifying
employees hired on or before December 31, 2001.
(2) The pension expense and postretirement benefit expense are determined using the assumptions as of the beginning of the year.
The benefit obligations and the funded status are determined using the assumptions as of the end of the year. The measurement
date of the Pension Plan is September 30.
(3) The assumed rate of increase in compensation is based on the age-related table with assumed rates of increase in compensation
ranging from 8.0% to 3.0%.
n/a Not applicable.
- 50 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
The accumulated benefit obligation for the Pension Plan was $311 million
and $283 million at September 30, 2004 and 2003, respectively.
To develop the expected long-term rate of return on assets assumption, U.S.
Trust considered the current level of expected returns on risk free investments
(primarily government bonds), the historical level of risk premium associated
with other classes in which the portfolio is invested and the expectations for
future returns of each asset class. The expected return for each asset class was
then weighted based on the target asset allocation to develop the expected
long-term rate of return on assets assumption for the portfolio. This resulted
in the selection of the 8.25% expected long-term rate of return on assets
assumption for 2004 and 2003.
The assumed rate of future increases in per capita cost of health care
benefits (the health care cost trend rate) is 13.0% at December 31, 2004,
decreasing gradually to 5.0% by the year 2013. A one-percentage-point change in
the assumed health care cost trend rates would have an immaterial effect on the
postretirement benefit obligation, as well as on service and interest costs.
The Pension Plan's weighted average asset allocations at September 30, 2004
and 2003, by asset category are as follows:
- --------------------------------------------------------------------------------
September 30, 2004 2003
- --------------------------------------------------------------------------------
Equity securities 62% 60%
Debt securities 37% 34%
Other 1% 6%
- --------------------------------------------------------------------------------
Total 100% 100%
================================================================================
The goals of the asset strategy are to ensure that the principal of the
Pension Plan is preserved and enhanced over the long term, both in real and
nominal terms, manage risk exposure, and exceed the funding requirement over a
market cycle (3 to 5 years).
Risk is managed by investing in a broad range of asset classes, and within
those classes, a broad range of individual securities.
The Pension Plan's Investment Committee, which oversees the investment of
Pension Plan assets, utilizes the following target asset allocation and ranges:
- --------------------------------------------------------------------------------
Low Target High
- --------------------------------------------------------------------------------
Domestic equity securities 28% 30% 32%
Foreign equity securities 18% 20% 22%
Domestic fixed income 30% 35% 40%
Other equity investments (1) 14% 15% 16%
- --------------------------------------------------------------------------------
(1) Includes real estate equity trusts, private equity funds, and hedge funds
with a 5% target allocation for each.
Equity securities include shares of common stock of CSC in the amount of $3
million (1% of total plan assets) at both September 30, 2004 and 2003. In
addition, due to external investment management of the funds, the Pension Plan
may indirectly hold additional shares of CSC stock. The aggregate amount of
these shares would not be considered material relative to the total fund assets.
U.S. Trust's funding policy is to make contributions consistent with
Federal laws and regulations. In September 2004, U.S. Trust contributed
$40 million to the Pension Plan. No contributions are expected to be made to the
Pension Plan during 2005, while $2 million is expected to be paid with respect
to postretirement benefits plans in 2005.
The following benefit payments, which reflect future service, as
appropriate, are expected to be paid:
- --------------------------------------------------------------------------------
Pension Health &
Plan Life Total
- --------------------------------------------------------------------------------
2005 $ 14 $ 2 $ 16
2006 16 2 18
2007 17 2 19
2008 18 2 20
2009 19 2 21
2010-2014 114 7 121
- --------------------------------------------------------------------------------
Total $ 198 $ 17 $ 215
================================================================================
- 51 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
20. Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss) represents cumulative gains
and losses that are not reflected in earnings. The components of accumulated
other comprehensive income (loss) are as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Net loss on cash flow hedging
instruments, net of tax:
Beginning balance $ (18) $ (37) $ (31)
Change during the year 15 19 (6)
- --------------------------------------------------------------------------------
Ending balance $ (3) $ (18) $ (37)
================================================================================
Net unrealized gain (loss) on securities
available for sale, net of tax:
Beginning balance $ 5 $ 24 $ 7
Net unrealized (loss) gain arising
during the year (9) (19) 15
Reclassification adjustment for
realized loss included in net income 1 - 2
- --------------------------------------------------------------------------------
Ending balance $ (3) $ 5 $ 24
================================================================================
Foreign currency translation adjustment:
Beginning balance $ - $ (5) $ (13)
Change during the year 1 5 8
- --------------------------------------------------------------------------------
Ending balance $ 1 $ - $ (5)
================================================================================
Total accumulated other comprehensive
income (loss), net of tax:
Beginning balance $ (13) $ (18) $ (37)
Change during the year 8 5 19
- --------------------------------------------------------------------------------
Ending balance $ (5) $ (13) $ (18)
================================================================================
21. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Net income $ 286 $ 472 $ 109
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,343 1,342 1,358
Common stock equivalent shares
related to stock incentive plans 22 22 17
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,365 1,364 1,375
================================================================================
Basic EPS:
Income from continuing operations
before extraordinary gain $ .31 $ .35 $ .11
Loss from discontinued operations,
net of tax $ (.10) $ - $ (.04)
Extraordinary gain, net of tax $ - $ - $ .01
Net income $ .21 $ .35 $ .08
- --------------------------------------------------------------------------------
Diluted EPS:
Income from continuing operations
before extraordinary gain $ .30 $ .35 $ .11
Loss from discontinued operations,
net of tax $ (.09) $ - $ (.04)
Extraordinary gain, net of tax $ - $ - $ .01
Net income $ .21 $ .35 $ .08
- --------------------------------------------------------------------------------
The computation of diluted EPS for the years ended December 31, 2004, 2003,
and 2002, respectively, excludes outstanding stock options to purchase
91 million, 107 million, and 111 million shares, respectively, because the
exercise prices for those options were greater than the average market price of
the common shares, and therefore the effect would be antidilutive.
22. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Federal Reserve Board under the
Bank Holding Company Act of 1956, as amended (the Act). The Act permits
financial holding companies to engage in activities that are financial in
nature, including banking, securities brokerage, underwriting, dealing in or
making a market in securities, investment management services and insurance
- 52 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
activities. The Federal Reserve Board may impose limitations, restrictions, or
prohibitions on the activities or acquisitions of a financial holding company if
the Federal Reserve Board believes that the company does not have the
appropriate financial and managerial resources to commence or conduct an
activity, make an acquisition, or retain ownership of a company. The Federal
Reserve Board may also take actions as appropriate to enforce applicable federal
law.
Federal Reserve Board policy provides that a bank holding company generally
should not pay cash dividends unless its net income is sufficient to fully fund
the dividends and the company's prospective retained earnings appear to be
sufficient to meet the capital needs, asset quality and overall financial
condition of the holding company and its depository institution subsidiaries.
CSC's primary depository institution subsidiaries are United States Trust
Company of New York (U.S. Trust NY), U.S. Trust Company, National Association
(U.S. Trust NA), and Schwab Bank. The operations and financial condition of
CSC's depository institution subsidiaries are subject to regulation and
supervision and to various requirements and restrictions under federal and state
law. Among other things, these requirements govern transactions with CSC and its
non-depository institution subsidiaries, including loans and other extensions of
credit, investments or asset purchases, dividends and investments. The federal
banking agencies have broad powers to enforce these regulations, including the
power to terminate deposit insurance, impose substantial fines and other civil
and criminal penalties and appoint a conservator or receiver. CSC, USTC, and
their U.S.-based insured depository institution subsidiaries must meet
regulatory capital guidelines adopted by the federal banking agencies. Under the
Federal Deposit Insurance Act, the banking regulatory agencies are permitted or,
in certain cases, required to take certain substantial restrictive actions with
respect to institutions falling within one of the lowest three of five capital
categories.
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. CSC and USTC are subject to
those guidelines. The Act prohibits the Federal Reserve Board from imposing
capital requirements on functionally regulated non-depository institution
subsidiaries of a financial holding company, such as broker-dealers and
investment advisors.
To maintain its status as a financial holding company, each of CSC's
depository institution subsidiaries must be kept "well capitalized" and "well
managed." In addition, each of CSC's insured depository institution subsidiaries
must be rated "satisfactory" or better in meeting the Community Reinvestment Act
of 1977 in order for CSC to engage in new financial activities or enter into
certain acquisitions of companies engaged in financial activities. At
December 31, 2004, CSC and its depository institution subsidiaries met all the
above requirements.
The regulatory capital and ratios of the Company, U.S. Trust, U.S. Trust
NY, U.S. Trust NA, and Schwab Bank are as follows:
- --------------------------------------------------------------------------------
2004 2003
----------------- -----------------
December 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,485 17.5% $ 3,569 20.3%
U.S. Trust $ 695 13.8% $ 653 15.4%
U.S. Trust NY $ 390 10.1% $ 357 10.4%
U.S. Trust NA $ 269 24.5% $ 252 33.7%
Schwab Bank $ 370 22.7% $ 277 35.1%
Total Capital:
Company $ 3,513 17.7% $ 3,598 20.4%
U.S. Trust $ 720 14.3% $ 679 16.0%
U.S. Trust NY $ 412 10.7% $ 380 11.1%
U.S. Trust NA $ 273 24.8% $ 255 34.1%
Schwab Bank $ 371 22.8% $ 278 35.2%
Leverage:
Company $ 3,485 7.8% $ 3,569 8.2%
U.S. Trust $ 695 7.6% $ 653 8.5%
U.S. Trust NY $ 390 5.8% $ 357 5.5%
U.S. Trust NA $ 269 9.6% $ 252 18.5%
Schwab Bank $ 370 8.8% $ 277 13.4%
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations. Well-capitalized tier 1
capital, total capital, and tier 1 leverage ratios are 6%, 10%, and 5%,
respectively.
Based on their respective regulatory capital ratios at December 31, 2004
and 2003, the Company, U.S. Trust, U.S. Trust NY, U.S. Trust NA, and Schwab Bank
are considered well capitalized (the highest category) pursuant to banking
regulatory guidelines. There are no conditions or events that management
believes have changed the Company's, U.S. Trust's, U.S. Trust NY's, U.S. Trust
NA's, or Schwab Bank's well-capitalized status.
CSC's depository institution subsidiaries are required, under federal
regulations, to maintain reserve balances at the Federal Reserve Bank based on
deposit levels. These amounts are included in cash and investments segregated
and on deposit for federal or other regulatory purposes. The average balances
were $94 million in 2004 and $57 million in 2003.
Schwab is subject to the Uniform Net Capital Rule under the Securities
Exchange Act of 1934 (the Rule). Schwab computes net capital under the
alternative method permitted by this Rule. This method requires the maintenance
of
- 53 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
minimum net capital, as defined, of the greater of 2% of aggregate debit
balances arising from client transactions or a minimum dollar requirement, which
is based on the type of business conducted by the broker-dealer. At December 31,
2004, 2% of aggregate debits was $205 million, which exceeded the minimum dollar
requirement for Schwab of $1 million. At December 31, 2004, Schwab's net capital
was $1.2 billion (12% of aggregate debit balances), which was $1.0 billion in
excess of its minimum required net capital and $723 million in excess of 5% of
aggregate debit balances. Under the alternative method, a broker-dealer may not
repay subordinated borrowings, pay cash dividends, or make any unsecured
advances or loans to its parent or employees if such payment would result in net
capital of less than 5% of aggregate debit balances or less than 120% of its
minimum dollar requirement.
