EXHIBIT 13.1
The Charles Schwab Corporation
2001 Annual Report to Stockholders
(Only those portions specifically incorporated by reference into
The Charles Schwab Corporation 2001 Annual Report on Form 10-K)
Selected Financial and Operating Data The Charles Schwab Corporation
(In Millions, Except Per Share Amounts, Ratios, Number of Offices, Average Commission and as Noted)
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Growth Rates
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Compounded Annual
5-Year 1-Year
1996-2001 2000-2001 2001 2000 1999 1998 1997
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Operating Results
Revenues 15% (25%) $ 4,353 $ 5,788 $ 4,486 $ 3,178 $ 2,672
Expenses excluding interest 20% (7%) $ 4,218 $ 4,557 $ 3,387 $ 2,500 $ 2,141
Operating income (1) 8% (52%) $ 407 $ 849 $ 666 $ 410 $ 345
Net income (2) (6%) (72%) $ 199 $ 718 $ 666 $ 410 $ 321
Basic earnings per share (3) (9%) (74%) $ .14 $ .53 $ .51 $ .32 $ .25
Diluted earnings per share (3) (8%) (73%) $ .14 $ .51 $ .49 $ .31 $ .24
Dividends declared per common share (4) 11% 8% $ .0440 $ .0407 $ .0373 $ .0360 $ .0311
Weighted-average common shares outstanding - diluted 1,399 1,404 1,373 1,343 1,338
Trading revenues as a percentage of revenues (5) 37% 49% 53% 51% 54%
Non-trading revenues as a percentage of revenues (5) 63% 51% 47% 49% 46%
Effective income tax rate 44.1% 41.7% 39.4% 39.5% 39.5%
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Performance Measures
Revenue growth (decline) (6) (25%) 29% 41% 19% 23%
Pre-tax profit margin - reported 8.2% 21.3% 24.5% 21.3% 19.9%
After-tax profit margin - reported 4.6% 12.4% 14.9% 12.9% 12.0%
After-tax profit margin - operating (1,6) 9.4% 14.7% 14.9% 12.9% 12.9%
Return on stockholders' equity (6) 5% 21% 31% 27% 26%
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Financial Condition (at year end)
Total assets 19% 6% $40,464 $38,154 $34,322 $26,407 $20,297
Long-term debt 19% (5%) $ 730 $ 770 $ 518 $ 419 $ 433
Stockholders' equity 31% (2%) $ 4,163 $ 4,230 $ 2,576 $ 1,673 $ 1,376
Assets to stockholders' equity ratio 10 9 13 16 15
Long-term debt to total financial capital
(long-term debt plus stockholders' equity) 15% 15% 17% 20% 24%
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Client Information (at year end)
Active client accounts (7) 14% 4% 7.8 7.5 6.6 5.6 4.8
Client assets (in billions) 21% (3%) $ 845.9 $ 871.7 $ 846.0 $ 594.3 $ 437.2
Total mutual fund assets (in billions) 23% 4% $ 342.8 $ 330.3 $ 294.0 $ 218.1 $ 166.3
Active independent investment managers (in thousands) 4% 2% 5.8 5.7 5.8 5.4 5.3
Independent investment manager client accounts (in thousands) 20% 10% 1,081.7 986.5 848.3 689.9 547.2
Independent investment manager client assets (in billions) 26% 2% $ 235.0 $ 231.3 $ 213.1 $ 146.4 $ 105.8
Number of Schwab domestic branch offices 11% 3% 395 384 340 291 272
Number of U.S. Trust offices 14% 10% 34 31 28 24 19
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Employee Information
Full-time equivalent employees (at year end, in thousands) 10% (25%) 19.6 26.3 20.1 15.1 14.3
Revenues per average full-time equivalent employee
(in thousands) (20%) $ 192 $ 239 $ 249 $ 214 $ 204
Compensation and benefits expense as a percentage of revenues 43.1% 41.7% 42.1% 43.3% 42.5%
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Selected Cash Flow Highlights
Net income plus depreciation and
amortization (including goodwill amortization) (2) 9% (41%) $ 603 $ 1,026 $ 847 $ 569 $ 460
Capital expenditures - cash purchases
of equipment, office facilities,
property and internal-use software development costs, net 12% (57%) $ 301 $ 705 $ 370 $ 199 $ 150
Capital expenditures as a percentage of revenues 6.9% 12.2% 8.3% 6.3% 5.6%
Cash dividends paid 8% (2%) $ 61 $ 62 $ 61 $ 56 $ 48
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Clients' Daily Average Trading Volume (in thousands) (8)
Daily average revenue trades 24% (34%) 159.7 242.0 163.1 97.2 71.8
Mutual Fund OneSource trades 15% (7%) 54.0 58.1 45.6 40.3 34.2
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Daily average trades 21% (29%) 213.7 300.1 208.7 137.5 106.0
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Average Commission Per Revenue Trade (13%) (6%) $ 35.02 $ 37.38 $ 45.55 $ 53.44 $ 64.27
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(1)Represents an adjusted income measure which in 2001 excludes an extraordinary gain, non-operating revenue (which primarily
consists of a gain on the sale of an investment), restructuring and other charges and merger- and acquisition-related costs
totaling $208 million after-tax. In 2000, excludes merger- and acquisition-related costs totaling $131 million after-tax. In
1997, excludes charges for a litigation settlement of $24 million after-tax.
(2)2001, 2000 and 1999 include an accounting change, for certain internal-use software development costs to conform with Statement
of Position 98-1, totaling $16 million, $55 million and $41 million after-tax, respectively. Excluding this accounting change,
net income would have been $183 million in 2001, $663 million in 2000 and $625 million in 1999.
(3)Both basic and diluted earnings per share include an extraordinary gain in 2001 of $.08 per share.
(4)Dividends declared per common share do not include dividends declared by USTC prior to the completion of the merger in 2000.
(5)Trading revenues include commission and principal transaction revenues. Non-trading revenues include asset management and
administration fees, net interest revenue and other revenues.
(6)The Company's long-term objectives for annual revenue growth, after-tax profit margin - operating and return on stockholders'
equity are 20%, 12% and 20%, respectively.
(7)Effective in 1998, active accounts are defined as accounts with balances or activity within the preceding eight months instead
of twelve months as previously defined. This change in definition had the effect of decreasing the number of active accounts in
1998 by approximately 200,000. Prior years have not been adjusted.
(8)Effective in 1997, revenue trades have been adjusted for all years presented to include all client trades (both domestic and
international) that generate either commission revenue or revenue from principal markups. This data is reported on a trade date
basis.
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The Charles Schwab Corporation
Management's Discussion and Analysis
of Results of Operations and Financial Condition
(Tabular Amounts in Millions, Except Trades, Average
Commission Per Revenue Trade, and as noted)
DESCRIPTION OF BUSINESS
The Company
The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company) provide securities brokerage and related financial
services for 7.8 million active client accounts(a). Client assets in these
accounts totaled $845.9 billion at December 31, 2001. Charles Schwab & Co., Inc.
(Schwab) is a securities broker-dealer with 395 domestic branch offices in 48
states, as well as branches in the Commonwealth of Puerto Rico and the U.S.
Virgin Islands. U.S. Trust Corporation (USTC, and with its subsidiaries
collectively referred to as U.S. Trust) is an investment management firm that
through its subsidiaries also provides fiduciary services and private banking
services with 34 offices in 12 states. Other subsidiaries include Charles Schwab
Europe (CSE), a retail securities brokerage firm located in the United Kingdom,
Charles Schwab Investment Management, Inc., the investment advisor for Schwab's
proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in
Nasdaq and other securities providing trade execution services to broker-dealers
and institutional clients, and CyberTrader, Inc. (CyberTrader, formerly known as
CyBerCorp, Inc.), an electronic trading technology and brokerage firm providing
services to highly active, online investors.
[CHART OMITTED]
The Company provides financial services to individuals, institutional clients
and broker-dealers through four segments -- Individual Investor, Institutional
Investor, Capital Markets and U.S. Trust. The Individual Investor segment
includes the Company's domestic and international retail operations. The
Institutional Investor segment provides custodial, trading and support services
to independent investment managers, serves company 401(k) plan sponsors and
third-party administrators, and supports company stock option plans and stock
purchase programs. The Capital Markets segment provides trade execution services
in Nasdaq, exchange-listed and other securities primarily to broker-dealers,
including Schwab, and institutional clients. The U.S. Trust segment provides
investment and wealth management, fiduciary services and private banking
services to individual and institutional clients.
Business Strategy
The Company's overall strategy is to attract and retain client assets by
focusing on a number of areas within the financial services industry - retail
brokerage, investment and wealth management, fiduciary services, support
services for independent investment managers, 401(k) defined contribution plans,
investment services to companies and their employees, equity securities
market-making and banking and other financial services.
To pursue its strategy and its objective of long-term profitable growth, the
Company plans to leverage its competitive advantages, which include nationally
recognized brands, a broad range of products, services, and advice offerings,
multi-channel delivery systems and an ongoing investment in technology.
Management continues to believe that the key to sustaining the Company's
competitive advantages will be its ability to combine people and technology in
ways that provide investors with the access, information, guidance, advice and
control they expect - as well as high-quality service - all at a lower cost than
traditional providers of financial services.
The Company's products and services are designed to meet clients' varying
investment and financial needs, including help and advice and access to
extensive investment research, news and information. The Company seeks to
provide clients with customized advice which is objective, uncomplicated and not
driven by commission. The Company's approach to advice is based on long-term
investment strategies and guidance on portfolio diversification and asset
allocation. This approach is built on fact-based research, with the goal of
improving clients' ability to achieve better investment outcomes.
Schwab strives to demystify investing by educating and assisting clients in
the development of investment plans. This approach is designed to be offered
consistently across all of Schwab's delivery channels and provides clients with
a wide selection of choices for their investment needs. Schwab's products,
services and advice offerings cross the spectrum of its clients - those who
manage their own investments and make independent investment decisions, those
who want ongoing access to guidance while retaining control over their
investment decisions, and those who desire to have experienced professionals
manage their assets.
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(a) Accounts with balances or activity within the preceding eight months.
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In 2001, the Company focused on aligning its infrastructure and resources
with its current strategic priorities, which include:
- providing the spectrum of affluent investors with the advice, relationships
and choices that support their desired investment outcomes;
- delivering the information, technology, service and pricing needed to
remain a leader in serving active traders;
- providing individual investing services through employers, including
retirement and option plans as well as personal brokerage accounts;
- offering selected banking services and developing investment products that
give clients greater control and understanding of their finances;
- retaining a strong capital markets business to address investors' financial
product and trade execution needs; and
- continuing to provide high-quality service to clients with smaller
investment portfolios.
Services for Affluent Investors: For affluent investors who make independent
investment decisions, the Company offers research, analytic tools and access to
fee-based portfolio consultations and financial planning services. Clients
looking for more guidance while retaining control have access to advanced
research, trading and planning resources, combined with professional advice from
Schwab's investment specialists designed to assist in developing an investment
strategy and carrying out investment and portfolio management decisions. In
2001, Schwab introduced Schwab Private Client (SPC) services on a limited basis.
SPC provides higher net-worth clients with more personalized, one-on-one advice
interactions, access to expanded financial planning, asset management
capabilities and enhanced performance reporting. Schwab also established its
MarketPlace, an internal Web site which includes the AdviceSuite, a software
platform that enables service representatives to apply a consistent set of
principles and practices when providing market viewpoints and investment advice.
MarketPlace also provides tools to support discussions with clients about events
such as retirement and college planning and charitable giving. Schwab's new
Mutual Fund internal Web site provides service representatives with news,
research and analytic tools designed to support their fund-related advice
interactions with clients. Schwab also expanded its advice offering to affluent
clients by adding access to Goldman Sachs research as well as Schwab's
proprietary rating system for individual equities.
Affluent clients who desire to have their assets managed for them may choose
to work with one of the approximately 5,800 independent investment managers who
use Schwab for custodial, trading, technology and other support services,
including the more than 400 independent investment managers who participate in
the Schwab AdvisorSource referral program. The Company is focused on enhancing
the support services it offers to independent investment managers, including
improvements to their business management and client service technology, as well
as expanding the wealth management services and investment alternatives
available to them and their clients. In 2001, Schwab established several new
services to help independent investment managers manage and build their
practices, including the Electronic Account Submission system, which allows
independent investment managers to establish new client account numbers
immediately upon request. In addition, Schwab introduced Managed Account Select,
which enables independent investment managers to provide clients with access to
pre-screened money managers under a simplified single-fee structure. During
2002, the Company expects to continue adding new support services for
independent investment managers including Advisor Branded Web Services, which
will build and maintain secure, customized Web sites using independent
investment managers' own brands, as well as support account aggregation
capabilities, supply access to a variety of research, and provide enhanced
communication tools.
The Company's most affluent clients and their families may choose to utilize
U.S. Trust's broad array of financial services, including investment and wealth
management, trust, financial and estate planning and private banking, which
includes mortgage, personal lending and deposit products. High net worth
investors can receive referrals to U.S. Trust as part of AdvisorSource. In 2001,
U.S. Trust introduced an enhanced Web site which provides clients with secure
access to consolidated account information as well as updated equity pricing,
proprietary research, and financial information from third-party providers. In
2002, the Company intends to continue leveraging U.S. Trust's highly
personalized service model, research capabilities, trust and estate services,
investment track record and reputation in wealth management services in
providing affluent investors, as well as independent investment managers and
their clients, with access to a broad array of wealth management services.
In order to more effectively refer affluent investors to the investment
professionals who meet their needs and improve their overall referral
experience, Schwab is redesigning its AdvisorSource program in 2002 to include
new criteria for participating investment managers and more involvement by
Schwab branch specialists. This enhanced referral program will be renamed the
Schwab Advisor Network.
Services for Active Traders: Schwab strives to deliver information,
technology, service and pricing which meets the needs of active traders. For
highly active traders, Schwab offers CyberTrader's integrated software-based
trading platforms and other online trading systems which provide enhanced trade
information and order execution. In 2001,
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CyberTrader upgraded its two direct-access trading platforms to include
streaming news and remote trading, and enhanced its Web site to include an
industry news center and CyberTrader U(TM), which offers a variety of
introductory and intermediate online classes. CyberTrader also introduced
CyberTrader Direct(TM), a software application that gives clients wireless
access to CyberTrader's proprietary order-routing capabilities.