Schwab had portions of its cash and investments segregated for the
exclusive benefit of clients at December 31, 2004, in accordance with applicable
regulations.
23. Commitments and Contingent Liabilities
Operating leases and other commitments: The Company has noncancelable
operating leases for office space and equipment. Future minimum rental
commitments under these leases, net of committed subleases, at December 31, 2004
are as follows:
- --------------------------------------------------------------------------------
Operating
Leases (1) Subleases (1) Net
- --------------------------------------------------------------------------------
2005 $ 232 $ (44) $ 188
2006 205 (41) 164
2007 200 (41) 159
2008 173 (38) 135
2009 170 (35) 135
Thereafter 804 (183) 621
- --------------------------------------------------------------------------------
Total $1,784 $ (382) $1,402
================================================================================
(1) Amounts include facilities under the Company's restructuring initiatives.
For further discussion, see note "3 - Restructuring Charges."
Certain leases contain provisions for renewal options, purchase options and
rent escalations based on increases in certain costs incurred by the lessor.
Rent expense was $262 million in 2004, $300 million in 2003, and $306 million in
2002.
Purchase Obligations: At December 31, 2004, the Company has purchase
obligations as follows, including $126 million which can be canceled by the
Company without penalty.
- --------------------------------------------------------------------------------
2005 $ 206
2006 85
2007 40
2008 28
2009 4
Thereafter 5
- --------------------------------------------------------------------------------
Total $ 368
================================================================================
Guarantees: The Company recognizes, at the inception of a guarantee, a
liability for the estimated fair value of the obligation undertaken in issuing
the guarantee. The fair values of the obligations relating to standby LOCs are
estimated based on fees charged to enter into similar agreements, considering
the creditworthiness of the counterparties. The fair values of the obligations
relating to other guarantees are estimated based on transactions for similar
guarantees or expected present value measures. The Company provides certain
indemnifications (i.e., protection against damage or loss) to counterparties in
connection with the disposition of certain of its assets. Such indemnifications
typically relate to title to the assets transferred, ownership of intellectual
property rights (e.g., patents), accuracy of financial statements, compliance
with laws and regulations, failure to pay, satisfy or discharge any liability,
or to defend claims, as well as errors, omissions, and misrepresentations. These
indemnification agreements have various expiration dates and the Company's
liability under these agreements is generally limited to certain maximum
amounts. At December 31, 2004, the Company's maximum potential liability under
these indemnification agreements is limited to approximately $115 million.
Additionally, the Company has guaranteed certain payments in the event of a
termination of certain mutual fund sub-advisor agreements, related to the
adoption of AXA Rosenberg LLC's U.S. family of mutual funds, known as the Laudus
Funds. The maximum aggregate guarantee is $75 million through 2011, and
$50 million thereafter. The Company does not believe that any material loss
related to such indemnifications is likely and therefore the liabilities
recorded for these guarantees are immaterial.
In connection with the sale of SSCM, the Company provided indemnifications
to UBS regarding certain litigation and income tax matters. The Company recorded
a liability of $19 million reflecting the estimated fair value of these
indemnifications.
LOCs are conditional commitments issued by U.S. Trust to guarantee the
performance of a client to a third party. For example, LOCs can be used to
guarantee performance under
- 54 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
lease and other agreements by professional business corporations and for other
purposes. The credit risk involved in issuing LOCs is essentially the same as
that involved in extending loans. LOCs are generally partially or fully
collateralized by cash, marketable equity securities, marketable debt securities
(including corporate and U.S. Treasury debt securities), and other assets. At
December 31, 2004, U.S. Trust had LOCs outstanding totaling $66 million which
are short-term in nature and generally expire within one year. At December 31,
2004, the liability recorded for these LOCs is immaterial.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging LOCs, in favor of the clearing houses, that are
guaranteed by multiple banks. At December 31, 2004, the outstanding value of
these LOCs totaled $630 million. In connection with its securities lending
activities, Schwab is required to provide collateral to certain brokerage
clients. Schwab satisfies the collateral requirements by arranging LOCs, in
favor of these brokerage clients, that are guaranteed by multiple banks. At
December 31, 2004, the outstanding value of these LOCs totaled $52 million. No
funds were drawn under these LOCs at December 31, 2004.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: The Company and its affiliates have been named in
various legal proceedings arising from the conduct of its business. Some of
these legal actions include claims for substantial damages or unspecified
damages. The Company believes it has strong defenses and is vigorously
contesting such actions. The Company is also involved, from time to time, in
investigations and proceedings by regulatory and other governmental agencies,
which may result in adverse judgments, fines or penalties. It is inherently
difficult to predict the ultimate outcome of these legal and regulatory matters,
particularly in cases in which claimants seek substantial or unspecified
damages, and a substantial judgment, settlement or penalty could be material to
the Company's operating results for a particular future period, depending on the
Company's results for that period. However, based on current information, it is
the opinion of management, after consultation with counsel, that the resolution
of these matters will not have a material adverse impact on the financial
condition, results of operations, or cash flows of the Company.
As part of the sale of SSCM to UBS, the Company agreed to indemnify UBS for
expenses associated with certain litigation, including multiple purported
securities class actions against SoundView and certain of its subsidiaries filed
in the United District Court for the Southern District of New York, brought on
behalf of persons who either directly or in the aftermarket purchased IPO
securities between March 1997 and December 2000. The Company is vigorously
contesting the claims on behalf of SoundView.
24. Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or
Market Risk
Securities lending: Through Schwab, the Company loans client securities
temporarily to other brokers in connection with its securities lending
activities. The Company receives cash as collateral for the securities loaned.
Increases in security prices may cause the market value of the securities loaned
to exceed the amount of cash received as collateral. In the event the
counterparty to these transactions does not return the loaned securities or
provide additional cash collateral, the Company may be exposed to the risk of
acquiring the securities at prevailing market prices in order to satisfy its
client obligations. The Company mitigates this risk by requiring credit
approvals for counterparties, by monitoring the market value of securities
loaned, and by requiring additional cash as collateral when necessary. The
market value of Schwab's client securities pledged in securities lending
transactions to other broker-dealers was $1.2 billion and $2.3 billion at
December 31, 2004 and 2003, respectively. Additionally, Schwab borrows
securities from other broker-dealers to fulfill short sales of its clients. The
market value of these borrowed securities was $254 million and $229 million at
December 31, 2004 and 2003, respectively.
Client trade settlement: The Company is obligated to settle transactions
with brokers and other financial institutions even if its clients fail to meet
their obligations to the Company. Clients are required to complete their
transactions on settlement date, generally three business days after trade date.
If clients do not fulfill their contractual obligations, the Company may incur
losses. The Company has established procedures to reduce this risk by requiring
deposits from clients in excess of amounts prescribed by regulatory requirements
for certain types of trades, and
- 55 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
therefore the potential for Schwab to make payments under these client
transactions is remote. Accordingly, no liability has been recognized for these
transactions.
Margin lending: Schwab provides margin loans to its clients which are
collateralized by securities in their brokerage accounts. Schwab may be liable
for the margin requirement of its client margin securities transactions. As
clients write options or sell securities short, the Company may incur losses if
the clients do not fulfill their obligations and the collateral in client
accounts is not sufficient to fully cover losses which clients may incur from
these strategies. To mitigate this risk, the Company monitors required margin
levels and clients are required to deposit additional collateral, or reduce
positions, when necessary. Clients with margin loans have agreed to allow Schwab
to pledge collateralized securities in their brokerage accounts in accordance
with federal regulations. Schwab was allowed, under such regulations, to pledge
securities with a market value of $13.8 billion and $12.0 billion at
December 31, 2004 and 2003, respectively. The market value of Schwab's client
securities pledged to fulfill the short sales of its clients was $1.2 billion
and $1.1 billion at December 31, 2004 and 2003, respectively. The market value
of Schwab's client securities pledged to fulfill Schwab's proprietary short
sales was $15 million and $13 million at December 31, 2004 and 2003,
respectively. Schwab has also pledged a portion of its securities owned in order
to fulfill the short sales of clients and in connection with securities lending
transactions to other broker-dealers. The market value of these pledged
securities was $8 million and $2 million at December 31, 2004 and 2003,
respectively. The Company may also pledge client securities to fulfill client
margin requirements for open option contracts established with the OCC. The
market value of these pledged securities to the OCC was $365 million and
$424 million at December 31, 2004 and 2003, respectively.
Financial instruments held for trading purposes: The Company maintains
inventories in securities on a long and short basis relating to its fixed income
operations. The Company could incur losses or gains as a result of changes in
the market value of these securities. To mitigate the risk of losses, long and
short positions are marked to market and are monitored by management to assure
compliance with limits established by the Company.
Resale and repurchase agreements: Schwab enters into collateralized resale
agreements principally with other broker-dealers, which could result in losses
in the event the counterparty to the transaction does not purchase the
securities held as collateral for the cash advanced and the market value of
these securities declines. To mitigate this risk, Schwab requires that the
counterparty deliver securities to a custodian, to be held as collateral, with a
market value in excess of the resale price. Schwab also sets standards for the
credit quality of the counterparty, monitors the market value of the underlying
securities as compared to the related receivable, including accrued interest,
and requires additional collateral where deemed appropriate. At December 31,
2004 and 2003, the market value of collateral received in connection with resale
agreements that is available to be repledged or sold was $13.4 billion and
$17.2 billion, respectively. U.S. Trust may enter into repurchase agreements
where it sells its fixed income securities with an agreement to repurchase the
securities at a future specified date. At December 31, 2004, U.S. Trust did not
have any of these agreements with third parties.
At both December 31, 2004 and 2003, financial instruments in the amount of
$1.3 billion were pledged to secure public deposits, to qualify for fiduciary
powers and for other purposes or as collateral for borrowings. Included in the
above amount at December 31, 2003, the fair value of collateral pledged under
repurchase agreements that is available to be repledged or sold by the
counterparties was $129 million. At December 31, 2004, there was no collateral
pledged under repurchase agreements that is available to be repledged or sold by
the counterparties.
Concentration risk: The Company's most significant concentration of risk is
its exposure to securities issued by the U.S. Government and its agencies (U.S.
Government). The Company's direct market risk exposure, primarily from
investments in securities available for sale, amounted to $3.2 billion and
$1.6 billion at December 31, 2004 and 2003, respectively. The Company maintains
indirect exposure to U.S. Government securities held as collateral to secure its
resale agreements. The Company's primary credit exposure on these resale
transactions is with its counterparty. The Company would have exposure to the
U.S. Government securities only in the event of the counterparty's default on
the resale agreements. Securities issued by the U.S. Government held as
collateral for resale agreements at December 31, 2004 and 2003 totaled
$13.4 billion and $17.2 billion, respectively.