In addition to its existing Velocity (TM) desktop trading software available
for active trader clients, Schwab began offering access to StreetSmart Pro in
2001, which leverages CyberTrader's trading technology and combines Nasdaq Level
II quotes, real-time streaming news, unlimited watch lists and real-time,
streaming, interactive charts with account management features, risk management
tools, multi-channel access and dedicated personal support. StreetSmart Pro
allows clients to execute their trades through SmartEx - Schwab's proprietary
order-routing technology - without having to access another trading program.
Through education initiatives such as the Branch Active Trader program, Schwab
clients can receive training from specially qualified representatives on all of
these advanced trading platforms. The Company expects to continue expanding its
services for active traders and leveraging CyberTrader's technological skills to
provide its actively trading clients with access to advanced technology.
Corporate Services: The Company also serves individuals through their
workplace in a variety of ways. The Company provides 401(k) recordkeeping and
other retirement plan services directly through a dedicated sales force, as well
as indirectly through alliances with third-party administrators. In the direct
channel, SchwabPlan, the Company's 401(k) retirement plan product, offers plan
sponsors a wide array of investment options, participant education and
servicing, trustee services, and participant-level recordkeeping. The Company
has also created a bundled 401(k) plan designed specifically to meet the needs
of 401(k) programs with as little as $2 million to $20 million in participant
assets. Additionally, the Company offers stock option plan, stock purchase
program and restricted stock services to companies, as well as trade execution
and education services to their employees. These services include online tools
such as the Schwab OptionCenter(R) and StockPlanCenter(R). A new self-service
tool to provide stock plan administrators with online access to real-time data
and customized on-demand reporting is currently in pilot. During 2002, the
Company intends to enhance its investing and advice services offered to
individuals through employers, including employee retirement and option plan
capabilities.
Banking and Other Financial Products: The Company is working to provide its
clients with access to selected banking products that complement its existing
asset and wealth management capabilities and facilitate the consolidation of
household financial assets at Schwab. The Company expects to begin offering a
broader array of cash management and credit products beginning in 2002. The
Company anticipates filing an application to charter a new bank, which will be
the platform for launching these new products. The Company intends for the first
phase of its product expansion to be focused on building and launching checking
and savings accounts products and consumer loans, including residential mortgage
loans. As the Company makes progress in its development of banking and other
financial products, it expects to provide a fully integrated client experience
which combines cash, credit, and asset management capabilities, helping clients
to gain greater control over, and more effectively manage, their personal
finances.
Capital Markets: The Company provides its clients with quick and efficient
access to the securities markets by offering trade execution services in Nasdaq,
exchange-listed and other securities through its market maker and specialist
operations; access to extended-hours trading through its participation in the
REDIBook ECN LLC (REDIBook), an electronic communication network; and the
ability to analyze and trade a variety of fixed income securities through
Schwab's multi-channel delivery systems. During 2001, SCM expanded its automated
order execution capabilities and established a securities market-making joint
venture in the United Kingdom. Schwab also expanded its fixed income offering in
2001 by introducing Schwab CDSource, a service that enables clients to research
and purchase certificates of deposits from a variety of FDIC-insured depository
institutions, including U.S. Trust, entirely online. Management believes that
the merger of REDIBook and Archipelago ECN LLC - announced in 2001 and expected
to close in the first quarter of 2002 after regulatory approvals - will provide
Schwab's clients with access to an increased pool of liquidity. The Company
intends to continue strengthening SCM's capabilities in the future through
further automation, increased scale in its market-making business and expanded
product offerings.
Services for Clients with Smaller Portfolios: The Company strives to provide
high-quality service to committed investors with portfolios of all sizes. As
part of its strategic priorities, the Company is focused on developing more
value-added products and services for smaller portfolio investors, including
advice that clients can use at their discretion and improved technology-enabled
tools such as online asset allocation, investment research and retirement
planning software. Other efforts underway include making it easier for clients
to develop as investors with Schwab and find the appropriate service model for
them over the long term, as well as creating incentives for clients to
consolidate their financial relationships at Schwab. The Company also
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expects to continue serving a full spectrum of investors by pricing services
appropriately based on resources utilized and by its ongoing work to combine
people and technology in ways that enable clients to manage and administer their
investments independently.
Capitalizing on and strengthening the Company's competitive advantages while
pursuing its strategic priorities requires significant development spending and
capital expenditures. In light of prevailing market conditions and uncertainty,
management continues to believe that these ongoing investments are critical to
increasing the Company's market share and achieving its long-term financial
objectives, which include annual growth in revenues of 20%, an after-tax
operating profit margin (as defined in Results of Operations - Financial
Overview) of at least 12%, and a return on stockholders' equity of 20%.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this Annual Report contains
forward-looking statements that reflect management's beliefs, objectives and
expectations as of the date hereof. These statements relate to, among other
things, the Company's ability to carry out its plans for its U.S.-dollar-based
international business, strengthen its brands through advertising, and achieve
anticipated service expansions and branch office openings (see
question-and-answer section with the Company's Co-Chief Executive Officers and
the Schwab enterprises section); revenue growth, after-tax operating profit
margin and return on stockholders' equity (see 11-Year Selected Financial and
Operating Data and Description of Business - Business Strategy); the Company's
ability to pursue its strategy of attracting and retaining client assets as well
as achieve its strategic priorities, and the Company's ability to realize the
expected benefits of the merger of REDIBook and Archipelago ECN LLC (see
Description of Business - Business Strategy); the impact of the restructuring
plan on the Company's results of operations (see Results of Operations -
Financial Overview); sources of liquidity and capital (see Liquidity and Capital
Resources - Liquidity and - Commitments); the impact of changes in management's
estimates on the Company's results of operations (see Description of Business -
Critical Accounting Policies); development spending (see Liquidity and Capital
Resources - Development Spending); capital expenditures and capital structure
(see Liquidity and Capital Resources - Cash Flows and Capital Resources); and
contingent liabilities (see note "21 - Commitments and Contingent Liabilities"
in the Notes to Consolidated Financial Statements). 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 described in
these statements. Important factors that may cause such differences include, but
are not limited to: 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 volatility of equity
prices; a significant downturn in the securities markets over a short period of
time or a sustained decline in securities prices and trading volumes; changes in
the rate of employee attrition; 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; the effects of competitors'
pricing, product and service decisions and intensified competition; evolving
legislation, regulation and changing industry practices adversely affecting the
Company; adverse results of litigation; the inability to obtain external
financing at acceptable rates; a significant decline in the real estate market,
including the Company's ability to successfully sublease certain properties;
risks associated with international operations; and the impact of the September
11, 2001 terrorist attacks and their aftermath on the U.S. and world economies
and the regulatory climate. Certain of these factors are discussed in greater
detail in this Annual Report and in the Company's Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the U.S. The Company
records trading revenues (i.e., commissions and principal transactions) and
related expenses on a trade date basis. The Company records non-trading revenues
(e.g., proprietary mutual fund and asset-based financial services fees, and
interest on client-related balances) and related expenses when the revenues are
earned. The majority of the Company's revenues, expenses, assets and liabilities
are not based on significant estimates. Management regularly reviews the
estimates and assumptions used in preparation of the Company's financial
statements for reasonableness and adequacy. Certain of the Company's accounting
policies that involve a higher degree of judgment and complexity are discussed
below.
Valuation of Long-Lived Assets, including Goodwill: The Company accounts for
business combinations in accordance with Statement of Financial Accounting
Standards (SFAS) No. 141 - Business Combinations. This statement requires
management to allocate the purchase price to the assets acquired and liabilities
assumed based on their estimated fair values on the date of acquisition. The
cost of an acquired
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entity in excess of the fair value of the related net assets is recognized as
goodwill. Goodwill and other long-lived assets including other intangibles,
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. The Company assesses the recoverability of
goodwill and other long-lived assets using expected undiscounted future cash
flows. These assets are considered impaired when the expected undiscounted
future cash flow is less than the carrying amount. The Company is required to
adopt SFAS No. 142 - Goodwill and Other Intangible Assets effective on January
1, 2002. This statement requires that goodwill and certain intangible assets
with an indefinite useful life not be amortized. SFAS No. 142 also requires that
goodwill and certain intangible assets be tested for impairment at least
annually under new criteria. The new criteria require management to estimate the
fair value of the Company's reporting units (generally defined as businesses for
which financial information is available and reviewed regularly by management),
as well as allocate the carrying value of the assets and liabilities, including
goodwill associated with those reporting units. In accordance with the
provisions of SFAS No. 142, the Company intends to complete the analyses and
implementation during the first half of 2002. Accordingly, the Company is
currently evaluating the impact of this statement on its financial position,
results of operations, earnings per share and cash flows.
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 does not have any other pension or other postretirement benefit
obligations subject to such estimates.
Software Development Costs: The Company capitalizes software and certain costs
incurred for developing software for internal use under Statement of Position
98-1 - Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use. Costs directly related to the development of the software incurred
in the application development stage are capitalized based on an estimate of the
portion of a project's total costs that relate to the application development
stage. This estimated percentage is based on the Company's historical computer
software project spending and is reviewed periodically by management for
reasonableness.
Reserves: Certain of the Company's reserves are based on significant estimates.
The Company uses historical information and the probability of ultimate legal
outcomes in determining its contingent liability reserve related to litigation.
Additionally, a portion of the reserves under the Company's restructuring plan
are based on assumptions, including the Company's ability to successfully
sublease certain real estate properties. Further, the Company's reserves for
credit losses on banking loans and receivables from brokerage clients are
reviewed regularly by management, taking into consideration current economic
conditions, the composition of those portfolios, past loss experience, risks
inherent in the portfolios and unsecured receivables.
For further information on the Company's accounting policies, see note "2 -
Significant Accounting Policies" in the Notes to Consolidated Financial
Statements.
RESULTS OF OPERATIONS
Financial Overview
The Company's 2001 financial performance was significantly affected by
declines in client trading activity, the change to decimal pricing in the
Company's market-making activities and lower client margin loan balances. In the
difficult market environment that prevailed during 2001, daily average revenue
trades decreased 34% from the record level in 2000 and average revenue per share
traded in the Capital Markets segment decreased 56% from 2000. As a result of
these two factors, the Company's trading revenues in 2001 decreased 44% from
2000.
Average margin loans to clients decreased 42% from 2000 which greatly
contributed to the 25% decline in interest revenue, net of interest expense
(referred to as net interest revenue), from 2000. Because the decline in net
interest revenue more than offset a 6% increase in asset management and
administration fees, the Company's non-trading revenues decreased 6% from 2000.
Despite declines of 21% and 13% in the Nasdaq Composite and Standard & Poor's
500 indices in 2001, respectively, assets in client accounts totaled $845.9
billion at December 31, 2001, down $25.8 billion, or 3%, from December 31, 2000.
This decrease resulted from net market losses of $99.4 billion, partially offset
by net new assets of $73.6 billion.
In 2001, the Company initiated a restructuring plan (the Plan) to reduce
operating expenses due to continued economic uncertainties and difficult market
conditions. The Plan included a workforce reduction, a reduction in operating
facilities, the removal of certain systems hardware, software and equipment from
service, and the withdrawal
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from certain international operations. The Plan realigned the Company's
workforce, facilities and systems capacity with the current market environment
and the Company's strategic priorities, allowing the Company to improve
financial performance while continuing to maintain appropriate capacity, provide
high-quality client service, and sustain essential investments in the Company's
future.
The Company recorded pre-tax charges for restructuring costs of $391 million
in 2001. There were no such charges in 2000 or 1999. A summary of pre-tax
restructuring charges is as follows:
2001
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Workforce reduction $ 187
Facilities reduction 141
Systems removal 63
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Total restructuring charges $ 391 (1)
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(1)Includes charges of $175 million recognized in the fourth quarter of 2001,
of which $31 million related to the Company's international restructuring
initiatives.
The Company expects to recognize approximately $20 million to $25 million in
additional estimated restructuring charges during the first quarter of 2002 as
it completes the Plan. The actual costs of the Plan could be greater than the
Company's estimates, depending primarily on the Company's ability to
successfully sublease certain properties.
The following table illustrates the savings in pre-tax operating expenses
directly attributable to the Plan during 2001 and the estimated future quarterly
savings. Overall changes in these and other operating expenses from period to
period have been, and may continue to be, affected by management decisions
outside of the Plan.
2001 Estimated
------------------------ Future
Third Fourth Quarterly
Quarter Quarter Total Savings
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Compensation and benefits $ 28 $ 70 $ 98 $ 90
Occupancy and equipment 6 14 20 18
Depreciation and amortization 1 1 2 2
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Total $ 35 $ 85 $ 120 $ 110
================================================================================
For further information on the Plan, see note "3 - Restructuring and Other
Charges" in the Notes to Consolidated Financial Statements.
The Company recorded other pre-tax charges of $28 million in 2001. These
charges include a regulatory fine assessed to USTC and its subsidiary, United
States Trust Company of New York (U.S. Trust NY), professional service fees for
operational and risk management remediation at USTC and U.S. Trust NY, and the
write-off of certain software development costs at CSE. There were no such
charges in 2000 or 1999.
Total expenses excluding interest during 2001 were $4.2 billion, down $339
million or 7% from 2000. Excluding the non-operating charges as detailed in the
following table, expenses during 2001 were $3.7 billion, down $720 million, or
16%, from $4.4 billion during 2000. The Company implemented a number of expense
reduction measures, including its restructuring plan, to reduce operating
expenses in light of prevailing market conditions. As a result of these expense
reduction measures and a substantial decline in bonuses, most expense categories
in 2001 decreased when compared to 2000.
In June 2001, USTC sold its Corporate Trust business to The Bank of New York
Company, Inc. (Bank of NY). The Company recognized a pre-tax extraordinary gain
of $221 million on this sale, or $121 million after tax. Total proceeds received
were $273 million and the Company incurred pre-tax closing and exit costs of $30
million for severance, professional fees and other related disposal costs. As
part of the sale agreement, up to $22 million of the sale proceeds may be
returned to Bank of NY if certain client retention requirements are not met.