Commitments to extend credit and LOCs: In the normal course of business,
U.S. Trust and Schwab Bank enter into various transactions involving off-balance
sheet financial instruments to meet the needs of their clients and to reduce
their own exposure to interest rate risk. The credit risk associated with these
instruments varies depending on the creditworthiness of the client and the value
of any collateral held. Collateral requirements vary by type of instrument. The
contractual amounts of these instruments represent the amounts at risk should
the contract be fully drawn upon, the client default, and the value of any
existing collateral become worthless.
Credit-related financial instruments include firm commitments to extend
credit (firm commitments) and LOCs.
- 56 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
Firm commitments are legally binding agreements to lend to a client that
generally have fixed expiration dates or other termination clauses, may require
payment of a fee and are not secured by collateral until funds are advanced.
Collateral held includes marketable securities, real estate mortgages or other
assets. The majority of U.S. Trust and Schwab Bank's firm commitments are
related to mortgage lending to banking clients. Firm commitments totaled $2.2
billion and $1.6 billion at December 31, 2004 and 2003, respectively. LOCs
outstanding at December 31, 2004 and 2003 amounted to $66 million and $64
million, respectively.
Interest rate swaps: As part of its consolidated asset and liability
management process, the Company utilizes Swaps to manage interest rate risk. The
market values of Swaps can vary depending on movements in interest rates. The
amounts at risk upon default are generally limited to the unrealized market
value gains of the Swaps, if any. The risk of default depends on the
creditworthiness of the counterparty. The Company evaluates the creditworthiness
of its counterparties as part of its normal credit review procedures.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with its variable rate deposits from banking clients. The Swaps are
structured for U.S. Trust to receive a variable rate of interest and pay a fixed
rate of interest. Information on these Swaps is summarized in the following
table:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Notional principal amount $ 625 $ 705
Weighted-average variable interest rate 2.39% 1.17%
Weighted-average fixed interest rate 4.25% 6.41%
Weighted-average maturity (in years) 3.3 1.0
- --------------------------------------------------------------------------------
These Swaps have been designated as cash flow hedges under SFAS No. 133 and
are recorded on the Company's consolidated balance sheet, with changes in their
fair values primarily recorded in other comprehensive income (loss), a component
of stockholders' equity. At December 31, 2004, U.S. Trust recorded a derivative
asset of $3 million and a derivative liability of $9 million related to these
Swaps. At December 31, 2003, U.S. Trust recorded a derivative liability of
$33 million for these Swaps. Based on current interest rate assumptions and
assuming no additional Swap agreements are entered into, U.S. Trust expects to
reclassify approximately $4 million, or $3 million after tax, from other
comprehensive loss to interest expense over the next twelve months.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months. Information on these Swaps is summarized in the
following table:
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Notional principal amount $ 293 $ 293
Weighted-average variable interest rate 4.85% 3.62%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 4.3 5.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Company's consolidated balance sheet. Changes in fair
value of the Swaps are completely offset by changes in fair value of the hedged
Medium-Term Notes. Therefore, there is no effect on net income. At December 31,
2004 and 2003, CSC recorded a derivative asset of $13 million and $19 million,
respectively, for these Swaps. Concurrently, the carrying value of the
Medium-Term Notes was increased by $13 million and $19 million at December 31,
2004 and 2003, respectively.
- 57 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
25. Fair Value of Financial Instruments
Substantially all of the Company's financial instruments are recorded at
estimated fair value or amounts that approximate fair value. The carrying
amounts (as recorded on the Company's consolidated balance sheet) and estimated
fair values of the Company's financial instruments are as follows:
- --------------------------------------------------------------------------------
2004 2003
---------------- -----------------
Carrying Fair Carrying Fair
December 31, Amount Value Amount Value
- --------------------------------------------------------------------------------
Financial Assets:
Cash and cash equivalents $ 2,778 $ 2,778 $ 2,785 $ 2,785
Cash and investments segregated 19,019 19,019 21,341 21,341
Securities owned 5,335 5,335 3,934 3,934
Receivables from
brokers, dealers and
clearing organizations 482 482 476 476
Receivables from
brokerage clients - net 9,841 9,841 8,581 8,581
Loans to banking clients - net 6,822 6,651 5,736 5,640
Loans held for sale 20 20 29 29
Swaps 16 16 19 19
- --------------------------------------------------------------------------------
Total $44,313 $44,142 $42,901 $42,805
================================================================================
Financial Liabilities:
Deposits from banking clients $11,118 $11,118 $ 8,308 $ 8,308
Drafts payable 363 363 152 152
Payables to brokers, dealers
and clearing organizations 1,468 1,468 2,633 2,633
Payables to brokerage clients 27,154 27,154 27,184 27,184
Accrued expenses and other
liabilities, excluding
interest rate swap agreements 1,387 1,387 1,183 1,183
Swaps 9 9 33 33
Short-term borrowings 663 663 996 996
Long-term debt 585 618 772 820
- --------------------------------------------------------------------------------
Total $42,747 $42,780 $41,261 $41,309
================================================================================
Cash and cash equivalents, cash and investments segregated, receivables,
deposits from banking clients, payables, accrued expenses and other liabilities,
and short-term borrowings are short-term in nature and accordingly are recorded
at fair value or amounts that approximate fair value.
Securities owned are recorded at estimated fair value. Such fair values are
estimated using quoted market prices, where available, or third-party pricing
services.
Loans to banking clients: The fair value of the Company's loans are estimated
using discounted contractual cash flows adjusted for current prepayment
estimates. The discount rates used are based on the interest rates charged to
current clients for comparable loans.
Loans held for sale: The fair value of the Company's loans held for sale are
estimated using the quoted market prices for securities backed by similar types
of loans.
Swaps: The fair value of the Company's Swaps are estimated by obtaining quotes
from dealers and third-party pricing services.
Long-term debt: A portion of the Company's long-term debt has been adjusted for
changes in the fair value of Swaps. See note "24 - Financial Instruments Subject
to Off-Balance Sheet Risk, Credit Risk or Market Risk." The fair value of the
Company's long-term debt is estimated using third-party pricing services and
discounted cash flow analyses utilizing discount rates currently available for
similar instruments.
Off-balance sheet financial instruments: In the normal course of business, the
Company is a party to certain off-balance sheet financial instruments, primarily
consisting of firm commitments and LOCs, which represent obligations of the
Company. As of December 31, 2004, the majority of these commitments mature
within one year. The fair value of firm commitments and LOCs are estimated based
on fees charged to enter into similar agreements, considering the
creditworthiness of the counterparties. The Company has reviewed the unfunded
portion of its firm commitments as well as its LOCs and determined that the fair
values of these instruments were immaterial at December 31, 2004 and 2003.
26. Segment Information
Segments are defined as components of a company in which separate financial
information is evaluated regularly by the chief operating decision maker, or
decision-making group, in deciding how to allocate resources and in assessing
performance. The Company structures its segments according to its various types
of clients and the services provided to those clients. These segments have been
aggregated, based on similarities in economic characteristics, types of clients,
services provided, distribution channels, and regulatory environment, into three
reportable segments - Individual Investor, Institutional Investor, and
U.S. Trust. In the third quarter of 2004, the Company exited from the capital
markets business, and as a result, the previously-reported Capital Markets
segment has been eliminated.
The Individual Investor segment includes the Company's retail brokerage and
banking operations. The Institutional Investor segment provides custodial,
trading, and support services to independent investment advisors, serves company
401(k) plan sponsors and third-party administrators, and supports company stock
option plans. The U.S. Trust segment provides investment, wealth management,
custody, fiduciary, and private banking services to individual and
- 58 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
institutional clients.
The accounting policies of the segments are the same as those described in
note "2 - Significant Accounting Policies." Financial information for the
Company's reportable segments is presented in the following table. In the first
quarter of 2004, the Company changed its methodology for the computation of its
segment information. The new methodology utilizes an activity-based costing
model to allocate traditional income statement line item expenses (e.g.,
compensation and benefits, depreciation, and professional services) to the
business activities driving segment expenses (e.g., client service, opening new
accounts, or business development). Previously-reported segment information has
been revised to reflect this new methodology. Previously, technology, corporate,
and general administrative expenses were allocated to the segments generally in
proportion to either their respective revenues or average full-time equivalent
employees, except for the U.S. Trust segment, for which expenses were directly
incurred.
The Company periodically reallocates certain revenues and expenses among
the segments to align them with the changes in the Company's organizational
structure. Previously-reported segment information has been revised to reflect
changes during the year in the Company's internal organization. The Company
evaluates the performance of its segments based on adjusted operating income
before taxes (a non-GAAP income measure), which excludes items such as
non-operating revenues, restructuring charges, impairment charges, acquisition-
and merger-related charges, discontinued operations, and extraordinary items.
Segment assets are not disclosed because they are not used for evaluating
segment performance and deciding how to allocate resources to segments. However,
capital expenditures are used in evaluating segment performance and are
therefore disclosed. Intersegment revenues, defined as revenues from
transactions with other segments within the Company, are not material and are
therefore not disclosed. Total revenues, net interest revenue (i.e., interest
revenue, net of interest expense), income from continuing operations before
taxes on income and extraordinary gain, and net income are equal to the
Company's consolidated amounts as reported in the consolidated financial
statements. Capital expenditures are reported gross, as opposed to net of
proceeds from the sale of fixed assets.
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Revenues
Individual Investor $ 2,444 $ 2,365 $ 2,375
Institutional Investor 897 821 855
U.S. Trust 773 629 651
Unallocated 74 64 63
- --------------------------------------------------------------------------------
Operating revenues 4,188 3,879 3,944
Non-operating revenue (1) 14 17 -
- --------------------------------------------------------------------------------
Total $ 4,202 $ 3,896 $ 3,944
================================================================================
Net interest revenue
Individual Investor $ 586 $ 437 $ 508
Institutional Investor 95 84 106
U.S. Trust 212 186 196
Unallocated 43 21 15
- --------------------------------------------------------------------------------
Total $ 936 $ 728 $ 825
================================================================================
Adjusted operating income
before taxes
Individual Investor $ 492 $ 434 $ 354
Institutional Investor 282 303 254
U.S. Trust (2) 49 40 51
Unallocated 22 4 (3)
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 845 781 656
Excluded items (3) (200) (64) (407)
- --------------------------------------------------------------------------------
Income from continuing
operations before taxes on
income and extraordinary gain 645 717 249
Taxes on income (231) (241) (100)
Loss from discontinued operations,
net of tax (128) (4) (52)
Extraordinary gain on sale of
corporate trust business,
net of tax - - 12
- --------------------------------------------------------------------------------
Net Income $ 286 $ 472 $ 109
================================================================================
Capital expenditures
Individual Investor $ 145 $ 97 $ 101
Institutional Investor 31 28 31
U.S. Trust 20 19 21
Unallocated 2 4 4
- --------------------------------------------------------------------------------
Total $ 198 $ 148 $ 157
================================================================================
Depreciation and amortization
Individual Investor $ 113 $ 140 $ 174
Institutional Investor 25 33 40
U.S. Trust 37 31 30
Unallocated 51 73 65
- --------------------------------------------------------------------------------
Total $ 226 $ 277 $ 309
================================================================================
(1) Primarily consists of gains on investments.
(2) In accordance with the Company's new cost allocation methodology, amounts
include costs ($63 million, $55 million, and $38 million in 2004, 2003, and
2002, respectively) allocated to U.S. Trust.
- 59 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(3) In 2004, includes restructuring charges of $214 million (see note "3 -
Restructuring Charges") and a pre-tax gain on an investment of $14 million.
In 2003, includes restructuring charges of $76 million (see note "3 -
Restructuring Charges"), an impairment charge of $5 million (see note "6 -
Business Acquisitions and Divestitures"), and a pre-tax gain recorded on
the sale of an investment of $17 million. In 2002, includes restructuring
charges of $343 million (see note "3 - Restructuring Charges"), impairment
charges of $37 million (see note "6 - Business Acquisitions and
Divestitures"), and acquisition- and merger-related charges of $27 million.
Fees received from Schwab's proprietary mutual funds represented
approximately 21% of the Company's consolidated revenues in 2004, 23% in 2003,
and 22% in 2002. Except for Schwab's proprietary mutual funds, which are
considered a single client for purposes of this computation, no single client
accounted for more than 10% of the Company's consolidated revenues in 2004,
2003, or 2002. Substantially all of the Company's revenues and assets are
attributed to or located in the U.S. The percentage of Schwab's total client
accounts located in California was approximately 26% at December 31, 2004 and
27% at each of December 31, 2003 and 2002.
27. Supplemental Cash Flow Information
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Income taxes paid $ 153 $ 255 $ 91
- --------------------------------------------------------------------------------
Interest paid:
Brokerage client cash balances $ 112 $ 77 $ 166
Deposits from banking clients 106 91 86
Long-term debt 30 37 55
Short-term borrowings 15 15 21
Other 9 19 6
- --------------------------------------------------------------------------------
Total interest paid $ 272 $ 239 $ 334
================================================================================
Non-cash investing and financing activities:
Consolidation of a Trust: (1)
Building and land $ - $ 229 -
Note payable and other liabilities $ - $ 228 -
Common stock and options issued
for purchases of businesses $ 3 $ 4 $ 4
- --------------------------------------------------------------------------------
(1) Upon adoption of FIN No. 46 in the first quarter 2003, the Company
consolidated a Trust. See note "2 - Significant Accounting Policies -
Variable Interest Entities."
28. The Charles Schwab Corporation - Parent Company Only Financial Statements
Condensed Statement of Income
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Interest revenue $ 26 $ 28 $ 41
Interest expense (18) (27) (41)
- --------------------------------------------------------------------------------
Net interest revenue 8 1 -
Other losses (8) (2) (2)
Restructuring credit (charges) 2 (25) (29)
Other gains (expenses) (16) (26) 5
- --------------------------------------------------------------------------------
Loss before income tax benefit and equity
in earnings of subsidiaries (14) (52) (26)
Income tax benefit 5 27 11
- --------------------------------------------------------------------------------
Loss from continuing operations before
equity in earnings of subsidiaries (9) (25) (15)
Equity in earnings of subsidiaries:
Equity in undistributed earnings/
(distributions in excess of earnings)
of subsidiaries 80 22 (273)
Dividends paid by non-banking subsidiaries 333 479 437
Dividends paid by banking subsidiaries 10 - -
Equity in extraordinary gain of subsidiary - - 12
Equity in discontinued operations of
subsidiaries (128) (4) (52)
- --------------------------------------------------------------------------------
Total 295 497 124
Net Income $ 286 $ 472 $ 109
- --------------------------------------------------------------------------------
- 60 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
Condensed Balance Sheet
- --------------------------------------------------------------------------------
December 31, 2004 2003
- --------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 693 $ 764
Securities owned - at market value 80 74
Intercompany receivables 11 18
Loans to non-banking subsidiaries 220 270
Loans to banking subsidiaries 30 45
Investments in non-banking subsidiaries, at equity 2,622 2,589
Investments in banking subsidiaries, at equity 1,538 1,397
Other assets 139 95
- --------------------------------------------------------------------------------
Total $5,333 $5,252
================================================================================
Liabilities and Stockholders' Equity
Accrued expenses and other liabilities $ 281 $ 195
Intercompany payables 267 87
Loans from non-banking subsidiaries - 24
Long-term debt 399 485
- --------------------------------------------------------------------------------
Total liabilities 947 791
- --------------------------------------------------------------------------------
Stockholders' equity 4,386 4,461
- --------------------------------------------------------------------------------
Total $5,333 $5,252
================================================================================
Condensed Statement of Cash Flows
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 286 $ 472 $ 109
Adjustments to reconcile net income to net
cash provided by operating activities:
Distributions in excess of earnings/
(equity in undistributed earnings) of
subsidiaries (80) (22) 273
Equity in extraordinary gain of subsidiary - - (12)
Equity in discontinued operations of
subsidiaries 128 4 52
Other (7) (7) 2
Net change in:
Other assets 6 9 (29)
Drafts payable - - (100)
Accrued expenses and other liabilities 44 24 6
- --------------------------------------------------------------------------------
Net cash provided by operating activities 377 480 301
- --------------------------------------------------------------------------------
Cash Flows from Investing Activities
Proceeds from sales of securities available
for sale - - 11
Advances to subsidiaries (230) (100) (71)
Repayments from subsidiaries 245 116 57
Change in net intercompany receivables 7 23 103
Decrease (increase) in investments
in subsidiaries (20) (643) 10
Cash payments for business combinations
and investments, net of cash received (1) (25) (1)
Proceeds from sale of subsidiary 271 - -
- --------------------------------------------------------------------------------
Net cash provided by (used for) investing
activities 272 (629) 109
- --------------------------------------------------------------------------------
Cash Flows from Financing Activities
Proceeds from loans from subsidiaries - - 24
Repayment of loans from subsidiaries (24) - -
Repayment of long-term debt (80) (100) (113)
Dividends paid (101) (68) (60)
Purchase of treasury stock (383) (32) (299)
Proceeds from stock options exercised
and other 51 34 34
- --------------------------------------------------------------------------------
Net cash used for financing activities (537) (166) (414)
- --------------------------------------------------------------------------------
Net cash used for discontinued operations (183) - (114)
- --------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (71) (315) (118)
Cash and Cash Equivalents at Beginning
of Year 764 1,079 1,197
- --------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 693 $ 764 $1,079
================================================================================
- 61 -
THE CHARLES SCHWAB CORPORATION
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
29. Quarterly Financial Information (Unaudited)
- --------------------------------------------------------------------------------
Fourth Third Second First
Quarter Quarter Quarter Quarter
- --------------------------------------------------------------------------------
Year Ended December 31, 2004:
Revenues (1) $1,060 $1,000 $1,034 $1,108
Expenses, Excluding Interest (1) $ 900 $ 928 $ 865 $ 864
Net Income (Loss) $ 53 $ (41) $ 113 $ 161
Weighted Average Common
Shares - Diluted 1,348 1,364 1,373 1,375
Basic Earnings (Loss)
Per Share (2) $ .04 $ (.03) $ .08 $ .12
Diluted Earnings (Loss)
Per Share (2) $ .04 $ (.03) $ .08 $ .12
Dividends Declared Per
Common Share $ .020 $ .020 $ .020 $ .014
Range of Common Stock
Price Per Share:
High $12.03 $10.03 $11.93 $13.76
Low $ 8.47 $ 8.30 $ 9.05 $10.74
Range of Price/Earnings Ratio (3):
High 57 36 30 34
Low 40 30 23 26
- --------------------------------------------------------------------------------
Year Ended December 31, 2003:
Revenues (1) $1,062 $ 997 $ 971 $ 866
Expenses, Excluding Interest (1) $ 829 $ 801 $ 788 $ 761
Net Income $ 148 $ 127 $ 126 $ 71
Weighted Average Common
Shares - Diluted 1,371 1,366 1,360 1,357
Basic Earnings Per Share (2) $ .11 $ .09 $ .10 $ .05
Diluted Earnings Per Share (2) $ .11 $ .09 $ .09 $ .05
Dividends Declared Per
Common Share $ .014 $ .014 $ .011 $ .011
Range of Common Stock
Price Per Share:
High $13.98 $12.73 $11.64 $12.46
Low $10.90 $10.01 $ 7.20 $ 6.25
Range of Price/Earnings Ratio (3):
High 40 75 146 208
Low 31 59 90 104
- --------------------------------------------------------------------------------
(1) Amounts have been adjusted to summarize the impact of the Company's sales
of SSCM and CSE in loss from discontinued operations. For further
discussion, see note "5 - Discontinued Operations."
(2) Both basic and diluted earnings per share include loss from discontinued
operations.
(3) Price/earnings ratio is computed by dividing the high and low market prices
by diluted earnings per share for the 12-month period ended on the last day
of the quarter presented.
- 62 -
THE CHARLES SCHWAB CORPORATION
Management's Report on Internal Control Over Financial Reporting
Management of The Charles Schwab Corporation, together with its
subsidiaries (the Company), is responsible for establishing and maintaining
adequate internal control over financial reporting. The Company's internal
control over financial reporting is a process designed under the supervision of
the Company's chief executive officer and chief financial officer to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of published financial statements in accordance with accounting
principles generally accepted in the United States of America.
As of December 31, 2004, management conducted an evaluation of the
effectiveness of the Company's internal control over financial reporting based
on the framework established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission. Based
on this evaluation, management has determined that the Company's internal
control over financial reporting was effective as of December 31, 2004.
The Company's internal control over financial reporting includes policies
and procedures that pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect transactions and dispositions of assets;
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America, and that receipts
and expenditures are being made only in accordance with authorizations of
management and the directors of the Company; and provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use or
disposition of the Company's assets that could have a material effect on the
Company's financial statements.
Management's assessment of the effectiveness of internal control over
financial reporting as of December 31, 2004 has been audited by Deloitte &
Touche LLP, an independent registered public accounting firm, as stated in their
report appearing on the following page, which expresses unqualified opinions on
management's assessment and on the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004.