This amount has been deferred and the appropriate amount will be recognized in
earnings based upon actual client retention. The Company expects to recognize
all of the remaining sales proceeds in income in the first quarter of 2002.
In evaluating the Company's financial performance, management uses adjusted
operating income, which excludes non-operating items as detailed in the
following table. The Company's after-tax operating income for 2001 was $407
million, down 52% from 2000, and its after-tax operating profit margin for 2001
was 9.4%, down from 14.7% for 2000. A reconciliation of the Company's operating
income to net income is shown in the following table:
- 7 -
- --------------------------------------------------------------------------------
Percent
2001 2000 Change
- --------------------------------------------------------------------------------
Operating income, after tax $407 $ 849 (52%)
Non-operating items:
Extraordinary gain (1) 221
Other income (2) 26
Restructuring charges (3) (391)
Other charges (4) (28)
Merger- and acquisition-related charges (5) (119) (157) (24)
- --------------------------------------------------------------------------------
Total non-operating items (291) (157) 85
Tax effect 83 26 n/m
- --------------------------------------------------------------------------------
Total non-operating items, after tax (208) (131) 59
Net income $199 $ 718 (72%)
================================================================================
(1) The Company recorded an extraordinary gain, net of closing and exit costs,
from the sale of USTC's Corporate Trust business to the Bank of NY.
(2) Primarily consists of a gain recorded on the sale of an investment.
(3) The restructuring plan primarily includes a workforce reduction, a reduction
in operating facilities, and the removal of certain systems hardware,
software and equipment from service.
(4) Other charges primarily include a regulatory fine assessed to USTC and U.S.
Trust NY and professional service fees for operational and risk management
remediation at USTC and U.S. Trust NY, and the write-off of certain
software development costs at CSE.
(5) Includes professional fees, change-in-control and retention program
compensation, and other expenses related to the merger with USTC, and
goodwill and intangible asset amortization and retention program
compensation related to the acquisition of CyberTrader.
n/m Not meaningful
The Company's operating income before taxes for 2001 was $647 million, down
$741 million, or 53%, from 2000 due to decreases of $589 million, or 71%, in the
Individual Investor segment, $18 million, or 6%, in the Institutional Investor
segment, $88 million, or 83%, in the Capital Markets segment and $46 million, or
29%, in the U.S. Trust segment. These decreases were primarily due to lower
levels of trading activity, lower levels of margin loans to clients, lower
average revenue per share traded in the Capital Markets segment, and higher
costs primarily related to repatriation of U.S. Trust's systems to the Company.
The Company's net income for 2001 was $199 million, or $.14 per share, down
72% from $718 million, or $.51 per share, for 2000. The Company's after-tax
profit margin for 2001 was 4.6%, down from 12.4% for 2000.
Return on stockholders' equity was 5% for 2001, compared to 21% in 2000. The
decrease was primarily due to the decline in earnings as discussed above, as
well as a 23% increase in average stockholders' equity from 2000.
Certain reclassifications have been made to prior year amounts to conform to
the current presentation. All references to earnings per share information in
this Annual Report reflect diluted earnings per share unless otherwise noted.
REVENUES
Revenues declined $1.4 billion, or 25%, to $4.4 billion in 2001, mainly due
to a 41% decrease in commission revenues, a 55% decrease in principal
transaction revenues, and a 25% decrease in net interest revenue. These declines
were slightly offset by a 6% increase in asset management and administration
fees and a 34% increase in other revenues. As trading volumes decreased
significantly during 2001, non-trading revenues represented 63% of total
revenues, up from 51% of total revenues for 2000 and 47% for 1999 as shown in
the following table.
- --------------------------------------------------------------------------------
Composition of Revenues 2001 2000 1999
- --------------------------------------------------------------------------------
Commissions 31% 39% 42%
Principal transactions 6 10 11
- --------------------------------------------------------------------------------
Total trading revenues 37 49 53
- --------------------------------------------------------------------------------
Asset management and administration fees 38 27 27
Net interest revenue 21 21 18
Other 4 3 2
- --------------------------------------------------------------------------------
Total non-trading revenues 63 51 47
- --------------------------------------------------------------------------------
Total 100% 100% 100%
================================================================================
While the Individual Investor and Institutional Investor segments generate
both trading and non-trading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. The $1.4 billion decline in revenues from 2000 was due to
decreases in revenues of $1.1 billion, or 31%, in the Individual Investor
segment, $17 million, or 2%, in the Institutional Investor segment and $329
million, or 51%, in the Capital Markets segment. These decreases were slightly
offset by increases of $11 million, or 2%, in the U.S. Trust segment and $26
million in non-operating revenues consisting primarily of a gain on the sale of
an investment. See note "23 - Segment Information" in the Notes to Consolidated
Financial Statements for financial information by segment for the last three
years.
[CHART OMITTED]
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
recordkeeping and shareholder services provided to third-party funds, and for
transfer agent services, shareholder services, administration and investment
management provided to its proprietary 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 primarily through the Individual Investor and
- 8 -
Institutional Investor segments. The Company also earns asset management and
administration fees for financial services, including investment management and
consulting, trust and fiduciary services, financial and estate planning, and
private banking services, provided to individual and institutional clients.
These fees are primarily based on the value and composition of assets under
management and are earned primarily through the U.S. Trust, Individual Investor
and Institutional Investor segments.
Asset management and administration fees were $1.7 billion in 2001, compared
to $1.6 billion in 2000 and $1.2 billion in 1999, as shown in the following
table:
- --------------------------------------------------------------------------------
Asset Management and Administration Fees 2001 2000 1999
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds
and Excelsior) $ 818 $ 673 $ 542
Mutual Fund OneSource 282 331 227
Other 41 35 19
Asset management and related services 534 544 432
- --------------------------------------------------------------------------------
Total $1,675 $ 1,583 $ 1,220
================================================================================
The increase from 2000 to 2001 was primarily due to a significant increase in
client assets in the Company's proprietary funds, partially offset by a decrease
in client assets in Schwab's Mutual Fund OneSource. The increase from 1999 to
2000 was primarily due to a significant increase in client assets in Schwab's
proprietary funds, an increase in client assets in Schwab's Mutual Fund
OneSource and an increase in U.S. Trust's client assets.
The Company's proprietary funds include money market funds, equity index
funds, bond funds, asset allocation funds, funds that primarily invest in stock,
bond and money market funds, and actively-managed equity funds. Schwab clients
may elect to have cash balances in their brokerage accounts automatically
invested in certain SchwabFunds money market funds. Client assets invested in
the SchwabFunds were $148.0 billion, $127.2 billion and $107.9 billion at the
end of 2001, 2000 and 1999, respectively.
At December 31, 2001, Schwab's Mutual Fund OneSource service enabled clients
to trade 1,079 mutual funds in 240 fund families without incurring transaction
fees. The service allows investors to access multiple mutual fund companies,
avoid brokerage transaction fees, and achieve investment diversity among fund
families. In addition, investors' recordkeeping and investment monitoring are
simplified through one consolidated statement. Client assets invested in
third-party funds that have been purchased through the Mutual Fund OneSource
service were $87.0 billion, $98.3 billion and $101.0 billion at the end of 2001,
2000 and 1999, respectively.
Further, U.S. Trust's client assets were $124.0 billion, $130.4 billion and
$120.8 billion at the end of 2001, 2000 and 1999, respectively.
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 commission-generating trades per account, and the average commission
per trade. Commission revenues were $1.4 billion in 2001, compared to $2.3
billion in 2000 and $1.9 billion in 1999.
The Company's client trading activity is shown in the following table (in
thousands):
- --------------------------------------------------------------------------------
Daily Average Trades 2001 2000 1999
- --------------------------------------------------------------------------------
Revenue Trades
Online 133.5 204.1 119.1
TeleBroker(R) and Schwab by Phone 7.5 8.2 8.5
Regional client telephone
service centers, branch offices
and other 18.7 29.7 35.5
- --------------------------------------------------------------------------------
Total 159.7 242.0 163.1
================================================================================
Mutual Fund OneSource Trades
Online 37.0 36.8 23.3
TeleBroker and Schwab by Phone .5 1.0 1.0
Regional client telephone
service centers, branch offices
and other 16.5 20.3 21.3
- --------------------------------------------------------------------------------
Total 54.0 58.1 45.6
================================================================================
Total Daily Average Trades
Online 170.5 240.9 142.4
TeleBroker and Schwab by Phone 8.0 9.2 9.5
Regional client telephone
service centers, branch offices
and other 35.2 50.0 56.8
- --------------------------------------------------------------------------------
Total 213.7 300.1 208.7
================================================================================
As illustrated in the following table, the total number of client revenue
trades executed by the Company decreased 35% in 2001 as both the number of
client accounts that traded and the average number of trades per account have
declined. Average commission per revenue trade decreased 6% from 2000 to 2001,
mainly due to reduced pricing for online equity trades placed by more actively
trading investors, as well as reduced pricing of equity trades made through
automated telephone channels to align them with online pricing. Average
commission per revenue trade decreased 18% from 1999 to 2000, mainly due to
reduced pricing for online equity trades placed by more actively trading
investors and the impact of CyberTrader's lower pricing. In 2000, the increase
in trading activity more than offset the effect of lower average commission per
revenue trade. However, in 2001 both trading activity and average commissions
per revenue trade declined.
- 9 -
- --------------------------------------------------------------------------------
Commissions Earned on
Client Revenue Trades 2001 2000 1999
- --------------------------------------------------------------------------------
Client accounts that traded
during the year (in thousands) 3,028 3,787 3,349
Average client revenue
trades per account 13.1 16.1 12.3
Total revenue trades (in thousands) 39,625 60,972 41,116
Average commission per revenue trade $ 35.02 $ 37.38 $ 45.55
Commissions earned on client
revenue trades (1) $ 1,388 $ 2,279 $ 1,873
- --------------------------------------------------------------------------------
(1)Includes certain non-commission revenues relating to the execution of client
trades. Excludes commissions on trades relating to specialist operations and
U.S. Trust commissions on trades.
Net Interest Revenue
Net interest revenue is the difference between interest earned on assets
(mainly margin loans to clients, investments required to be segregated for
clients, securities available for sale and private banking loans) and interest
paid on liabilities (mainly brokerage client cash balances and banking
deposits). 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.
Most of the Company's net interest revenue is earned through the Individual
Investor, Institutional Investor and U.S. Trust 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. Schwab also may lend funds to
clients on a secured basis to purchase qualified securities -- a practice
commonly known as "margin lending." Pursuant to Securities and Exchange
Commission (SEC) regulations, client cash balances that are not used for margin
lending are generally segregated into an investment account that is 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 and 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 80% of Schwab's investments of segregated client
cash balances. The average maturities of Schwab's total investments of
segregated client cash balances were 66 days for 2001, 59 days for 2000 and 62
days for 1999. U.S. Trust lends funds to its private banking clients primarily
in the form of mortgage loans. These loans are largely funded by
interest-bearing deposits from banking clients.
Net interest revenue was $929 million in 2001, compared to $1.2 billion in
2000 and $820 million in 1999, as shown in the following table:
- --------------------------------------------------------------------------------
2001 2000 1999
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 832 $ 1,772 $ 983
Investments, client-related 555 338 404
Private banking loans 240 219 175
Securities available for sale 79 69 57
Other 151 191 99
- --------------------------------------------------------------------------------
Total 1,857 2,589 1,718
- --------------------------------------------------------------------------------
Interest Expense:
Brokerage client cash balances 696 1,076 701
Deposits from banking clients 128 155 117
Long-term debt 55 55 33
Short-term borrowings 27 20 8
Stock-lending activities 17 40 32
Other 5 6 7
- --------------------------------------------------------------------------------
Total 928 1,352 898
- --------------------------------------------------------------------------------
Net interest revenue $ 929 $ 1,237 $ 820
================================================================================
The Company's interest-earning assets are financed primarily by
interest-bearing brokerage client cash balances and banking deposits. Other
funding sources include noninterest-bearing brokerage client cash balances,
proceeds from stock-lending activities, short-term borrowings and long-term
debt, and stockholders' equity. Client-related daily average balances, interest
rates, and average net interest spread are summarized as follows:
- 10 -
- --------------------------------------------------------------------------------
2001 2000 1999
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $14,198 $ 6,170 $ 8,555
Average interest rate 3.91% 5.48% 4.72%
Margin loans to clients:
Average balance outstanding $11,432 $19,764 $13,172
Average interest rate 7.28% 8.96% 7.46%
Private banking loans:
Average balance outstanding $ 3,469 $ 2,867 $ 2,404
Average interest rate 6.91% 7.65% 7.26%
Securities available for sale:
Average balance outstanding $ 1,317 $ 1,133 $ 997
Average interest rate 5.98% 6.08% 5.75%
Average yield on interest-earning assets 5.61% 8.01% 6.44%
Funding Sources(client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $22,295 $20,961 $17,344
Average interest rate 3.12% 5.14% 4.04%
Interest-bearing banking deposits:
Average balance outstanding $ 3,365 $ 3,071 $ 2,779
Average interest rate 3.80% 5.05% 4.23%
Other interest-bearing sources:
Average balance outstanding $ 1,117 $ 1,831 $ 1,510
Average interest rate 3.99% 4.53% 3.85%
Average noninterest-bearing portion $ 3,639 $ 4,071 $ 3,495
Average interest rate
on funding sources 2.85% 4.39% 3.49%
Summary:
Average yield on interest-earning assets 5.61% 8.01% 6.44%
Average interest rate on funding sources 2.85% 4.39% 3.49%
- --------------------------------------------------------------------------------
Average net interest spread 2.76% 3.62% 2.95%
================================================================================
The decrease in net interest revenue from 2000 to 2001 was primarily due to
lower levels of, and lower rates received on, margin loans to clients, partially
offset by higher average balances of client-related investments and lower rates
paid on brokerage client cash balances. After reaching a peak of $22.3 billion
in April 2000, margin loans to clients declined to $15.8 billion at December 31,
2000 along with the decline in equity valuations in the securities markets. The
increase in net interest revenue from 1999 to 2000 was also due to an increase
in the average rate on margin loans to clients, which was partially offset by an
increase in the average rate on brokerage client cash balances.