/s/ Charles R. Schwab
- --------------------------
Charles R. Schwab
Chairman and Chief Executive Officer
February 28, 2005
/s/ Christopher V. Dodds
- --------------------------
Christopher V. Dodds
Executive Vice President and Chief Financial Officer
February 28, 2005
- 63 -
THE CHARLES SCHWAB CORPORATION
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of The Charles Schwab Corporation:
We have audited the accompanying consolidated balance sheets of The Charles
Schwab Corporation and subsidiaries (the Company) as of December 31, 2004 and
2003, and the related consolidated statements of income, stockholders' equity,
and cash flows for each of the three years in the period ended December 31,
2004. Our audits also included the financial statement schedule of the Company
on page F-2. We also have audited management's assessment, included in the
accompanying Management's Report on Internal Control Over Financial Reporting,
that the Company maintained effective internal control over financial reporting
as of December 31, 2004, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. The Company's management is responsible for these financial
statements and financial statement schedule, for maintaining effective internal
control over financial reporting, and for its assessment of the effectiveness of
internal control over financial reporting. Our responsibility is to express an
opinion on these financial statements and financial statement schedule, an
opinion on management's assessment, and an opinion on the effectiveness of the
Company's internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects. Our audit of financial statements included examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. Our
audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, evaluating
management's assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a
reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed
by, or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Company
as of December 31, 2004 and 2003, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 2004, in
conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth
therein. Also, in our opinion, management's assessment that the Company
maintained effective internal control over financial reporting as of
December 31, 2004, is fairly stated, in all material respects, based on the
criteria established in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. Furthermore,
in our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2004, based on the
criteria established in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
/s/ Deloitte & Touche LLP
San Francisco, California
February 28, 2005
- 64 -
THE CHARLES SCHWAB CORPORATION
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures (as defined in Rule
13a-15(e) under the Securities Exchange Act of 1934) as of December 31, 2004.
Based on this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer have concluded that the Company's disclosure controls and
procedures were effective as of December 31, 2004. Additionally in connection
with this evaluation, no change in the Company's internal control over financial
reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of
1934) was identified during the quarter ended December 31, 2004 that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
Management's Report on Internal Control Over Financial Reporting and the
Report of Independent Registered Public Accounting Firm are included in "Item 8
- - Financial Statements and Supplementary Data."
Item 9B. Other Information
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
The information relating to directors of the Company required to be
furnished pursuant to this item is incorporated by reference from portions of
the Company's definitive proxy statement for its annual meeting of stockholders
to be filed with the SEC pursuant to Regulation 14A by April 29, 2005 (the Proxy
Statement) under "The Board of Directors - Members of the Board of Directors,"
"The Board of Directors - Board and Committee Meetings," "The Board of Directors
- - Director Nominations," and "Section 16(a) Beneficial Ownership Reporting
Compliance." The Company's Code of Conduct and Business Ethics, applicable to
directors and all employees, including senior financial officers, is available
on the Company's website at www.aboutschwab.com/corpgov. If the Company makes
any amendments to or grants any waivers from its Code of Conduct and Business
Ethics which are required to be disclosed pursuant to the Securities Exchange
Act of 1934, the Company will make such disclosures on this website.
Executive Officers of the Registrant
The following table provides certain information about each of the
Company's current executive officers.
- 65 -
THE CHARLES SCHWAB CORPORATION
================================================================================
Executive Officers of the Registrant
Name Age Title
---- --- -----
Charles R. Schwab 67 Chairman, Chief Executive Officer,
and Director
William L. Atwell 54 Executive Vice President and
President - Individual Investor
Enterprise
Walter W. Bettinger 44 Executive Vice President and Chief
Operating Officer - Individual
Investor Enterprise
Jeremiah H. Chafkin 45 Executive Vice President and
President - Advised Investor
Christopher V. Dodds 45 Executive Vice President and Chief
Financial Officer
Carrie E. Dwyer 54 Executive Vice President, General
Counsel and Corporate Secretary
Charles G. Goldman 43 Executive Vice President -
Strategy and Corporate Development
Jan Hier-King 50 Executive Vice President -
Human Resources
Jeffrey M. Lyons 50 Executive Vice President and
President - Active Trader
Deborah D. McWhinney 49 Executive Vice President and
President - Schwab Institutional
Randall W. Merk 50 Executive Vice President and
President - Asset Management
Products and Services
Rebecca Saeger 49 Executive Vice President - Brand
Management and Marketing
Communications
Gideon Sasson 49 Executive Vice President and Chief
Information Officer
Alan J. Weber 56 Executive Vice President of
The Charles Schwab Corporation,
Chairman and Chief Executive
Officer of U.S. Trust Corporation
================================================================================
Mr. Schwab has been Chairman and a director of CSC since its incorporation
in 1986. Effective July 20, 2004, CSC's Board of Directors appointed Mr. Schwab
as Chief Executive Officer of CSC, replacing David S. Pottruck. Mr. Schwab was
Co-Chief Executive Officer of CSC from 1998 to 2003, and Chief Executive Officer
of CSC from 1986 to 1997. Mr. Schwab was a founder of Schwab in 1971, its
Chairman since 1978, and its Chief Executive Officer since July 20, 2004.
Mr. Schwab is currently a director of USTC and its principal subsidiary,
U.S. Trust NY. Mr. Schwab is also Chairman of Charles Schwab Bank, N.A., and is
a trustee of The Charles Schwab Family of Funds, Schwab Investments, Schwab
Capital Trust and Schwab Annuity Portfolios, all registered investment
companies.
- 66 -
THE CHARLES SCHWAB CORPORATION
Mr. Atwell has been Executive Vice President and President - Individual
Investor Enterprise of CSC and Schwab since December 2004. He served as
Executive Vice President and President - Client Sales and Service and Banking of
CSC and Schwab from 2003 until December 2004, Executive Vice President -
Institutional, International and Banking of CSC and Schwab from 2002 until 2003,
and Executive Vice President - International and Banking of Schwab for part of
2002. Mr. Atwell was Executive Vice President - International of Schwab from
2000 to 2002. Prior to joining Schwab, Mr. Atwell was Senior Vice President -
National Sales and Delivery Network for CIGNA Healthcare from 1996 to 2000.
Mr. Atwell is currently a director of the Securities Industry Association.
Mr. Bettinger has been Executive Vice President and Chief Operating Officer
- - Individual Investor Enterprise of CSC and Schwab since June 2004. He served as
Executive Vice President and President - Corporate Services of Schwab from 2002
until June 2004, and Executive Vice President and President - Retirement Plan
Services of Schwab from 2000 to 2002. Mr. Bettinger was appointed to CSC's
Executive Committee effective June 28, 2004. Mr. Bettinger joined Schwab in
1995.
Mr. Chafkin has been Executive Vice President and President - Advised
Investor of CSC and Schwab since December 2004. He was Executive Vice President
- - Advice, Products and Tools of Schwab from 2002 to December 2004, Executive
Vice President - Investment Advice and Products of Schwab from 2001 to 2002, and
Executive Vice President - Asset Management Products and Services of Schwab from
2000 to 2001. Mr. Chafkin was appointed to CSC's Executive Committee effective
January 1, 2005. Mr. Chafkin joined Schwab in 1999.
Mr. Dodds has been Chief Financial Officer of CSC and Schwab since 1999 and
Executive Vice President of CSC and Schwab since 1998. Mr. Dodds was Corporate
Controller of Schwab from 1997 to 1999 and Corporate Treasurer of Schwab from
1993 to 1997. Mr. Dodds joined Schwab in 1986.
Ms. Dwyer has been Executive Vice President, General Counsel and Corporate
Secretary of CSC and Executive Vice President - Corporate Oversight of Schwab
since 1996. Ms. Dwyer was appointed to CSC's Executive Committee effective June
28, 2004. Ms. Dwyer joined Schwab in 1996.
Mr. Goldman has been Executive Vice President - Strategy and Corporate
Development of CSC and Schwab since May 2004. He served as Senior Vice President
of Corporate Development of Schwab from 2002 until May 2004. Mr. Goldman joined
Schwab in 2001 as Senior Vice President of Venture Capital Investing and served
in that role until 2002. Prior to joining Schwab, Mr. Goldman was President and
Chief Operating Officer of Paramount Farms, Inc. and Paramount Citrus
Association from 1996 to 2000. Mr. Goldman was appointed to CSC's Executive
Committee effective January 1, 2005. Mr. Goldman is currently a director of
Woolf Enterprises, Inc. and Chairman of the Board of Wall Street on Demand.
Ms. Hier-King has been Executive Vice President - Human Resources of CSC
and Schwab since July 2004. She served as Senior Vice President of Human
Resources of Schwab from 2002 until July 2004. Ms. Hier-King joined Schwab in
1994 as Senior Vice President - Technology and served in that role until 2002.
Ms. Hier-King was appointed to CSC's Executive Committee effective January 1,
2005. Ms. Hier-King is currently a director of Akamai Technologies, Inc.
Mr. Lyons has been Executive Vice President and President - Active Trader
of CSC and Schwab since June 2004. He served as Executive Vice President and
President - Asset Management Products and Services of Schwab from 2002 until
June 2004, and Executive Vice President - Mutual Funds of Schwab from 1999 to
2002. Mr. Lyons was appointed to CSC's Executive Committee effective June 28,
2004. Mr. Lyons joined Schwab in 1984.
Mr. Merk has been Executive Vice President and President - Asset Management
Products and Services of CSC and Schwab since December 2004. Mr. Merk joined
Schwab in 2002 as Executive Vice President and President - Investment Management
of Schwab and served in that role until December 2004. Prior to joining Schwab,
Mr. Merk was Chief Investment Officer - Fixed Income for American Century from
1998 to 2001, and President and Chief Investment Officer for American Century
from 2001 to 2002. Mr. Merk was appointed to CSC's Executive Committee effective
January 1, 2005.
Ms. McWhinney has been Executive Vice President and President - Schwab
Institutional of CSC and Schwab since 2001 when she joined Schwab. Prior to
joining Schwab, Ms. McWhinney was Group President for Engage Media Services from
1999 to 2001. Ms. McWhinney was appointed to CSC's Executive Committee effective
June 28, 2004. Ms. McWhinney is currently a director of SIPC and serves as
Executive Advisor of Hitachi Data Systems.
Ms. Saeger has been Executive Vice President - Brand Management and
Marketing Communications of CSC and Schwab since December 2004. Ms. Saeger
joined Schwab in March 2004 as Executive Vice President - Brand Management and
served in that role until December 2004. Prior to joining Schwab, Ms. Saeger was
Executive Vice President of Brand Marketing for Visa USA from 1997 to 2004.
Ms. Saeger was appointed to CSC's Executive
- 67 -
THE CHARLES SCHWAB CORPORATION
Committee effective January 1, 2005. Ms. Saeger is currently a director of the
Association of National Advertisers.
Mr. Sasson has been Executive Vice President and Chief Information Officer
of CSC and Schwab since June 2004. He served as Executive Vice President and
President - Active Trader of Schwab from 2001 until June 2004, and Executive
Vice President and President - Electronic Brokerage of Schwab from 1997 to 2001.
Mr. Sasson was appointed to CSC's Executive Committee effective June 28, 2004.
Mr. Sasson joined Schwab in 1995. Mr. Sasson is currently a director of Quris,
Inc., an affiliate of CSC, and CommercialWare.
Mr. Weber has been Executive Vice President of CSC, Chief Executive Officer
of USTC and U.S. Trust NY, and a director of USTC since 2002 and Chairman of
USTC since 2003. Prior to joining USTC, Mr. Weber was Vice Chairman and Chief
Financial Officer for Aetna, Inc. from 1998 to 2001. Mr. Weber currently serves
as Advisory Committee Chairman of Computer Repair Systems, LLC.