Since the Company establishes the rates paid on brokerage client cash
balances and certain banking deposits and the rates charged on margin and
private banking loans, a substantial portion of its net interest spread is
managed by the Company. However, the spread is influenced by external factors
such as the interest rate environment and competition. The Company's average net
interest spread decreased from 2000 to 2001 as the average yield on
interest-earning assets, primarily margin loans to clients, declined more than
the decline in average interest rate on funding sources. The Company's average
net interest spread increased from 1999 to 2000 as the average yield on
interest-earning assets, primarily margin loans to clients, increased more than
the increase in average interest rate on funding sources.
Principal Transactions
Principal transaction revenues are primarily comprised of net gains from
market-making activities in Nasdaq and other securities effected through the
Capital Markets segment. Factors that influence principal transaction revenues
include the volume of client trades, market price volatility, average revenue
per share traded and changes in regulations and industry practices. As a market
maker in Nasdaq and other securities, SCM generally executes client trades as
principal. While substantially all Nasdaq security trades originated by the
clients of Schwab are directed to SCM, a substantial portion of SCM's trading
volume comes from parties other than Schwab. Orders handled by SCM represented
approximately 4% and 7% of the total shares traded on Nasdaq in 2001 and 2000,
respectively(b).
Principal transaction revenues were $255 million in 2001, compared to $570
million in 2000 and $500 million in 1999. The decrease from 2000 to 2001 was
primarily due to the change to decimal pricing which was fully implemented by
April 2001, and lower share volume handled by SCM. The increase from 1999 to
2000 was primarily due to a significant increase in share volume handled by SCM,
partially offset by lower average revenue per share traded. SCM's average
revenue per share traded decreased from 2.8(cent) in 1999 to 1.8(cent) in 2000
primarily due to market conditions. Additionally, SCM's average revenue per
share traded decreased from 1.8(cent) in 2000 to .8(cent) in 2001 primarily due
to the change to decimal pricing as well as market conditions.
Principal transaction revenues also include revenues relating to Schwab's
specialist operations and to client trading of fixed income securities. These
amounts totaled $51 million in 2001, $84 million in 2000 and $67 million in
1999.
Other Revenues
Other revenues include fees for services, such as payments received by Schwab
for order flow, net gains and losses on certain investments, software
maintenance and account service fees. Other revenues are earned primarily
through the Individual Investor, Institutional Investor and U.S. Trust segments.
These revenues were $139 million in 2001, compared to $104 million in 2000 and
$71 million in 1999. The increase from 2000 to 2001 was primarily due to gains
recorded on sales of investments. The increase from 1999 to
- --------
(b) Source: The Nasdaq Stock Market, Inc.
- 11 -
2000 was due to higher levels of client activity-related revenues and financial
services fees, as well as a higher volume of payment for order flow.
EXPENSES EXCLUDING INTEREST
Total expenses excluding interest declined $339 million, or 7%, in 2001.
Total expenses excluding non-operating charges declined $720 million, or 16%, in
2001. The Company's initiatives under its restructuring plan and other expense
reduction measures resulted in decreases in most expense categories during 2001
when compared to 2000. Increases in 2001 in occupancy and equipment expense and
depreciation and amortization expense were due to the Company's continued
investment in technology and facilities during 2000.
- --------------------------------------------------------------------------------
Expenses Excluding Interest as a Percentage
of Revenues 2001 2000 1999
- --------------------------------------------------------------------------------
Compensation and benefits 43% 42% 42%
Other compensation - merger retention programs 1 1
Occupancy and equipment 11 7 7
Communications 8 6 6
Depreciation and amortization 8 4 4
Advertising and market development 6 6 6
Professional services 4 4 4
Commissions, clearance and floor brokerage 2 2 2
Goodwill amortization 2 1
Merger-related 1
Restructuring and other charges 10
Other 2 5 5
- --------------------------------------------------------------------------------
Total 97% 79% 76%
================================================================================
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, variable
compensation, and related employee benefits and taxes. Employees receive
variable compensation that is tied to the achievement of specified objectives
relating primarily to revenue growth, profit margin and growth in client assets.
Therefore, a significant portion of compensation and benefits expense will
fluctuate with these measures.
Compensation and benefits expense was $1.9 billion in 2001, down 22% from
2000 and unchanged from 1999. The decrease from 2000 to 2001 was primarily due
to a substantial decline in variable compensation expense resulting from the
Company's financial performance, as well as a reduction in full-time equivalent
employees. The increase from 1999 to 2000 was primarily due to a greater number
of employees. The following table shows a comparison of certain compensation and
benefits components and employee data (in thousands):
- --------------------------------------------------------------------------------
2001 2000 1999
- --------------------------------------------------------------------------------
Variable compensation as a
% of compensation and benefits expense 11% 28% 30%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 6% 9% 11%
Full-time equivalent employees(1)
(at year end) 19.6 26.3 20.1
Revenues per average full-time equivalent
employee $ 192 $ 239 $ 249
================================================================================
(1)Includes full-time, part-time and temporary employees, and persons employed
on a contract basis.
The Company encourages and provides for employee ownership of the Company's
common stock through its qualified retirement plan, its stock incentive plans
and its automatic investment plan. The Company's overall compensation structure
is intended to attract, retain and reward highly qualified employees, and to
align the interests of employees with those of stockholders. To further this
alignment, the Company granted to all non-officer employees 26 million, 11
million and 6 million stock options in 2001, 2000 and 1999, respectively. (Stock
options granted in 1999 were granted prior to the merger with USTC and therefore
did not include U.S. Trust employees.)
At December 31, 2001, directors, management and employees, and their
respective families, trusts and foundations, owned, including stock held for
employees' benefit in the Company's retirement plan, approximately 28% of the
Company's outstanding common stock. In addition, directors, management and
employees held options to purchase common stock in an amount equal to
approximately 11% of the Company's outstanding common stock at December 31,
2001.
Other Compensation - Merger Retention Programs
Other compensation - merger retention programs consists of retention programs
established for U.S. Trust and CyberTrader employees, under which the employees
will receive cash compensation, contingent upon continued employment for the
two-year periods ending May 31, 2002 and March 1, 2002, respectively. The
aggregate cost of the U.S. Trust and CyberTrader retention programs is
approximately $119 million and is being amortized over the programs' respective
two-year periods. The combined expense for the programs was $56 million in 2001
and $39 million in 2000. The increase from 2000 to 2001 was due to the fact that
the retention programs were in place for the full year, partially offset by
employees who have left U.S. Trust and CyberTrader. At December 31, 2001, the
remaining estimated expense under these merger retention programs was $24
million, which the Company plans to record in the first half of 2002.
- 12 -
Occupancy and Equipment
Occupancy and equipment expense includes the costs of leasing and maintaining
the Company's office space, five regional client telephone service centers, two
online client support centers, two primary data centers, 395 Schwab domestic
branch offices and 34 U.S. Trust offices. It also includes lease and rental
expenses for computer and other equipment. Occupancy and equipment expense was
$490 million in 2001, compared to $415 million in 2000 and $307 million in 1999.
This trend reflects the Company's growth and expansion in 1999 and 2000, and its
commitment to client service and investment in technology. Schwab opened 22 new
domestic branch offices in 2001, 44 in 2000 and 49 in 1999. U.S. Trust opened 3
new offices in both 2001 and 2000, and 4 in 1999. The Company opened its fifth
regional client telephone service center in 2000. The increases in occupancy and
equipment expense from 1999 to 2001 also reflect higher lease and maintenance
expenses for information technology equipment.
Communications
Communications expense includes telephone, postage and printing, and news and
quotation costs. This expense was $339 million in 2001, compared to $353 million
in 2000 and $279 million in 1999. The decrease from 2000 to 2001 was primarily
due to lower client trading volumes and the Company's expense reduction
measures, partially offset by increased client use of automated telephonic and
online channel news, quotation and information services. The increase from 1999
to 2000 primarily resulted from higher client trading volumes, higher postage
and printing costs in connection with the growth in client accounts, and
increased client use of automated telephonic and online channel news, quotation
and information services.
Depreciation and Amortization
Depreciation and amortization includes expenses relating to equipment and
office facilities, capitalized software, leasehold improvements, property and
other intangibles. This expense was $338 million in 2001, compared to $255
million in 2000 and $169 million in 1999. The increases from 1999 to 2001 were
primarily due to increased amortization of internally-developed software,
information technology equipment acquired in 2000 and 1999, and leasehold
improvements for new branches and expanded office space. Amortization expense
related to intangible assets was $11 million in 2001, compared to $10 million in
2000 and $2 million in 1999. The increase from 1999 to 2000 was primarily due to
intangible assets (excluding goodwill) related to the acquisition of
CyberTrader.
Advertising and Market Development
Advertising and market development expense includes media, print and direct
mail advertising expenses, and related production, printing and postage costs.
This expense was $246 million in 2001, compared to $332 million in 2000 and $248
million in 1999. The decrease from 2000 to 2001 was primarily a result of
reductions, as part of the Company's expense reduction measures, in
brand-focused television and print media spending. The increase from 1999 to
2000 was primarily a result of the Company's increased brand-focused television
and print media spending.
Professional Services
Professional services expense includes fees paid to consultants engaged to
support product, service and information technology projects, as well as legal
and accounting fees, but excludes all merger-related professional fees. This
expense was $193 million in 2001, compared to $255 million in 2000 and $184
million in 1999. The decrease from 2000 to 2001 was primarily due to the
Company's expense reduction measures. The increase from 1999 to 2000 was
primarily due to higher levels of consulting fees in several areas, including
new and expanded products and services, information technology projects, and
capacity expansion.
Commissions, Clearance and Floor Brokerage
Commissions, clearance and floor brokerage expense includes fees paid to
stock and option exchanges for trade executions, fees paid by SCM to
broker-dealers for orders received for execution, and fees paid to clearing
entities for trade processing. This expense was $92 million in 2001, compared to
$138 million in 2000 and $100 million in 1999. The decrease from 2000 to 2001
was primarily due to a decrease in trading volume processed by SCM and Schwab.
The increase from 1999 to 2000 was primarily due to an increase in trading
volume processed by SCM and Schwab.
Goodwill Amortization
Goodwill represents the cost of acquired businesses in excess of fair value
of the related net assets at acquisition and is amortized on a straight-line
basis. Goodwill amortization expense was $66 million in 2001, compared to $53
million in 2000 and $12 million in 1999. The increases from 1999 to 2001 were
primarily due to goodwill related to the acquisition of CyberTrader.
Merger-related
Merger-related expense includes professional fees, change-in-control related
compensation expense and other expenses relating to the merger with USTC. This
expense was $69 million in 2000. There were no such expenses in 2001 or 1999.
Other Expenses
Other expenses include trading volume-related regulatory expenses, travel and
entertainment, trade-related errors, and
- 13 -
other miscellaneous expenses. These other expenses were $104 million in 2001,
compared to $234 million in 2000 and $200 million in 1999. The decrease from
2000 to 2001 was primarily due to lower levels of trade-related errors, travel
and related costs, and trading volume-related regulatory expenses. The increase
from 1999 to 2000 was primarily due to higher levels of travel and related costs
and trading volume-related regulatory expenses.
Taxes on Income
The Company's effective income tax rate was 44.1% in 2001, 41.7% in 2000, and
39.4% in 1999. The increase from 2000 to 2001 was primarily due to the greater
impact of goodwill amortization, which is non-deductible for tax purposes, as a
percentage of income before taxes on income. The increase from 1999 to 2000 was
primarily due to charges, which are non-deductible for tax purposes, for certain
professional costs related to the merger with USTC as well as goodwill
amortization primarily related to the acquisition of CyberTrader.
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 (the Act). 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 consistent with
its operations. See note "20 - Regulatory Requirements" in the Notes to
Consolidated Financial Statements.
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, CSC's depository institution subsidiaries and SCM 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, meeting CSC's depository institution subsidiaries' capital
guidelines and maintaining Schwab's and SCM's net capital. Based on their
respective regulatory capital ratios at December 31, 2001 and 2000, the Company
and its depository institution subsidiaries are considered well capitalized.
CSC has liquidity needs that arise from its issued and outstanding $679
million 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 have maturities ranging from 2002 to 2010 and fixed interest
rates ranging from 6.04% to 8.05% with interest payable semiannually. The
Medium-Term Notes are rated A2 by Moody's Investors Service, A by Standard &
Poor's Ratings Group and A+ by Fitch IBCA, Inc.
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, 2001, all of these notes remained unissued.
CSC has authorization from its Board of Directors to issue up to $1.2 billion
in commercial paper. At December 31, 2001, no commercial paper has been issued.
CSC's ratings for these short-term borrowings are P-1 by Moody's Investors
Service and A-1 by Standard & Poor's Ratings Group.
CSC maintains a $1.2 billion committed, unsecured credit facility with a
group of twenty-three banks which is scheduled to expire in June 2002. CSC plans
to establish a similar facility to replace this one when it expires. 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 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 tangible net worth, and Schwab and
SCM to maintain specified levels of net capital, as defined. Management believes
that these restrictions will not have a material effect on its ability to meet
foreseeable dividend or funding requirements. This facility was unused in 2001.
CSC also has direct access to $665 million of the $845 million uncommitted,
unsecured bank credit lines, provided by seven 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, while
the credit line provided by another one of these banks includes a sub-limit on
credit available to CSC. These lines were not used by CSC in 2001.
During 2001, the Company began occupying and making lease payments on a
newly renovated office building. The lease for the building was arranged by
working with a bank to create an unconsolidated special purpose trust (Trust).
The Trust, through an agent, raised the $245 million needed to acquire and
renovate the building by issuing long-term debt ($235 million) and raising
equity capital ($10 million). The Company's lease payments to the Trust vary
with fluctuations in interest rates and are structured to cover the interest on
the debt obligations and a specified return on the equity. This financing
arrangement, known as a synthetic lease, enables the Company to acquire office
space at attractive rates; it is, however, more complex than standard
- 14 -
lease structures. For example, upon the expiration of the lease in June 2005,
the Company may renew the lease for an additional five years subject to certain
approvals and conditions, or arrange a sale of the office building to a third
party. The Company also has an option to purchase the office building for $245
million at any time after June 18, 2003. The Company has provided the Trust with
a residual value guarantee, which means that if the building is sold to a third
party the Company is responsible for making up any shortfall between the actual
sales price and the $245 million funded by the Trust, up to a maximum of $202
million. The Company has recently obtained a preliminary appraisal of $200
million for the estimated value of the building at the end of the lease term.