Item 11. Executive Compensation
The information required to be furnished pursuant to this item is
incorporated by reference from portions of the Proxy Statement under "The Board
of Directors - Compensation Committee Interlocks and Insider Participation," "-
Director Compensation," "Executive Compensation - Summary Compensation Table,"
"- Options Granted in 2004," "- Fiscal Year-End Option Values," "- Long-Term
Incentive Plan - Awards in 2004," "Certain Relationships and Related
Transactions," "Appendix B - Description of Charles R. Schwab's Employment and
License Agreements," "Appendix C - Description of Lon Gorman's Employment
Agreement," and "Appendix D - Description of Dave Pottruck's Severance
Agreement."
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
The information required to be furnished pursuant to this item is
incorporated by reference from portions of the Proxy Statement under "Principal
Stockholders," "Executive Compensation - Securities Authorized for Issuance
Under Equity Compensation Plans," and "- Material Features of Employee Stock
Incentive Plan."
Item 13. Certain Relationships and Related Transactions
The information required to be furnished pursuant to this item is
incorporated by reference from a portion of the Proxy Statement under "Certain
Relationships and Related Transactions."
Item 14. Principal Accountant Fees and Services
The information required to be furnished pursuant to this item is
incorporated by reference from a portion of the Proxy Statement under
"Independent Auditors - Auditor Selection and Fees."
PART IV
Item 15. Exhibits and Financial Statement Schedule
(a) Documents filed as part of this Report
1. Financial Statements
The financial statements and independent auditors' report are included in
"Item 8 - Financial Statements and Supplementary Data" and are listed below:
Consolidated Statement of Income
Consolidated Balance Sheet
Consolidated Statement of Cash Flows
Consolidated Statement of Stockholders' Equity
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
2. Financial Statement Schedule
The financial statement schedule required to be furnished pursuant to this
item is listed in the accompanying index appearing on page F-1.
- 68 -
THE CHARLES SCHWAB CORPORATION
(b) Exhibits
The exhibits listed below are filed as part of this annual report on Form
10-K.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
1.3 The Charles Schwab Corporation Medium-Term Notes Distribution
Agreement filed as Exhibit 1.3 to the Registrant's Form 10-Q for the
quarter ended June 30, 2000 and incorporated herein by reference.
2.1 Agreement and Plan of Merger dated as of January 12, 2000, by and
among The Charles Schwab Corporation, Patriot Merger Corporation and
U.S. Trust Corporation, filed as Exhibit 2.1 to the Registrant's Form
8-K dated January 12, 2000 and incorporated herein by reference.
3.11 Fifth Restated Certificate of Incorporation, effective May 7, 2001, of
the Registrant (supersedes Exhibit 3.10), filed as Exhibit 3.11 to the
Registrant's Form 10-Q for the quarter ended September 30, 2001 and
incorporated herein by reference.
3.12 Third Restated Bylaws, as amended on May 9, 2003, of the Registrant
(supersedes Exhibit 3.9), filed as Exhibit 3.12 to the Registrant's
Form 10-Q for the quarter ended June 30, 2003 and incorporated herein
by reference.
4.2 Neither the Registrant nor its subsidiaries are parties to any
instrument with respect to long-term debt for which securities
authorized thereunder exceed 10% of the total assets of the Registrant
and its subsidiaries on a consolidated basis. Copies of instruments
with respect to long-term debt of lesser amounts will be provided to
the SEC upon request.
10.4 Form of Release Agreement dated as of March 31, 1987 among BAC,
Registrant, Schwab Holdings, Inc., Charles Schwab & Co., Inc. and
former shareholders of Schwab Holdings, Inc. *
10.57 Registration Rights and Stock Restriction Agreement, dated as of
March 31, 1987, between the Registrant and the holders of the Common
Stock, filed as Exhibit 4.23 to Registrant's Registration Statement
No. 33-16192 on Form S-1 and incorporated herein by reference.
10.72 Restatement of Assignment and License, as amended January 25, 1988,
among Charles Schwab & Co., Inc., Charles R. Schwab and the
Registrant.
10.87 Trust Agreement under the Charles Schwab Profit Sharing and Employee
Stock Ownership Plan, effective November 1, 1990, dated October 25,
1990, filed as Exhibit 10.87 to the Registrant's Form 10-Q for the
quarter ended September 30, 2000 and incorporated herein by reference.
+
10.101 First Amendment to the Trust Agreement under the Charles Schwab Profit
Sharing and Employee Stock Ownership Plan, effective January 1, 1992,
dated December 20, 1991, filed as Exhibit 10.101 to the Registrant's
Form 10-K for the year ended December 31, 2001 and incorporated herein
by reference. +
- 69 -
THE CHARLES SCHWAB CORPORATION
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.116 Second Amendment to the Trust Agreement for the Charles Schwab Profit
Sharing and Employee Stock Ownership Plan effective July 1, 1992,
dated June 30, 1992, filed as Exhibit 10.116 to the Registrant's Form
10-Q for the quarter ended June 30, 2002 and incorporated herein by
reference. +
10.138 Form of Nonstatutory Stock Option Agreement for Non-Employee
Directors, filed as Exhibit 4.4 to the Registrant's Registration
Statement No. 33-47842 on Form S-8 and incorporated herein by
reference. +
10.140 Form of Restricted Shares Agreement, filed as Exhibit 4.6 to the
Registrant's Registration Statement No. 33-54701 on Form S-8 and
incorporated herein by reference. +
10.169 Third Amendment to the Trust Agreement for the Charles Schwab Profit
Sharing and Employee Stock Ownership Plan effective January 1, 1996,
dated May 8, 1996 filed as Exhibit 10.169 to the Registrant's Form
10-Q for the quarter ended June 30, 2002 and incorporated herein by
reference. +
10.191 Form of Restricted Shares Award Agreement of The Charles Schwab
Corporation 1992 Stock Incentive Plan (supersedes Exhibit 10.171),
filed as Exhibit 10.191 to the Registrant's Form 10-K for the year
ended December 31, 2002 and incorporated herein by reference. +
10.192 Form of Nonstatutory Stock Option Agreement of The Charles Schwab
Corporation 1992 Stock Incentive Plan (supersedes Exhibit 10.172),
filed as Exhibit 10.192 to the Registrant's Form 10-K for the year
ended December 31, 2002 and incorporated herein by reference. +
10.202 Fourth Amendment to the Trust Agreement for the Charles Schwab Profit
Sharing and Employee Stock Ownership Plan effective January 1, 1998,
filed as Exhibit 10.202 to the Registrant's Form 10-K for the year
ended December 31, 2003. +
10.215 The Charles Schwab Corporation Directors' Deferred Compensation Plan,
restated to include amendments through December 13, 2000 (supersedes
Exhibit 10.209), filed as Exhibit 10.215 to the Registrant's Form 10-K
for the year ended December 31, 2000 and incorporated herein by
reference. +
10.218 Executive Employment Agreement and Covenant Not To Compete for
Jeffrey S. Maurer, filed as Exhibit 10.218 to the Registrant's Form
10-Q for the quarter ended March 31, 2001 and incorporated herein by
reference. +
10.221 The SchwabPlan(R) Retirement Savings and Investment Plan, restated and
amended as of April 1, 2001 (supersedes Exhibit 10.216), filed as
Exhibit 10.221 to the Registrant's Form 10-Q for the quarter ended
June 30, 2001 and incorporated herein by reference. +
- 70 -
THE CHARLES SCHWAB CORPORATION
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.226 The Charles Schwab Corporation Employee Stock Incentive Plan, restated
and amended as of September 20, 2001 (supersedes Exhibit 10.190),
filed as Exhibit 10.226 to the Registrant's Form 10-Q for the quarter
ended September 30, 2001 and incorporated herein by reference. +
10.227 Benefit Equalization Plan of U.S. Trust Corporation, filed as
Exhibit 10.227 to the Registrant's Form 10-Q for the quarter ended
September 30, 2001 and incorporated herein by reference. +
10.228 1990 Change in Control and Severance Policy for Top Tier Officers of
United States Trust Company of New York and Affiliated Companies,
filed as Exhibit 10.228 to the Registrant's Form 10-Q for the quarter
ended September 30, 2001 and incorporated herein by reference. +
10.231 1989 Stock Compensation Plan and Predecessor Plans of U.S. Trust
Corporation, filed as Exhibit 10.231 to the Registrant's Form 10-Q for
the quarter ended September 30, 2001 and incorporated herein by
reference. +
10.234 Executive Deferred Compensation Plan of U.S. Trust Corporation, as
amended and restated effective as of January 1, 2001 (supersedes
Exhibit 10.229), filed as Exhibit 10.234 to the Registrant's Form 10-K
for the year ended December 31, 2001 and incorporated herein by
reference. +
10.235 Executive Incentive Plan of U.S. Trust Corporation, as amended and
restated effective as of January 1, 2001 (supersedes Exhibit 10.230),
filed as Exhibit 10.235 to the Registrant's Form 10-K for the year
ended December 31, 2001 and incorporated herein by reference. +
10.236 U.S. Trust Corporation 401(k) Plan, as amended and restated effective
as of January 1, 2001 (supersedes Exhibit 10.233), filed as Exhibit
10.236 to the Registrant's Form 10-K for the year ended December 31,
2001 and incorporated herein by reference. +
10.237 U.S. Trust Corporation Employees' Retirement Plan, as amended and
restated effective as of January 1, 2001 (supersedes Exhibit 10.232),
filed as Exhibit 10.237 to the Registrant's Form 10-K for the year
ended December 31, 2001 and incorporated herein by reference. +
10.239 The Charles Schwab Corporation Annual Executive Individual Performance
Plan, restated to include amendments approved at the Annual Meeting of
Stockholders on May 13, 2002 (supersedes Exhibit 10.220), filed as
Exhibit 10.239 to the Registrant's Form 10-Q for the quarter ended
June 30, 2002 and incorporated herein by reference. +
10.240 The Charles Schwab Corporation Corporate Executive Bonus Plan,
restated to include amendments approved at the Annual Meeting of
Stockholders on May 13, 2002 (supersedes Exhibit 10.212), filed as
Exhibit 10.240 to the Registrant's Form 10-Q for the quarter ended
June 30, 2002 and incorporated herein by reference. +
- 71 -
THE CHARLES SCHWAB CORPORATION
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.242 The Charles Schwab Corporation 1987 Stock Option Plan, amended and
restated as of September 25, 2002, with form of Non-Qualified Stock
Option Agreement attached (supersedes Exhibit 10.222), filed as
Exhibit 10.242 to the Registrant's Form 10-Q for the quarter ended
September 30, 2002 and incorporated herein by reference. +
10.243 The Charles Schwab Corporation 1987 Executive Officer Stock Option
Plan, amended and restated as of September 25, 2002, with form of
Non-Qualified Stock Option Agreement attached (supersedes Exhibit
10.223), filed as Exhibit 10.243 to the Registrant's Form 10-Q for the
quarter ended September 30, 2002 and incorporated herein by reference.
+
10.244 The Charles Schwab Corporation 1992 Stock Incentive Plan, amended and
restated as of September 25, 2002 (supersedes Exhibit 10.224), filed
as Exhibit 10.244 to the Registrant's Form 10-Q for the quarter ended
September 30, 2002 and incorporated herein by reference. +
10.246 Executive Employment Agreement by and among The Charles Schwab
Corporation, Schwab Capital Markets L.P., and Lon Gorman, and
Supplemental Agreement thereto, filed as Exhibit 10.246 to the
Registrant's Form 10-Q for the quarter ended September 30, 2002 and
incorporated herein by reference. +
10.250 Separation Agreement by and between Jeffrey S. Maurer and The Charles
Schwab Corporation, filed as Exhibit 10.250 to the Registrant's
Form 10-K for the year ended December 31, 2002 and incorporated herein
by reference. +
10.251 The Charles Schwab Corporation 2001 Stock Incentive Plan, restated to
include amendments through May 2003 (supersedes Exhibit 10.248), filed
as Exhibit 10.251 to the Registrant's Form 10-Q for the quarter ended
June 30, 2003 and incorporated herein by reference. +
10.252 The Charles Schwab Corporation Long-Term Incentive Plan, filed as
Exhibit 10.252 to the Registrant's Form 10-Q for the quarter ended
June 30, 2003 and incorporated herein by reference. +
10.253 Employment Agreement dated as of March 31, 2003 between the Registrant
and Charles R. Schwab (supersedes Exhibit 10.149), filed as Exhibit
10.253 to the Registrant's Form 10-Q for the quarter ended June 30,
2003 and incorporated herein by reference. +
10.254 The Charles Schwab Severance Pay Plan restated as of May 1, 2003
(supersedes Exhibit 10.247), filed as Exhibit 10.254 to the
Registrant's Form 10-Q for the quarter ended June 30, 2003 and
incorporated herein by reference. +
10.255 Credit Agreement (364-Day Commitment) dated as of June 20, 2003
between the Registrant and the financial institutions listed therein
(supersedes Exhibit 10.241), filed as Exhibit 10.255 to the
Registrant's Form 10-Q for the quarter ended June 30, 2003 and
incorporated herein by reference.
- 72 -
THE CHARLES SCHWAB CORPORATION
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.256 Separation Agreement and General Release by and among The Charles
Schwab Corporation, Charles Schwab & Co., Inc., and John Philip
Coghlan dated July 25, 2003, filed as Exhibit 10.256 to the
Registrant's Form 10-Q for the quarter ended September 30, 2003 and
incorporated herein by reference. +
10.257 The Charles Schwab Corporation Deferred Compensation Plan, as amended
through January 1, 2004, filed as Exhibit 10.257 to the Registrant's
Form 10-Q for the quarter ended March 31, 2004 and incorporated herein
by reference. +
10.258 Credit Agreement (364-Day Commitment) dated as of June 18, 2004
between the Registrant and the financial institutions listed therein
(supersedes Exhibit 10.255), filed as Exhibit 10.258 to the
Registrant's Form 10-Q for the quarter ended June 30, 2004 and
incorporated herein by reference.
10.259 The Charles Schwab Corporation 2004 Stock Incentive Plan, approved at
the Annual Meeting of Stockholders on May 17, 2004, filed as Exhibit
10.259 to the Registrant's Form 10-Q for the quarter ended June 30,
2004 and incorporated herein by reference. +
10.260 The Charles Schwab Severance Pay Plan, restated as of September 14,
2004 (supersedes Exhibit 10.254), filed as Exhibit 10.260 to the
Registrant's Form 10-Q for the quarter ended September 30, 2004 and
incorporated herein by reference. +
10.261 Purchase Agreement by and among The Charles Schwab Corporation, CS
Capital Markets and Co., Schwab Associates and Co., UBS Securities
LLC, and UBS Americas Inc., dated as of August 31, 2004, filed as
Exhibit 10.261 to the Registrant's Form 10-Q for the quarter ended
September 30, 2004 and incorporated herein by reference. ***
10.262 Equities Order Handling Agreement dated October 29, 2004 by and among
UBS Securities LLC, Schwab Capital Markets L.P., Charles Schwab & Co.,
Inc., and The Charles Schwab Corporation, filed as Exhibit 10.262 to
the Registrant's Form 10-Q for the quarter ended September 30, 2004
and incorporated herein by reference. ***
10.263 Separation Agreement, General Release and Waiver of Claims by and
among The Charles Schwab Corporation, Charles Schwab & Co., Inc., and
David S. Pottruck dated August 2, 2004, filed as Exhibit 10.263 to the
Registrant's Form 10-Q for the quarter ended September 30, 2004 and
incorporated herein by reference. +
10.264 The Charles Schwab Corporation Deferred Compensation Plan II,
effective December 9, 2004. +
10.265 The Charles Schwab Corporation Directors' Deferred Compensation Plan
II, effective December 9, 2004. +
10.266 Form of Notice and Restricted Stock Agreement for Non-Employee
Directors Under The Charles Schwab Corporation 2004 Stock Incentive
Plan. +
- 73 -
THE CHARLES SCHWAB CORPORATION
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.267 Form of Notice and Restricted Stock Unit Agreement for Non-Employee
Directors Under The Charles Schwab Corporation 2004 Stock Incentive
Plan. +
10.268 Form of Notice and Stock Option Agreement for Non-Employee Directors
Under The Charles Schwab Corporation 2004 Stock Incentive Plan. +
10.269 Form of Notice and Non-Qualified Stock Option Agreement Under The
Charles Schwab Corporation 2004 Stock Incentive Plan. +
10.270 Form of Notice and Restricted Stock Agreement Under The Charles Schwab
Corporation 2004 Stock Incentive Plan. +
10.271 The Charles Schwab Corporation Directors' Deferred Compensation Plan,
as amended through December 8, 2004 (supersedes Exhibit 10.215). +
10.272 The Charles Schwab Corporation Deferred Compensation Plan, as amended
through December 8, 2004 (supersedes Exhibit 10.257). +
10.273 Executive Deferred Compensation Plan of U.S. Trust Corporation, as
amended and restated effective January 1, 2001, and incorporating
action taken as of December 31, 2004 (supersedes Exhibit 10.234). +
12.1 Computation of Ratio of Earnings to Fixed Charges.
21.1 Subsidiaries of the Registrant.
23.1 Independent Auditors' Consent.
31.1 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002. **
32.2 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002. **
* Incorporated by reference to the identically-numbered exhibit to
Registrant's Registration Statement No. 33-16192 on Form S-1, as
amended and declared effective on September 22, 1987.
** Furnished as an exhibit to this annual report on Form 10-K.
*** Confidential treatment has been requested for certain portions of this
exhibit.
+ Management contract or compensatory plan.
- 74 -
THE CHARLES SCHWAB CORPORATION
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on February 28, 2005.
THE CHARLES SCHWAB CORPORATION
(Registrant)
BY: /s/ Charles R. Schwab
---------------------------
Charles R. Schwab
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated, on February 28, 2005.
Signature / Title Signature / Title
----------------- -----------------
/s/ Charles R. Schwab /s/ Christopher V. Dodds
- ---------------------------- ----------------------------
Charles R. Schwab, Christopher V. Dodds,
Chairman and Chief Executive Executive Vice President
Officer and Chief Financial Officer
(principal financial and
accounting officer)
/s/ Nancy H. Bechtle /s/ C. Preston Butcher
- ---------------------------- ----------------------------
Nancy H. Bechtle, Director C. Preston Butcher, Director
/s/ Donald G. Fisher /s/ Frank C. Herringer
- ---------------------------- ----------------------------
Donald G. Fisher, Director Frank C. Herringer, Director
/s/ Stephen T. McLin /s/ Paula A. Sneed
- ---------------------------- ----------------------------
Stephen T. McLin, Director Paula A. Sneed, Director
/s/ Roger O. Walther /s/ Robert N. Wilson
- ---------------------------- ----------------------------
Roger O. Walther, Director Robert N. Wilson, Director
/s/ David B. Yoffie
- ----------------------------
David B. Yoffie, Director
- 75 -
THE CHARLES SCHWAB CORPORATION
Index to Financial Statement Schedule
Page
----
Schedule II - Valuation and Qualifying Accounts F-2
Combined Supplemental Financial Data for U.S. Trust Corporation
and Charles Schwab Bank, N.A. (Unaudited) F-3 - F-9
Schedules not listed are omitted because of the absence of the conditions under
which they are required or because the information is included in the Company's
consolidated financial statements and notes in "Item 8 - Financial Statements
and Supplementary Data."
F-1
THE CHARLES SCHWAB CORPORATION
SCHEDULE II
Valuation and Qualifying Accounts
(In millions)
Additions
Balance at -------------------------- Balance at
Beginning Charged End
Description of Year to Expense Other (1) Written off of Year
- ------------------------------------------------------------------------------------------------------------------------------------
For the year ended
December 31, 2004:
Allowance for doubtful accounts of
brokerage clients (2) $ 2 $ 1 $ - $ (2) $ 1
==========================================================================
For the year ended
December 31, 2003:
Allowance for doubtful accounts of
brokerage clients (2) $ 4 $ 1 $ - $ (3) $ 2
==========================================================================
For the year ended
December 31, 2002:
Allowance for doubtful accounts of
brokerage clients (2) $ 5 $ 3 $ 1 $ (5) $ 4
==========================================================================
(1) Represents collections of previously written-off accounts.
(2) Excludes banking-related valuation and qualifying accounts. See "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 9. Loans to Banking Clients and Related Allowance for Credit Losses."
F-2
THE CHARLES SCHWAB CORPORATION
Combined Supplemental Financial Data for U.S. Trust Corporation
and Charles Schwab Bank, N.A. (Unaudited)
(Dollars in Millions)
The following supplemental financial data is presented in accordance with
the Securities Exchange Act of 1934, Industry Guide 3 - Statistical Disclosure
by Bank Holding Companies. The accompanying unaudited financial information
includes U.S. Trust Corporation (U.S. Trust) and Charles Schwab Bank, N.A.
(Schwab Bank), which are subsidiaries of The Charles Schwab Corporation. U.S.
Trust is a wealth management firm that also provides fiduciary and private
banking services. Schwab Bank is a retail bank which commenced operations in
April 2003.
- ------------------------------------------------------------------------------------------------------------------------------------
1. Analysis of Change in Net Interest Revenue
An analysis of the year-to-year changes in the categories of interest revenue and interest expense resulting from changes in volume
and rate, on a taxable equivalent basis, is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
2004 Compared to 2003 2003 Compared to 2002
Increase (Decrease) Due to Increase (Decrease) Due to
Change in: Change in:
-------------------------------- --------------------------------
Average Average Total Average Average Total
Volume Rate Volume Rate
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-Earning assets:
Cash equivalents $ 2 $ 1 $ 3 $ 1 $ (2) $ (1)
Securities available for sale (1)
U.S. Treasury securities (2) (3) (5) 1 (1) -
U.S. Government agencies and
collateralized mortgage obligations (2) 70 3 73 8 (9) (1)
State and municipal obligations (5) - (5) (1) - (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Total securities available for sale 63 - 63 8 (10) (2)
Loans to banking clients (3) 58 (13) 45 45 (51) (6)
Other interest-earning assets 8 2 10 7 - 7
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets 131 (10) 121 61 (63) (2)
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-bearing sources of funds:
Interest-bearing banking deposits 34 (23) 11 21 (19) 2
Short-term borrowings (2) 6 4 5 (11) (6)
Long-term debt 41 (27) 14 (3) 1 (2)
- ------------------------------------------------------------------------------------------------------------------------------------
Total sources on which interest is paid 73 (44) 29 23 (29) (6)
- ------------------------------------------------------------------------------------------------------------------------------------
Change in net interest revenue-taxable equivalent basis $ 58 $ 34 92 38 (34) 4
====================================================================================================================================
Tax equivalent adjustment 2 (1)
Provision for credit loss 2 -
- ------------------------------------------------------------------------------------------------------------------------------------
Change in net interest revenue $ 96 $ 3
====================================================================================================================================
Changes that are not due solely to volume or rate have been allocated to rate.