The shortfall in estimated value below $245 million will be recorded as expense
using the straight-line method over the remaining term of the lease.
Schwab
Most of Schwab's assets are liquid, consisting primarily of short-term (i.e.,
less than 90 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
$25.0 billion, $25.2 billion and $23.0 billion at December 31, 2001, 2000 and
1999, 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.
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 amount requirement of $1
million. At December 31, 2001, Schwab's net capital was $1.2 billion (12% of
aggregate debit balances), which was $968 million in excess of its minimum
required net capital and $673 million in excess of 5% of aggregate debit
balances. Schwab has historically targeted net capital to be 10% of its
aggregate debit balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital position, CSC provides Schwab with a
$1.4 billion subordinated revolving credit facility maturing in September 2003,
of which $220 million was outstanding at December 31, 2001. At year end, Schwab
also had outstanding $25 million in fixed-rate subordinated term loans from CSC
maturing in 2003. Borrowings under these subordinated lending arrangements
qualify as regulatory capital for Schwab.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank
credit lines with a group of seven banks totaling $845 million at December 31,
2001 (as noted previously, $665 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 twenty-one days in
2001 and twenty-six days in both 2000 and 1999, with the daily amounts borrowed
averaging $33 million, $80 million and $125 million, respectively. There were no
borrowings outstanding under these lines at December 31, 2001.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with eleven banks in favor of the OCC aggregating $805 million at
December 31, 2001. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2001.
U.S. Trust
U.S. Trust's liquidity needs are generally met through earnings generated by
its operations.
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, CSC's depository institution
subsidiaries are subject to limitations on the amount of dividends they can pay
to USTC.
In addition to traditional funding sources such as deposits, federal funds
purchased and repurchase agreements, CSC's depository institution subsidiaries
have established their own external funding sources. At December 31, 2001, U.S.
Trust had $50 million in Trust Preferred Capital Securities outstanding with a
fixed interest rate of 8.41%. Certain of CSC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $737 million. At December 31, 2001, $350 million in
short-term borrowings and $1 million in long-term debt were outstanding under
these facilities.
Under a new agreement effective in 2001, CSC provides U.S. Trust with a
$300 million short-term credit facility maturing in 2003. 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, 2001.
- 15 -
SCM
SCM's liquidity needs are generally met through earnings generated by its
operations. Most of SCM's assets are liquid, consisting primarily of cash and
cash equivalents, marketable securities and receivables from brokers, dealers
and clearing organizations.
SCM's liquidity is affected by the same net capital regulatory requirements
as Schwab (see discussion above). At December 31, 2001, SCM's net capital was
$14 million, which was $13 million in excess of its minimum required net
capital.
SCM may borrow up to $70 million under a subordinated lending arrangement
with CSC maturing in 2003. Borrowings under this arrangement qualify as
regulatory capital for SCM. In addition, CSC provides SCM with a $50 million
short-term credit facility. Borrowings under this arrangement do not qualify as
regulatory capital for SCM. No funds were drawn under these facilities at
December 31, 2001.
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 its subsidiaries' 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:
- - 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;
- - a significant increase in client order flow in SCM's market-making
activities, creating an imbalance of long or short securities positions which
may reduce the Company's liquid resources and excess capital position;
- - a reduction in cash held in banking or brokerage client accounts which may
affect the amount of the Company's liquid assets; and
- - a significant downgrade in the Company's credit ratings which could increase
its borrowing costs and limit its access to the capital markets.
Development Spending
A significant portion of the Company's liquidity needs arises from ongoing
investments to support future growth. These investments, which the Company
refers to as development spending, are comprised of two categories: media
spending (including media and production expenses) and project spending.
Approximately 75% of project spending in 2002 is targeted towards enhancing
future revenue growth and improving productivity in line with the Company's
strategic priorities. The remaining 25% is targeted towards enhancing the
Company's infrastructure and ensuring compliance with appropriate risk
management policies and industry practices. This spending is imbedded throughout
certain categories of the Company's non-interest expenses.
Development spending in 2001 was approximately $406 million, down 23% from
2000. Given the prevailing market conditions and the Company's financial
performance, the Company reduced its development spending in 2001 below the
level originally anticipated. Management currently anticipates 2002 development
spending to be 5% to 10% lower than the 2001 level, reflecting management's
continued focus on expense containment in light of prevailing market conditions.
Development spending in 2002 is anticipated to be evenly split between project
and media spending.
As has been the case in recent years, the Company may adjust its development
spending from period to period as business conditions change. In general, the
level of future spending will be influenced by the rate of growth in client
assets and trading activities, the opportunities to invest in technology that
improve capacity, productivity or the client experience, and the expected return
on these investments as compared to the Company's financial objectives and cost
of capital. While development spending is discretionary and can be altered in
response to business conditions, the Company views its development spending as
essential for future growth and therefore prefers to avoid major adjustments in
such spending unless faced with what it believes is a sustained slowdown in
revenue growth.
Cash Flows and Capital Resources
Net income plus depreciation and amortization including goodwill amortization
was $603 million in 2001, down 41% from $1.0 billion in 2000. Depreciation and
amortization expense related to equipment, office facilities and property was
$327 million in 2001 and $245 million in 2000. Amortization expense related to
intangible assets was $11 million in 2001 and $10 million in 2000. Goodwill
amortization expense was $66 million in 2001 and $53 million in 2000.
[CHART OMITTED]
The Company's capital expenditures were $301 million in 2001 and $705
million in 2000, or 7% and 12% of revenues, respectively. In 2001, 69% of
capital expenditures were for information technology and 31% for facilities
expansion and improvements. The $404 million, or 57%, decrease in capital
expenditures in 2001 was primarily due to the declines in client trading volumes
and difficult market conditions which characterized most of the year. Capital
expenditures as
- 16 -
described above include the capitalized costs for developing internal-use
software of $79 million in 2001 and $109 million in 2000. Schwab opened 22 new
domestic branch offices during 2001, compared to 44 in 2000. U.S. Trust opened 3
new offices in both 2001 and 2000. The Company continues to view its office
network as important to pursuing its strategy of attracting client assets.
Management currently anticipates that 2002 capital expenditures will be
approximately 10% to 20% lower than 2001 spending. As has been the case in
recent years, the Company may adjust its capital expenditures from period to
period as business conditions change.
During 2001, the Company:
- Repaid $40 million of long-term debt;
- Received cash proceeds of $30 million on the exercise of 6 million of the
Company's stock options, with a weighted-average exercise price of $4.73,
and a related tax benefit of $37 million; and
- Paid common stock dividends of $61 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, 2001 was $4.9 billion, down $107 million,
or 2%, from a year ago. At December 31, 2001, the Company had long-term debt of
$730 million, or 15% of total financial capital, bearing interest at a
weighted-average rate of 7.35%. At December 31, 2001, the Company's
stockholders' equity was $4.2 billion, or 85% of total financial capital.
Management currently anticipates that long-term debt will remain below 30% of
total financial capital.
Commitments
A summary of the Company's principal contractual obligations and other
commitments as of December 31, 2001 is shown in the following table. Management
believes that funds generated by the operations of the Company's subsidiaries
will continue to be the primary funding source in meeting these obligations and
commitments.
Less than 1 - 3 4 - 5 After 5
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
Operating leases (1) $ 267 $ 443 $ 471 $ 632 $1,813
Long-term debt (2) 114 181 124 311 730
Short-term borrowings (3) 578 578
Merger-retention programs (4) 117 117
Credit-related financial
instruments (5) 568 95 663
Other commitments (6) 20 20
- --------------------------------------------------------------------------------
Total $1,664 $ 719 $ 595 $ 943 $3,921
================================================================================
(1)Includes minimum rental commitments and maximum guaranteed residual
values under noncancelable leases for office space and equipment. See Note
21 to the Consolidated Financial Statements.
(2)See Note 14 to the Consolidated Financial Statements.
(3)See Note 13 to the Consolidated Financial Statements.
(4)Includes commitments under merger-retention programs for employees of
U.S. Trust and CyberTrader. See Note 4 to the Consolidated Financial
Statements.
(5)Includes U.S. Trust firm commitments to extend credit primarily for
mortgage loans to private banking clients and standby letters of credit.
See Note 22 to the Consolidated Financial Statements.
(6)Includes a guarantee on a bank credit facility and committed capital
contributions to venture capital funds. See Note 21 to the Consolidated
Financial Statements.
In addition to the commitments summarized above, in the ordinary course of
its business, the Company has entered into various agreements with third-party
vendors, including agreements for advertising, sponsorships of sporting events,
data processing equipment purchases, licensing and software installation. These
agreements typically can be revoked by the Company if notice is given on the
pre-determined dates specified in the agreements.
Share Repurchases
On September 20, 2001, the Board of Directors authorized repurchases of the
Company's common stock totaling up to $500 million. The shares may be
repurchased through open market or privately negotiated transactions based on
prevailing market conditions. This authorization superseded the Board of
Directors' repurchase authorization on March 21, 2001 for up to 20 million
shares of CSC's common stock. CSC repurchased 27 million shares of its common
stock for $368 million in 2001 and 3 million shares of its common stock for $54
million in 1999. CSC did not repurchase any common stock in 2000. At December
31, 2001, the authorization granted by the Board of Directors allows for future
repurchases of CSC's common stock totaling up to $399 million.
- 17 -
Dividend Policy
Since the initial dividend in 1989, CSC has paid 51 consecutive quarterly
dividends and has increased the dividend 12 times. Since 1989, dividends have
increased by a 29% compounded annual growth rate. CSC paid common stock
dividends of $.0440 per share in 2001, $.0407 per share in 2000 and $.0373 per
share in 1999. Dividends declared per common share do not include dividends
declared by USTC prior to the completion of the merger. While the payment and
amount of dividends are at the discretion of the Company's Board of Directors,
subject to certain regulatory and other restrictions, the Company targets its
cash dividend at approximately 5% to 10% of net income plus depreciation and
amortization.
Risk MANAGEMENT
Overview
The Company's business and activities expose it to different types of risks
including, but not limited to, those discussed below. Proper identification,
assessment and management of these risks are essential to the success and
financial soundness of the Company. Managing risk at the Company begins with the
expertise and experience of management at the business unit level. To supplement
risk management at the business unit level, the Company has formed a Global Risk
Steering Committee, and various other functional risk committees consisting of
members of senior management. The Global Risk Steering Committee takes an active
role in the oversight of the various risk committees by reviewing risk
exposures, leading in the continued development of the Company's risk management
practices, discussing changes in regulations and other risk-related
developments, and reporting regularly to the Audit Committee of the Company's
Board of Directors. Other risk committees include the Technology and Operations
Risk Committee, which focuses on the integrity of operational controls and
operating capacity of the Company's technology and operations systems; the
Credit and Market Risk Oversight Committee, which focuses on the credit
exposures resulting from client activity (i.e., margin lending activities and
private banking loans), the investing activities of certain of the Company's
proprietary funds, and corporate credit activities (i.e., counterparty and
corporate investing activities) and on the market risk resulting from securities
positioning activities; the Fiduciary Risk Committee, which focuses on financial
or reputational risk caused by a potential breach of fiduciary duties to a
client; and the Financial Risk Management Committee, which focuses on liquidity
and capital resources, and interest rate risk. Further, the U.S. Trust Risk
Policy Committee, which has broad responsibilities for the oversight of risk
management at U.S. Trust, reports to the Company's Global Risk Steering
Committee, as well as to the Board of Directors of U.S. Trust. Additionally, the
Finance, Compliance, and Internal Audit Departments and the Office of Corporate
Counsel assist management and the various risk committees in evaluating and
monitoring the Company's risk profile.
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 note
"22 - Financial Instruments Subject to Off-Balance-Sheet Risk or Credit Risk" in
the Notes to Consolidated Financial Statements for additional discussion on
credit risk.
The Company's business, like that of other securities brokerage and related
financial services firms, is directly affected by the fluctuations in securities
trading volumes and price levels that occur in fundamentally cyclical financial
markets, as well as by changes in government monetary policies that impact the
growth of bank loans and investments and the level of interest charged for loans
and paid on deposits and other funding sources. The Company may experience
significant variations in revenues from period to period depending on changes in
these factors and the overall business environment.
Given the nature of the Company's revenues, expenses and risk profile, the
Company's earnings and CSC's common stock price may be subject to significant
volatility from period to period. The Company's results for a period are not
necessarily indicative of results for any future period. Risk is inherent in the
Company's business. Consequently, despite the Company's attempts 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.
Competition
The Company faces significant competition from companies seeking to attract
client financial assets, including traditional, discount and online brokerage
firms, mutual fund companies, banks, asset management and wealth management
companies. Certain of these competitors have greater financial resources than
the Company. The financial modernization legislation which became effective in
March 2000 allows banks, securities firms and insurance companies more
flexibility to affiliate under one holding company. Holding companies can engage
in activities and acquire companies engaged in activities that are financial in
nature. As the Company makes progress in its development of banking and other
financial products as well as advice offerings to affluent clients, it may face
competition from different companies. The expansion and client acceptance of
conducting financial transactions online, as well as through wireless
applications, have also attracted competition from providers of online services,
software development companies and other providers of financial services.
Finally,
- 18 -
online trading has led to the creation of ECNs and new exchanges which may
intensify competition. Increased competition may have a negative impact on the
Company's business and operations.
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 client demands. 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. Technology and operating risk also includes human error, fraud and
natural disaster. The Company attempts to mitigate technology and operating risk
by maintaining a comprehensive internal control system and by employing
experienced personnel. Also, the Company maintains backup and recovery
functions, including facilities for backup and communications, and conducts
periodic testing of a disaster recovery plan. Each functional area deemed to be
potentially of medium to high risk by management performs a risk self-assessment
on an annual basis to evaluate the appropriateness of these internal controls
and recovery plans. The Company is committed to an ongoing process of upgrading,
enhancing and testing its technology systems. This effort is focused on meeting
client demands, meeting market and regulatory changes, and deploying
standardized technology platforms.