(1) The average balance and average rate for securities available for sale have been calculated using their amortized cost.
(2) Includes collateralized mortgage obligations securities issued by agencies including GNMA, FNMA and FHLMC.
(3) Includes average principal balances of non-accrual and reduced rate loans.
F-3
2. Three-year Net Interest Revenue (Tax Equivalent Basis) and Average Balances
- ------------------------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31, 2004 2003 2002
--------------------------- --------------------------- ---------------------------
(Dollars in Millions) Average Average Average Average Average Average
Balance Interest Rate Balance Interest Rate Balance Interest Rate
- ------------------------------------------------------------------------------------------------------------------------------------
Assets:
Cash equivalents $ 396 $ 5 1.30% $ 229 $ 2 1.00% $ 193 $ 3 1.55%
Securities available for sale (1), (2) 4,031 141 3.50% 1,904 78 4.12% 1,508 80 5.31%
Loans to banking clients (3) 6,453 275 4.24% 5,034 230 4.56% 4,204 236 5.62%
Other interest-earning assets 896 19 2.20% 447 9 1.89% 45 2 4.49%
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets 11,776 440 3.74% 7,614 319 4.19% 5,950 321 5.40%
- ------------------------------------------------------------------------------------------------------------------------------------
Non-interest-earning assets 1,179 810 771
- ------------------------------------------------------------------------------------------------------------------------------------
Total Assets $12,955 $ 8,424 $ 6,721
====================================================================================================================================
Liabilities and Stockholder's Equity:
Interest-bearing banking deposits 9,077 108 1.19% 5,395 97 1.80% 4,046 95 2.36%
Short-term borrowings 848 17 2.01% 1,013 13 1.24% 813 19 2.30%
Long-term debt 582 18 3.14% 58 4 7.76% 96 6 6.28%
- ------------------------------------------------------------------------------------------------------------------------------------
Total sources on which interest is paid 10,507 143 1.37% 6,466 114 1.77% 4,955 120 2.43%
====================================================================================================================================
Non-interest-bearing deposits 615 589 632
Non-interest-bearing liabilities 369 392 446
Stockholder's equity 1,464 977 688
- ------------------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholder's Equity $12,955 $ 8,424 $ 6,721
====================================================================================================================================
Net interest revenue - taxable equivalent
basis 297 205 201
Net free funds $ 1,269 $ 1,149 $ 994
- ------------------------------------------------------------------------------------------------------------------------------------
Tax equivalent adjustment (2) (2) (4) (4)
Provision for credit loss (2) (4) (3)
$ 293 $ 197 $ 194
====================================================================================================================================
Net yield on interest earning assets
(tax equivalent basis) 2.52% 2.69% 3.38%
- ------------------------------------------------------------------------------------------------------------------------------------
(1) The average balance and average rate for securities available for sale have been calculated using their amortized cost.
(2) Yields on state and municipal obligations are stated on a taxable equivalent basis, employing the federal statutory income tax
rate adjusted for the effect of state and local taxes, resulting in a marginal tax rate of approximately 40% for 2004, 40% for
2003, and 41% for 2002.
(3) Includes average principal balances of non-accrual and reduced rate loans.
F-4
3. Securities Available for Sale
The amortized cost, estimated fair value and gross unrealized gains and losses on securities available for sale are as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
U.S. treasury securities:
Amortized cost $ 263 $ 301 $ 290
Aggregate fair value $ 262 $ 302 $ 296
Gross unrealized gains - $ 1 $ 6
Gross unrealized losses $ 1 - -
U.S. government sponsored agencies and corporations:
Amortized cost 1,534 1,421 701
Aggregate fair value 1,534 1,421 727
Gross unrealized gains 5 5 26
Gross unrealized losses 5 5 -
State and municipal obligations:
Amortized cost 1 148 169
Aggregate fair value 1 155 178
Gross unrealized gains - 7 9
Gross unrealized losses - - -
Collateralized mortgage obligations:
Amortized cost 3,062 1,508 88
Aggregate fair value 3,051 1,508 87
Gross unrealized gains 5 4 -
Gross unrealized losses 16 4 1
Other securities:
Amortized cost 22 51 33
Aggregate fair value 22 51 34
Gross unrealized gains - - 1
Gross unrealized losses - - -
- ------------------------------------------------------------------------------------------------------------------------------------
Total securities available for sale:
Amortized cost $ 4,882 $ 3,429 $ 1,281
Aggregate fair value $ 4,870 $ 3,437 $ 1,322
Gross unrealized gains $ 10 $ 17 $ 42
Gross unrealized losses $ 22 $ 9 $ 1
====================================================================================================================================
F-5
4. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Residential real estate mortgages $ 5,342 $ 4,624 $ 3,580 $ 3,076 $ 2,239
Consumer loans 971 735 630 584 554
Other 536 404 369 407 374
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 6,849 $ 5,763 $ 4,579 $ 4,067 $ 3,167
====================================================================================================================================
An analysis of nonperforming assets is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Non-accrual loans $ 1 $ 1 $ 1 $ 5 $ 1
Average non-accrual loans $ 1 $ 1 $ 3 $ 4 $ 1
- ------------------------------------------------------------------------------------------------------------------------------------
An analysis of the allowance for credit losses on the loan portfolio is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at beginning of year $ 27 $ 24 $ 21 $ 20 $ 20
Provision charged to income 2 4 3 - -
Net recoveries - - - 1 -
Release of reserves on loans sold (2) (1) - - -
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at end of year $ 27 $ 27 $ 24 $ 21 $ 20
====================================================================================================================================
The maturities of the loan portfolio at December 31, 2004 is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
Within 1-5 Over
1 Year Years 5 Years Total
- ------------------------------------------------------------------------------------------------------------------------------------
Residential real estate mortgages (1) $ 96 $ 771 $ 4,475 $ 5,342
Consumer loans 938 21 12 971
Other 380 104 52 536
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 1,414 $ 896 $ 4,539 $ 6,849
====================================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
(1) Maturities are based upon the contractual terms of the loans.
F-6
The interest sensitivity of loans with maturities in excess of one year at December 31, 2004 is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
1-5 Over
Years 5 Years Total
- ------------------------------------------------------------------------------------------------------------------------------------
Loans with predetermined interest rates $ 197 $ 1,055 $ 1,252
Loans with floating or adjustable interest rates 699 3,484 4,183
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 896 $ 4,539 $ 5,435
====================================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
5. Summary of Credit Loss on Banking Loans Experience
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Average loans $ 6,453 $ 5,034 $ 4,204 $ 3,469 $ 2,867
Allowance to year end loans .39% .46% .52% .53% .64%
Allowance to nonperforming loans n/m n/m n/m n/m n/m
Net recoveries to average loans - - - .01% -
Nonperforming assets to average
loans and real estate owned .01% .03% .03% .14% .05%
- ------------------------------------------------------------------------------------------------------------------------------------
n/m - Not meaningful, greater than two hundred percent.
At December 31, 2004, U.S. Trust's loan portfolio included loans to individuals involved in the financial services industry of
approximately $1.4 billion. Recoveries exceeded charge-offs from loans to individuals involved in the financial services industry in
2000 to 2001. Recoveries approximated charge-offs from loans to individuals involved in the financial services industry in 2002 to
2004.
6. Deposits from Banking Clients
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
------------------- -------------------- -------------------
Amount Rate Amount Rate Amount Rate
- ------------------------------------------------------------------------------------------------------------------------------------
Analysis of average daily deposits:
Noninterest-bearing deposits $ 615 - $ 589 - $ 632 -
Certificates of deposits of $100,000 or more 397 1.35% 372 1.23% 63 2.30%
Money market and other savings deposits 8,680 1.19% 5,023 1.85% 3,983 2.36%
- ------------------------------------------------------------------------------------------------------------------------------------
Total deposits $ 9,692 $ 5,984 $ 4,678
====================================================================================================================================
F-7
- ------------------------------------------------------------------------------------------------------------------------------------
Certificates Other
of Deposit Deposits
- ------------------------------------------------------------------------------------------------------------------------------------
Maturity distribution of interest bearing deposits in
Amounts of $100,000 or more at December 31, 2004:
Three months or less $ 281 $ 7,730
Three through six months 37 -
Six through twelve months 17 -
Over twelve months 5 -
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 340 $ 7,730
====================================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
7. Short-term Borrowings
An analysis of outstanding short-term borrowings is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002
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Federal funds purchased:
Year-end balance $ 7 $ 58 $ 16
Daily average balance $ 78 $ 82 $ 133
Maximum month-end balance $ 611 $ 232 $ 449
Weighted-average interest rate during the year 1.09% 1.13% 1.74%
Weighted-average interest rate at year end 2.13% .93% 1.13%
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Securities sold under agreements to repurchase:
Year-end balance $ - $ 128 $ 326
Daily average balance $ 14 $ 304 $ 296
Maximum month-end balance $ 51 $ 354 $ 388
Weighted-average interest rate during the year 1.18% 1.29% 2.20%
Weighted-average interest rate at year end -% 1.17% 2.00%
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Other borrowed funds:
Year-end balance $ 685 $ 905 $ 200
Daily average balance $ 756 $ 627 $ 384
Maximum month-end balance $ 1,138 $ 983 $ 449
Weighted-average interest rate during the year 1.58% 1.23% 2.60%
Weighted-average interest rate at year end 2.48% 1.19% 1.43%
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F-8
8. Ratios
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Year ended December 31, 2004 2003 2002 2001 2000
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Return on average stockholder's equity (1) 5.01% 5.90% 4.53% 22.50% 10.54%
Return on average total assets (1) .57% .69% .46% 2.41% .87%
Average stockholder's equity as a percentage of
Average total assets 11.30% 11.61% 10.24% 10.70% 8.29%
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(1) Includes after-tax restructuring charges of $17 million in 2004. Excluding these charges, return on average stockholder's
equity would have been 6.17% and return on average total assets would have been .70%. Includes a tax benefit related to
retention programs of $11 million in 2003. Excluding this tax benefit, return on average stockholder's equity would have been
4.81% and return on average total assets would have been .56%. Includes after-tax extraordinary gain related to the sale of
corporate trust business of $12 million, retention program costs of $13 million, and restructuring and other charges of $24
million in 2002. Excluding these costs, return on average stockholder's equity would have been 8.17% and return on average
total assets would have been .84%.
F-9