See note "20 - Regulatory Requirements" in the Notes to Consolidated
Financial Statements for a discussion on the improvements to U.S. Trust's risk
management processes and systems as a result of the USTC and U.S. Trust NY cease
and desist order with the Federal Reserve Board and the Superintendent of Banks
of the State of New York.
The Company is 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, third parties indicate that they
believe the Company may be infringing on their intellectual property rights. The
Company's efforts to assess the merits of third-party claims of infringement of
intellectual property, and its efforts to protect its own intellectual property,
require an investment of time and resources. In certain circumstances, the
Company attempts to obtain licenses under third-party intellectual property
rights. In some circumstances, a license may not be available from a third party
under acceptable terms. Similarly, the Company from time to time licenses its
intellectual property to third parties. Under some circumstances, litigation may
result from questions regarding infringement, ownership, validity, and scope of
intellectual property. 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 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 its margin lending activities, securities
lending activities, 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 increasing 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 private banking loan portfolio held at U.S. Trust. This counterparty
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 risk review department which is separate from the loan
origination and monitoring department. Management regularly reviews asset
quality including concentrations, delinquencies, non-performing private banking
loans, losses and recoveries. All are factors in the determination of an
appropriate allowance for credit losses, which is reviewed quarterly by senior
management. See notes "8 - Loans to Banking Clients and Related
- 19 -
Allowance for Credit Losses" and "22 - Financial Instruments Subject to
Off-Balance-Sheet Risk or Credit Risk" in the Notes to Consolidated Financial
Statements for an analysis of the Company's loan portfolio and allowance for
credit losses, and for an additional discussion on credit risk, respectively.
There were no troubled debt restructurings at December 31, 2001 and 2000. As
of December 31, 2001, management is not aware of any significant potential
problem loans other than the amounts disclosed in the table in note "8 - Loans
to Banking Clients and Related Allowance for Credit Losses" in the Notes to
Consolidated Financial Statements.
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 corporate 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 is provided
through the creation, approval and ongoing review of applicable policies by
business units and the Fiduciary Risk Committee.
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, private banking loans, mortgage-backed securities and other
fixed-rate investments) and its funding sources (including brokerage client cash
balances, banking deposits, proceeds from stock-lending activities, long-term
debt, and stockholders' equity) 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 interest rate
swaps (Swaps) to mitigate interest rate exposure associated with short-term
floating interest-rate deposits.
The Company is exposed to equity price risk through its role as a financial
intermediary in client-related transactions, and by holding financial
instruments mainly in its capacity as a market maker and relating to its
specialists' and proprietary equity trading operations. To mitigate the risk of
losses, these financial instruments are monitored by management to assure
compliance with limits established by the Company. In addition, these financial
instruments are marked to market on a daily basis. Also, the Company purchases
and sells from time to time exchange-traded futures and options to offset market
risk on these inventories. The Company may enter into foreign currency contracts
to reduce currency exchange rate risk. However, the Company's exposure to
currency exchange risks through its international operations is not material.
Additional qualitative and quantitative disclosures about market risk are
summarized in the following paragraphs. See note "22 - Financial Instruments
Subject to Off-Balance-Sheet Risk or Credit Risk" in the Notes to Consolidated
Financial Statements for an additional discussion on credit risk.
Financial Instruments Held For Trading Purposes
The Company held municipal, other fixed income and government securities and
certificates of deposit with a fair value of approximately $36 million and $32
million at December 31, 2001 and 2000, respectively. These securities, and the
associated interest rate risk, are not material to the Company's financial
position, results of operations or cash flows.
The Company maintains inventories in exchange-listed, Nasdaq and other equity
securities on both a long and short basis. The fair value of these securities at
December 31, 2001 was $167 million in long positions and $27 million in short
positions. The fair value of these securities at December 31, 2000 was $69
million in long positions and $30 million in short positions. Using a
hypothetical 10% increase or decrease in prices, the potential loss or gain in
fair value is estimated to be approximately $14 million and $4 million at
December 31, 2001 and 2000, respectively, due to the offset of the change in
fair value in long and short positions. In addition, the Company generally
enters into exchange-traded futures and options to hedge against potential
losses in equity inventory positions, thus offsetting this potential loss
exposure. A hypothetical 10% change in fair value of the futures and options at
December 31, 2001 and 2000 would substantially offset the potential loss or gain
on the equity securities discussed above. The notional amount of futures and
options was approximately $148 million and $66 million at December 31, 2001 and
2000, respectively. The fair value of such futures and options was not material
to the Company's consolidated balance sheets at December 31, 2001 and 2000.
- 20 -
Financial Instruments Held For Purposes Other Than Trading
The Company maintains investments primarily in mutual funds related to its
deferred compensation plan, which is available to certain employees. These
investments were approximately $67 million and $70 million at December 31, 2001
and 2000, respectively. These securities, and the associated market risk, are
not material to the Company's financial position, results of operations or cash
flows.
Debt Issuances
At December 31, 2001, CSC had $679 million aggregate principal amount of
Medium-Term Notes outstanding, with fixed interest rates ranging from 6.04% to
8.05%. At December 31, 2000, CSC had $718 million aggregate principal amount of
Medium-Term Notes outstanding, with fixed interest rates ranging from 5.96% to
8.05%. At December 31, 2001 and 2000, U.S. Trust had $50 million Trust Preferred
Capital Securities outstanding, with a fixed interest rate of 8.41%. In
addition, at December 31, 2001 and 2000, U.S. Trust had $1 million and $2
million FHLB borrowings outstanding, respectively. The FHLB borrowings had a
fixed interest rate of 6.69% at December 31, 2001 and interest rates ranging
from 6.69% to 6.76% at December 31, 2000.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The estimated fair value of these
obligations at December 31, 2001 and 2000, based on estimates of market rates
for debt with similar terms and remaining maturities, was $765 million and $785
million, respectively, which approximated their carrying amounts of $730 million
and $770 million, respectively.
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 U.S. Trust to hedge its interest rate risk. Key variables in
the model include assumed margin loan and brokerage client cash balance growth
or decline, changes to the level and term structure of interest rates, the
repricing of financial instruments, prepayment and reinvestment assumptions,
loan, banking deposit, and brokerage client cash balance pricing and volume
assumptions. The simulations involve assumptions that are inherently uncertain
and as a result, the simulations cannot precisely estimate net 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). Historically, this position has
partially offset decreases in trading activity, and therefore commission
revenues, which have resulted during periods of rising interest rates. U.S.
Trust's interest-bearing liabilities are positioned to reprice more quickly than
interest-earning assets, which naturally offsets a portion of Schwab's
asset-sensitive interest-rate risk exposure.
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 and the effect on simulated net interest revenue over the next twelve
months at December 31, 2001 and 2000. While the Company typically uses a gradual
200 basis point change, it revised the methodology at December 31, 2001 due to
the current low levels of interest rates. The Company will use a gradual 100
basis point change until such time as the level of interest rates justifies a
return to the previous methodology. The disproportionate net interest revenue
sensitivity in the decrease of 100 basis points scenario is primarily due to
assumptions that rates paid on certain brokerage client cash balances and
banking deposits cannot go below zero percent.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue
Percentage Increase (Decrease)
December 31, 2001 2000
- --------------------------------------------------------------------------------
Increase of 100 basis points 3.8% 3.8%
Decrease of 100 basis points (7.0%) (3.8%)
================================================================================
The impact of the Company's hedging activities upon net interest revenue for
the years ended December 31, 2001, 2000 and 1999 was immaterial to the Company's
results of operations.
Legal and Compliance Risk
Legal and compliance risk refers to the possibility that the Company will
be found, by a court, arbitration panel or regulatory authority, not to have
complied with an applicable legal or regulatory requirement. The Company may be
subject to lawsuits or arbitration claims by clients, employees or other third
parties in the different jurisdictions in which it conducts business. In
addition, the Company is subject to
- 21 -
extensive regulation by the SEC, the National Association of Securities Dealers,
Inc., the NYSE, the Federal Reserve Board, the Federal Deposit Insurance
Corporation, the Superintendent of Banks of the State of New York, and other
federal, state and market regulators, as well as certain foreign regulatory
authorities. New rules and changes in application of current rules could affect
the Company's manner of operations and profitability. The Company attempts to
mitigate legal and compliance risk through policies and procedures that it
believes are reasonably designed to prevent or detect violations of applicable
statutory and regulatory requirements (see note "21 - Commitments and Contingent
Liabilities" in the Notes to Consolidated Financial Statements). However,
violations of applicable statutory and regulatory requirements could subject the
Company and/or its directors, officers or employees to disciplinary proceedings
or civil or criminal liability. Any such proceeding could cause a significant
negative impact on the Company's business and operations.
BANK HOLDING COMPANY ACT 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
Act.
Under the Gramm-Leach-Bliley Act (the GLB Act), financial holding companies
may affiliate with a far broader range of financial companies than is permitted
for bank holding companies. 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 and the
Federal Reserve Board may 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 subsidiary is U.S. Trust NY. 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, including requirements governing:
transactions with CSC and its non-depository institution subsidiaries, including
loans and other extensions of credit, investments or asset purchases, or
otherwise financing or supplying funds to CSC; dividends; investments; and
aspects of CSC's operations. 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, U.S. Trust and their U.S.-based insured depository
institution subsidiaries must meet regulatory capital guidelines adopted by the
federal banking agencies. The Federal Reserve Board has not indicated whether
the guidelines will be modified with respect to a bank holding company, such as
CSC, that also qualifies as a financial holding company. 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.
To remain a financial holding company, each of CSC's depository institution
subsidiaries must be well capitalized and well managed. In addition, each of
CSC's insured depository institution subsidiaries must be rated "satisfactory"
or better on the institutions' records of meeting the credit needs of their
communities under the Community Reinvestment Act of 1977 in order for CSC to
engage in new financial activities or, with certain limited exceptions, acquire
a company engaged in financial activities. If CSC ceases to qualify as a
financial holding company it will be subject to substantial additional
restrictions on its activities.
The Federal Reserve Board has not published consolidated capital requirements
specific to financial holding companies. In January 2001, the federal bank
agencies requested comment on a new Capital Accord proposed by the Basel
Committee on Banking Supervision (Basel Committee). The Basel Committee is
reviewing the comments received on the proposal and is expected to reissue the
proposal.
Subject to limited exceptions, the privacy provisions of the GLB Act prohibit
financial institutions from disclosing to unaffiliated third parties nonpublic
personal information regarding consumers and require financial institutions to
disclose consumer privacy policies. Federal law does not preempt state financial
privacy laws that are stricter than the federal provisions. Schwab and U.S.
Trust have amended their privacy policies and consumer disclosures to comply
with the GLB Act. See note "20 - Regulatory Requirements" in the Notes to
Consolidated Financial Statements.
The USA Patriot Act (Patriot Act), which became a law in October 2001,
enhances the obligations of financial institutions to detect and prevent money
laundering. The Patriot Act requires: financial institutions to collect enhanced
information concerning certain types of accounts, especially for foreign
financial institutions and individuals; the development of anti-money-laundering
programs; the filing of reports to the government when financial institutions
detect suspicious activities; and enhanced verification of clients' identities.
The Patriot Act is expected to be implemented by regulations to be issued by the
U.S.
- 22 -
Treasury Department by October 2002. The Company is participating in the
development of these regulations and is monitoring and evaluating their
potential effect on its operations.
- 23 -
Consolidated Statement of Income The Charles Schwab Corporation
(In Millions, Except Per Share Amounts)
Year Ended December 31, 2001 2000 1999
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 1,675 $ 1,583 $ 1,220
Commissions 1,355 2,294 1,875
Interest revenue, net of interest expense of $928 in 2001,
$1,352 in 2000 and $898 in 1999 929 1,237 820
Principal transactions 255 570 500
Other 139 104 71
- ------------------------------------------------------------------------------------------------------------------------------------
Total 4,353 5,788 4,486
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 1,875 2,414 1,888
Other compensation - merger retention programs 56 39
Occupancy and equipment 490 415 307
Communications 339 353 279
Depreciation and amortization 338 255 169
Advertising and market development 246 332 248
Professional services 193 255 184
Commissions, clearance and floor brokerage 92 138 100
Goodwill amortization 66 53 12
Merger-related 69
Restructuring and other charges 419
Other 104 234 200
- ------------------------------------------------------------------------------------------------------------------------------------
Total 4,218 4,557 3,387
- ------------------------------------------------------------------------------------------------------------------------------------
Income before taxes on income and extraordinary gain 135 1,231 1,099
Taxes on income 57 513 433
- ------------------------------------------------------------------------------------------------------------------------------------
Income before extraordinary gain 78 718 666
Extraordinary gain on sale of corporate trust business, net of tax of $100 121
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 199 $ 718 $ 666
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,399 1,404 1,373
====================================================================================================================================
Earnings Per Share - Basic
Income before extraordinary gain $ .06 $ .53 $ .51
Extraordinary gain, net of tax $ .08
Net income $ .14 $ .53 $ .51
Earnings Per Share - Diluted
Income before extraordinary gain $ .06 $ .51 $ .49
Extraordinary gain, net of tax $ .08
Net income $ .14 $ .51 $ .49
====================================================================================================================================
Dividends Declared Per Common Share $ .0440 $ .0407 $ .0373
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 24 -
Consolidated Balance Sheet The Charles Schwab Corporation
(In Millions, Except Share and Per Share Amounts)
December 31, 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 4,407 $ 4,876
Cash and investments segregated and on deposit for federal or other regulatory
purposes (1) (including resale agreements of $14,811 in 2001 and $7,002 in 2000) 17,741 9,425
Securities owned - at market value (including securities pledged of $185 in 2001
and $104 in 2000) 1,700 1,618
Receivables from brokers, dealers and clearing organizations 446 348
Receivables from brokerage clients - net 9,620 16,332
Loans to banking clients - net 4,046 3,147
Equipment, office facilities and property - net 1,058 1,133
Goodwill - net 628 605
Other assets 818 670
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 40,464 $ 38,154
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 5,448 $ 4,209
Drafts payable 396 544
Payables to brokers, dealers and clearing organizations 833 1,070
Payables to brokerage clients 26,989 25,715
Accrued expenses and other liabilities 1,327 1,277
Short-term borrowings 578 339
Long-term debt 730 770
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 36,301 33,924
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share; none issued
Common stock - 3 billion shares authorized in 2001 and 2 billion shares authorized
in 2000; $.01 par value per share; 1,391,673,494 shares issued in 2001 and
1,385,624,827 shares issued and outstanding in 2000 14 14
Additional paid-in capital 1,726 1,588
Retained earnings 2,794 2,713
Treasury stock - 23,110,972 shares in 2001, at cost (295)
Unamortized stock-based compensation (39) (71)
Accumulated other comprehensive loss (37) (14)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,163 4,230
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 40,464 $ 38,154
====================================================================================================================================
(1)Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $18,261 million and $10,998 million at December 31, 2001 and 2000, respectively. As of January 3,
2002, the Company had deposited $710 million to meet its segregated cash requirement. On January 2, 2001, the Company deposited
$1,779 million to meet its segregated cash requirement.
See Notes to Consolidated Financial Statements.
- 25 -
Consolidated Statement of Cash Flows The Charles Schwab Corporation
(In Millions)
Year Ended December 31, 2001 2000 1999
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 199 $ 718 $ 666
Adjustments to reconcile net income to net cash provided
by (used for) operating activities:
Depreciation and amortization 338 255 169
Goodwill amortization 66 53 12
Compensation payable in common stock 32 82 35
Deferred income taxes (79) (27) (3)
Tax benefits from stock options exercised and other stock-based
compensation 37 330 215
Non-cash restructuring and other charges 80
Net gain on sale of an investment (26)
Extraordinary gain on sale of corporate trust business, net of tax (121)
Other 22 8 12
Net change in:
Cash and investments segregated and on deposit for federal
or other regulatory purposes (8,334) (942) 1,563
Securities owned (excluding securities available for sale) 14 (54) (98)
Receivables from brokers, dealers and clearing organizations (89) 131 (154)
Receivables from brokerage clients 6,709 727 (7,419)
Other assets (35) (94) (28)
Drafts payable (150) 75 144
Payables to brokers, dealers and clearing organizations (335) (662) 329
Payables to brokerage clients 1,291 2,329 5,317
Accrued expenses and other liabilities (203) (13) 334
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities (584) 2,916 1,094
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,025) (545) (466)
Proceeds from sales of securities available for sale 473 93 10
Proceeds from maturities, calls and mandatory redemptions of
securities available for sale 611 227 414
Net increase in loans to banking clients (835) (458) (518)
Purchase of equipment, office facilities and property - net (301) (705) (370)
Cash payments for business combinations and investments,
net of cash received (52) (35) (26)
Proceeds from sale of an investment 49
Proceeds from sale of corporate trust business 273
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (807) (1,423) (956)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net increase in deposits from banking clients 1,139 4 790
Net increase in short-term borrowings 224 198
Proceeds from long-term debt 311 144
Repayment of long-term debt (40) (59) (45)
Dividends paid (61) (62) (61)
Purchase of treasury stock (368) (54)
Proceeds from stock options exercised and other 30 85 66
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 924 477 840
- ------------------------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents (2) (4) 2
- ------------------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents (469) 1,966 980
Cash and Cash Equivalents at Beginning of Year 4,876 2,910 1,930
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 4,407 $ 4,876 $ 2,910
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 26 -
Consolidated Statement of Stockholders' Equity The Charles Schwab Corporation
(In Millions)
Common
Stock Accumu-
Issued lated
Deferred Unamortized to Other
Addi- Compen- Employee Stock- Deferred Compre-
tional sation Stock based Compen- hensive
Common Paid-In Retained Stock Treasury Ownership Compen- sation Income
Stock Capital Earnings Trust(1) Stock Plan sation Trust (1) (Loss) Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 $ 13 $ 251 $1,540 $ (88) $ (5) $ (44) $ 6 $1,673
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income 666 666
Foreign currency translation adjustment 3 3
Net unrealized gain (loss) on securities
available for sale, net of
reclassification adjustment and tax (17) (17)
-------
Total comprehensive income 652
Dividends declared on common stock (62) (62)
Purchase of treasury stock (54) (54)
Deferred compensation liability
settled by issuing common stock 2 $ 2 $ (2) 2
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans 326 1 13 (54) 286
Issuance of shares for acquisitions 13 32 45
Amortization of stock-based
compensation awards 27 27
Principal payment by U.S. Trust
Corporation ESOP 4 4
ESOP shares released for allocation 3 3
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1999 13 595 2,145 2 (97) (1) (71) (2) (8) 2,576
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income 718 718
Foreign currency translation adjustment (16) (16)
Net unrealized gain (loss) on securities
available for sale, net of
reclassification adjustment and tax 10 10
-------
Total comprehensive income 712
Dividends declared on common stock (58) (58)
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans 1 440 (37) 404
Issuance of shares for acquisitions 529 529
Retirement of treasury stock (5) (92) 97
Amortization of stock-based
compensation awards 37 37
ESOP shares released for allocation 29 1 30
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 14 1,588 2,713 2 (71) (2) (14) 4,230
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income 199 199
Cumulative effect of accounting
change, net of tax (12) (12)
Net loss on cash flow hedging
instruments, net of tax (19) (19)
Foreign currency translation adjustment (2) (2)
Net unrealized gain (loss) on securities
available for sale, net of
reclassification adjustment and tax 10 10
-------
Total comprehensive income 176
Dividends declared on common stock (61) (61)
Purchase of treasury stock (368) (368)
Deferred compensation payable in
common stock 1 (1)
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans 48 (57) 77 (3) 65
Non-cash stock-based compensation
expense related to restructuring 19 1 20
Issuance of shares for acquisitions 71 71
Receipt of shares in settlement of
accounts receivable (4) (4)
Amortization of stock-based
compensation awards 34 34
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 $ 14 $1,726 $2,794 $ 3 $(295) $ (39) $ (3) $ (37) $4,163
====================================================================================================================================
(1) Deferred compensation stock trust amounts are presented net on the Consolidated Balance Sheet.
See Notes to Consolidated Financial Statements.
- 27-
The Charles Schwab Corporation
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share and Option Price Amounts)
1. Introduction and Basis of Presentation
The Charles Schwab Corporation (CSC) is a financial holding company engaged,
through its subsidiaries, in securities brokerage and related financial
services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with
395 domestic branch offices in 48 states, as well as branches in the
Commonwealth of Puerto Rico and the U.S. Virgin Islands. U.S. Trust Corporation
(USTC, and with its subsidiaries collectively referred to as U.S. Trust) is an
investment management firm that through its subsidiaries also provides fiduciary
services and private banking services with 34 offices in 12 states. Other
subsidiaries include Charles Schwab Europe (CSE), a retail securities brokerage
firm located in the United Kingdom, Charles Schwab Investment Management, Inc.,
the investment advisor for Schwab's proprietary mutual funds, Schwab Capital
Markets L.P. (SCM), a market maker in Nasdaq and other securities providing
trade execution services to broker-dealers and institutional clients, and
CyberTrader, Inc. (CyberTrader, formerly known as CyBerCorp, Inc.), an
electronic trading technology and brokerage firm providing services to highly
active, online investors.
The consolidated financial statements include CSC and its majority-owned
subsidiaries (collectively referred to as the Company). Investments in equity
securities of other firms where the Company has significant influence, but owns
less than a majority of the voting securities are generally accounted for by the
equity method. Under the equity method, the investment is initially recorded at
cost with the carrying amount subsequently adjusted to recognize the Company's
proportionate share of the earnings or losses of the investee.
The consolidated financial statements are 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 equipment, office
facilities, property, goodwill and other intangible assets, 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 liabilities and
legal reserves. Actual results could differ from such estimates. Certain
prior-year amounts have been reclassified to conform to the 2001 presentation.
All material intercompany balances and transactions have been eliminated.
On May 31, 2000, CSC completed its merger (the Merger) with USTC. The
consolidated financial statements, included in this Annual Report, give
retroactive effect to the Merger, which was accounted for as a pooling of
interests. The pooling of interests method of accounting requires the
restatement of all periods presented as if CSC and USTC had been operating as a
combined entity during such periods.
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 securities purchased under agreements to resell (resale agreements)
which are collateralized by U.S. government securities, 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 resale agreements and certificates of deposit.
Certificates of deposit are stated at cost, which approximates market.
Securities financing activities: Resale agreements are accounted for as
collateralized financing transactions and 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 by the Company, with additional collateral obtained or refunded when
necessary.
Securities borrowed and securities loaned are reported as collateralized
financing transactions. 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
- 28 -
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.
Securities owned include securities available for sale that are recorded at
estimated fair value with unrealized gains and losses reported, net of taxes, in
accumulated other comprehensive income (loss) included in stockholders' equity.
Realized gains and losses from sales of securities 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 money market funds and equity and bond mutual funds. These
securities are recorded at estimated fair value with unrealized gains and losses
included in principal transaction revenues.
Receivables from brokerage clients that remain unsecured for more than 30 days
or partially secured for more than 90 days are generally fully reserved for, and
are stated net of allowance for doubtful accounts.
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. In addition, interest accruals may be discontinued
when principal or interest is contractually past due less than 90 days if, in
the opinion of management, the amount due is not likely to be received in
accordance with the terms of the contractual agreement, even though the
financial instruments are currently performing. Any accrued but unpaid interest
previously recorded on a non-accrual financial instrument is reversed and
recorded as a reduction of interest income. Interest received on non-accrual
financial instruments is applied either to the outstanding principal balance or
recorded as interest income, depending on management's assessment of the
ultimate collectibility of principal. 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.
Allowance for credit losses on banking loans 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.
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 two to fifteen 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 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. For a discussion of the
Company's restructuring plan, which included the removal of assets from service,
see note "3 - Restructuring and Other Charges."
Goodwill, which represents the cost of acquired businesses in excess of the fair
value of the related net assets acquired, is amortized on a straight-line basis
over a period generally not exceeding fifteen years. Goodwill is reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of goodwill may not be recoverable. The Company assesses the
recoverability of goodwill using expected undiscounted future cash flows.
Goodwill is considered impaired when the expected undiscounted future cash flow
is less than the carrying amount. There was no impairment recognized for
goodwill in 2001, 2000 or 1999. The Company is required to adopt Statement of
Financial Accounting Standards (SFAS) No. 142 effective on January 1, 2002 (see
discussion below). Goodwill is stated at cost net of accumulated amortization of
$167 million and $101 million at December 31, 2001 and 2000, respectively.
Estimated 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 fair value of securities, loans and long-term debt are estimated using
quoted market prices, third-party pricing services, discounted cash flow
analyses utilizing discount rates currently available for similar instruments,
or other valuation techniques. Other equity securities where quoted market
prices are not available are initially recorded at cost. The carrying value of
such securities is adjusted when changes in the underlying fair values are
readily ascertainable, generally as evidenced by listed market prices or
transactions which directly affect the value of such securities.
Derivative financial instruments: The Company uses interest rate swaps (Swaps)
to hedge the interest rate risk associated with variable rate deposits from
banking clients. These Swaps have been designated as cash flow hedges and are
recorded at fair value on the consolidated balance sheet, with changes in their
fair value primarily recorded in other comprehensive income (loss).
- 29 -
Other derivative activities primarily consist of exchange-traded futures and
options to offset market risk on inventories in Nasdaq and exchange-listed
securities. These futures and options are recorded at fair value in securities
owned on the consolidated balance sheet, and gains and losses are included in
principal transaction revenues.
Foreign currency translation: Assets and liabilities denominated in foreign
currencies where the local currency is the functional currency are translated at
the exchange rate on the balance sheet date, while revenues and expenses are
translated at average rates of exchange prevailing during the year. Translation
adjustments are included in other comprehensive income (loss).
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.
Accounting change: SFAS No. 133 - Accounting for Derivative Instruments and
Hedging Activities, was adopted by the Company on January 1, 2001. This
statement requires that all derivatives be recorded on the balance sheet at fair
value. Upon adoption of SFAS No. 133, the Company recorded a derivative
liability of $20 million in accrued expenses and other liabilities and an
after-tax net loss in other comprehensive income (loss) of $12 million for the
Swaps. Previously, Swaps were accounted for under the accrual method, whereby
the difference between interest revenue and interest expense was recognized over
the life of the contract in net interest revenue. The cumulative effect of the
accounting change was not material to the Company's consolidated financial
statements.
New accounting standards: Pledged Collateral: On April 1, 2001, the Company
completed its adoption of SFAS No. 140 - Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities. The Company adopted SFAS
No. 140 in the fourth quarter of 2000 for recognition and reclassification of
collateral and for disclosures relating to collateral, and in the second quarter
of 2001 for transfers of financial assets and extinguishments of liabilities
(see note "22 - Financial Instruments Subject to Off-Balance-Sheet Risk or
Credit Risk").
Under SFAS No. 140, the Company is required to report the value of securities
that it has received as collateral and which can in turn be used (or repledged)
by the Company to generate financing such as securities lending, or to fulfill
either client-originated or proprietary short sale transactions. The Company is
also required to disclose the value of such securities that it has actually
repledged as of the reporting date.
The Company receives securities collateral in connection with its business as
a broker-dealer through collateralized resale agreements, client margin lending
and securities borrowed.
Business Combinations: SFAS No. 141 - Business Combinations, was issued in
June 2001. This statement eliminates, on a prospective basis, the pooling of
interest method for accounting for business combinations and requires the use of
the purchase method for business combinations initiated after June 30, 2001.
This statement also broadens the criteria for recording intangible assets
separately from goodwill.
The adoption of SFAS Nos. 140 and 141 did not have a material impact on the
Company's financial position, results of operations, earnings per share or cash
flows.
Goodwill and Other Intangible Assets: SFAS No. 142 - Goodwill and Other
Intangible Assets, was issued in June 2001 and establishes new standards for
accounting for goodwill and intangible assets. The Company is required to adopt
this statement effective on January 1, 2002. This statement requires that
goodwill and certain intangible assets with an indefinite useful life not be
amortized. This statement also requires that goodwill and certain intangible
assets be tested for impairment at least annually under new criteria. The new
criteria require management to estimate the fair value of the Company's
reporting units (generally defined as businesses for which financial information
is available and reviewed regularly by management), as well as allocate the
carrying value of the assets and liabilities, including goodwill associated with
those reporting units. Previously, goodwill was tested for impairment using a
cost recoverability approach based on expected undiscounted future cash flows.
In accordance with the provisions of SFAS No. 142, the Company intends to
complete the analyses and implementation during the first half of 2002.
Accordingly, the Company is currently evaluating the full impact of this
statement on its financial position, results of operations, earnings per share
and cash flows. However, amortization of the existing goodwill will cease upon
adoption. This amortization totaled $66 million, $53 million and $12 million in
2001, 2000 and 1999, respectively.
Long-Lived Assets: SFAS No. 144 - Accounting for the Impairment or Disposal
of Long-Lived Assets, was issued in August 2001 and addresses the financial
accounting and reporting for the impairment or disposal of long-lived assets
(e.g., equipment and office facilities). This statement supersedes SFAS No. 121
- - Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of, and certain accounting and reporting provisions of Accounting
Principles Board Opinion No. 30 - Reporting the Results of Operations. The
Company is required to adopt this statement effective on January 1, 2002. The
adoption of this statement is not expected to have an impact on the Company's
financial position, results of operations, earnings per share or cash flows.
- 30 -
3. Restructuring and Other Charges
Restructuring
In 2001, the Company initiated a restructuring plan (the Plan) to reduce
operating expenses due to continued economic uncertainties and difficult market
conditions. The Plan included a workforce reduction, a reduction in operating
facilities, the removal of certain systems hardware, software and equipment from
service, and the withdrawal from certain international operations. The Company
recorded pre-tax restructuring charges of $391 million in 2001. The Company
expects to recognize additional restructuring charges during the first quarter
of 2002 as it completes the Plan. The actual costs of the Plan could be greater
than the Company's estimates, depending primarily on the Company's ability to
successfully sublease certain properties.
Workforce: During 2001, the Company reduced full-time equivalent employees by
6,700, or 25%, including 4,200 through mandatory staff reductions. While the
Plan's total workforce reduction encompassed employees from across the Company,
Schwab's retail brokerage division and technology support functions accounted
for most of the affected employees.
Facilities: The Plan included a reduction of the Company's operating space,
primarily through subleases of certain space subject to lease commitments at the
Company's telephone service and data centers, corporate administrative office
space, and certain branch expansion space. The Plan also included impairment
losses on assets removed from service at these facilities, as well as
accelerated depreciation of leasehold improvements, furniture and equipment over
their shortened remaining estimated useful lives.
Systems: The Plan included the removal of certain computer systems hardware,
software and equipment from service at certain of the Company's facilities,
including data center and international facilities.
A summary of pre-tax restructuring charges is as follows:
2001
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 167
Non-cash compensation expense for officers'
stock options and restricted stock 20
- --------------------------------------------------------------------------------
Total workforce reduction 187
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated
sublease income 105
Impairment losses 19
Accelerated depreciation 17
- --------------------------------------------------------------------------------
Total facilities reduction 141
- --------------------------------------------------------------------------------
Systems removal:
Equipment lease and service agreement buyout costs 47
Impairment losses 16
- --------------------------------------------------------------------------------
Total systems removal 63
- --------------------------------------------------------------------------------
Total restructuring charges $ 391 (1)
================================================================================
(1)Includes charges of $175 million recognized in the fourth quarter of 2001, of
which $31 million related to the Company's international restructuring
initiatives.
A summary of the activity in the restructuring liability for the year ended
December 31, 2001 is as follows:
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Restructuring charges $ 187 $ 141 $ 63 $ 391
Utilization:
Cash payments (93) (8) (43) (144)
Non-cash charges (1) (20) (36) (16) (72)
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $ 74 (2) $ 97 (3) $ 4 (2) $ 175
================================================================================
(1)Includes charges for officers' stock-based compensation, impairment losses
and accelerated depreciation.
(2)The Company expects to substantially utilize the remaining restructuring
liability in the first quarter of 2002.
(3)The Company expects to utilize the remaining restructuring liability through
cash payments for the net lease expense over the respective lease terms
through 2010.
Other Charges
The Company recorded other pre-tax charges of $28 million in 2001. These
charges include a regulatory fine assessed to USTC and United States Trust
Company of New York (U.S. Trust NY), professional service fees for operational
and risk management remediation at USTC and U.S. Trust NY, and the write-off of
certain software development costs at CSE. There were no such charges for 2000
or 1999.
- 31 -
4. Business Combinations
On May 31, 2000, CSC completed the Merger with USTC. Under the terms of the
merger agreement, USTC became a wholly owned subsidiary of CSC and USTC
shareholders received 5.1405 shares of CSC's common stock for each common share
of USTC. The Merger was treated as a non-taxable stock-for-stock exchange and
USTC's shareholders received approximately 112,000,000 shares of CSC's common
stock. Upon completion of the Merger, CSC became 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. During 2000,
merger-related costs totaled $69 million pre-tax, or $63 million after-tax for
change-in-control related compensation payable to U.S. Trust employees and
professional fees. Merger-related costs are recorded separately on the
consolidated statement of income. In addition, under the terms of the merger
agreement, U.S. Trust employees received an aggregate of 2,718,000 stock
options, of which 50% vest at the end of the three-year period following the
completion of the Merger and 50% vest at the end of the four-year period
following the completion of the Merger.
On March 1, 2000, the Company acquired CyberTrader for $517 million in a
non-taxable stock-for-stock exchange. Pursuant to the acquisition, CyberTrader
became a wholly owned subsidiary of CSC which resulted in 17,570,000 shares of
CSC's common stock and 3,077,000 options to purchase CSC common stock being
exchanged for all of the outstanding shares, options and equity rights of
CyberTrader. Because the acquisition is accounted for using the purchase method,
the operating results of CyberTrader are included in the consolidated results of
the Company since the acquisition date. The historical results of CyberTrader
are not included in periods prior to the acquisition. The net assets acquired
are recorded at fair value and the excess of the purchase price over the fair
value of net assets acquired is recorded as goodwill. The Company recorded
intangible assets acquired of $512 million, including $482 million of goodwill.
In 2001 and 2000, the goodwill was amortized on a straight-line basis over a
period of ten years. Upon the adoption of SFAS No. 142, (see note "2 -
Significant Accounting Policies") on January 1, 2002, amortization of the
goodwill will cease. Other intangible assets acquired, which consist primarily
of purchased technology and total $30 million, are amortized on a straight-line
basis over a period of three years.
The Company established retention programs for U.S. Trust and CyberTrader
employees, whereby the employees will receive cash compensation, contingent upon
continued employment, at the end of the two-year period following the completion
of the Merger and the CyberTrader acquisition. The Company is recognizing the
costs of the cash component of the U.S. Trust and CyberTrader retention programs
over the two-year periods ending May 31, 2002 and March 1, 2002, respectively.
The cost of these programs is recorded separately on the consolidated statement
of income as other compensation expense - merger retention programs. At December
31, 2001, the estimated liability under these merger retention programs was $117
million, including the remaining estimated expense of $24 million which is
expected to be recognized in the first half of 2002.
5. Sale of Corporate Trust Business
In June 2001, USTC sold its Corporate Trust business to The Bank of New York
Company, Inc. (Bank of NY). During 2001, the Company recognized a pre-tax
extraordinary gain of $221 million on this sale, or $121 million after tax.
Total proceeds received were $273 million and the Company incurred pre-tax
closing and exit costs of $30 million for severance, professional fees, and
other related disposal costs. As part of the sale agreement, up to $22 million
of the sale proceeds may be returned to Bank of NY if certain client retention
requirements are not met. This amount has been deferred and the appropriate
amount will be recognized in earnings based upon actual client retention. The
Company expects to recognize all of the remaining sale proceeds in income in the
first quarter of 2002.
6. Securities Owned
A summary of securities owned is as follows:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Securities available for sale $1,200 $1,222
Equity, fixed income and other securities 222 117
SchwabFunds money market funds 172 139
Equity and bond mutual funds 106 140
- --------------------------------------------------------------------------------
Total $1,700 $1,618
================================================================================
- 32 -
The amortized cost, estimated fair value and gross unrealized gains and
losses on securities available for sale are as follows:
December 31, 2001 2000
- --------------------------------------------------------------------------------
U.S. treasury securities:
Amortized cost $ 159 $ 157
Aggregate fair value $ 160 $ 157
Gross unrealized gains $ 1
Gross unrealized losses
U.S. government sponsored agencies
and corporations:
Amortized cost 748 774
Aggregate fair value 754 776
Gross unrealized gains 7 6
Gross unrealized losses 1 4
State and municipal obligations:
Amortized cost 154 134
Aggregate fair value 158 135
Gross unrealized gains 4 1
Gross unrealized losses
Collateralized mortgage obligations (1):
Amortized cost 84 129
Aggregate fair value 84 129
Gross unrealized gains
Gross unrealized losses
Other securities:
Amortized cost 43 34
Aggregate fair value 44 25
Gross unrealized gains 1
Gross unrealized losses 9
- --------------------------------------------------------------------------------
Total securities available for sale:
Amortized cost $ 1,188 $ 1,228
Aggregate fair value $ 1,200 $ 1,222
Gross unrealized gains $ 13 $ 7
Gross unrealized losses $ 1 $ 13
================================================================================
(1)Collateralized by either GNMA, FNMA or FHLC obligations.
The maturities of debt securities available for sale at December 31, 2001,
and the related weighted-average yield on such debt securities are as follows:
Within 1 - 5 5 - 10 Over 10
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
U.S. treasury securities $ 10 $ 149 $ 159
U.S. government sponsored
agencies and corporations 16 675 $ 56 $ 1 748
State and municipal obligations 12 139 3 154
Collateralized mortgage
obligations (1) 60 3 21 84
Other debt securities 2 36 38
- --------------------------------------------------------------------------------
Total at amortized cost 40 1,059 62 22 1,183
Estimated fair value 41 1,066 63 25 1,195
- --------------------------------------------------------------------------------
Net unrealized gains (losses) $ 1 $ 7 $ 1 $ 3 $ 12
================================================================================
Weighted-average yield (2) 5.57% 5.73% 6.55% 2.98% 5.72%
================================================================================
(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, 2001.
Equity and other securities include the Company's inventories resulting from
proprietary equity trading, market making and its specialist operations. Fixed
income securities consist primarily of municipal bonds held to meet clients'
trading activities. The Company's positions in SchwabFunds money market funds
arise from certain overnight funding of clients' redemption, check-writing and
debit card 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 $27 million and $30 million at
December 31, 2001 and 2000, respectively, consist of equity and other
securities, and are recorded at market value in accrued expenses and other
liabilities.
7. Receivables from Brokerage Clients
Receivables from brokerage clients consist primarily of margin loans to
brokerage clients of $9.2 billion and $15.8 billion at December 31, 2001 and
2000, respectively. Securities owned by brokerage clients are held as collateral
for margin loans. Such collateral is not reflected in the consolidated financial
statements. Receivables from brokerage clients are stated net of allowance for
doubtful accounts of $5 million and $11 million at December 31, 2001 and 2000,
respectively.
- 33 -
8. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Private banking:
Residential real estate mortgages $3,085 $2,249
Other 943 849
- --------------------------------------------------------------------------------
Total private banking loans 4,028 3,098
- --------------------------------------------------------------------------------
Loans to financial institutions for purchasing
and carrying securities 32 61
All other 7 8
- --------------------------------------------------------------------------------
Total $4,067 $3,167
================================================================================
Nonperforming assets consist of non-accrual loans of $5 million and $1
million at December 31, 2001 and 2000, respectively. The Company considers all
non-accrual loans impaired. For 2001 and 2000, 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 immaterial at both December 31, 2001 and 2000.
The allowance for credit losses on the loan portfolio was $21 million at
December 31, 2001 and $20 million at both December 31, 2000 and 1999. Total
charge-offs and total recoveries were immaterial for each of 2001, 2000 and
1999.
The estimated fair value of the loan portfolio was $4.0 billion and $3.1
billion at December 31, 2001 and 2000, respectively.
9. Equipment, Office Facilities and Property
Equipment, office facilities and property are detailed below:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Land $ 22 $ 19
Buildings 264 235
Leasehold improvements 410 378
Furniture and equipment 247 228
Telecommunications equipment 184 166
Information technology equipment and software 875 801
Construction and software development
in progress 72 181
- --------------------------------------------------------------------------------
Subtotal 2,074 2,008
Accumulated depreciation and amortization 1,016 875
- --------------------------------------------------------------------------------
Total $ 1,058 $ 1,133
================================================================================
10. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, noninterest-bearing deposits and certificates of deposit. Deposits
from banking clients are as follows:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Interest-bearing deposits $4,046 $3,331
Noninterest-bearing deposits 1,402 878
- --------------------------------------------------------------------------------
Total $5,448 $4,209
================================================================================
During the years ended December 31, 2001 and 2000, the Company paid an
average rate of 3.8% and 5.1%, respectively, on its interest-bearing deposits
from banking clients.
11. Payables to Brokers, Dealers and Clearing
Organizations
Payables to brokers, dealers and clearing organizations consist primarily of
securities loaned of $628 million and $900 million at December 31, 2001 and
2000, respectively. The cash collateral received from counterparties under
securities lending transactions was equal to or greater than the market value of
the securities loaned.
12. Payables to Brokerage Clients
The principal source of funding for Schwab's margin lending is cash balances
in brokerage client accounts. At December 31, 2001, Schwab was paying interest
at 1.1% on $23.1 billion of cash balances in brokerage client accounts, which
were included in payables to brokerage clients. At December 31, 2000, Schwab was
paying interest at 5.4% on $22.0 billion of such cash balances.
13. Short-term Borrowings
CSC may borrow under its $1.2 billion committed, unsecured credit facility
with a group of twenty-three banks which is scheduled to expire in June 2002.
CSC plans to establish a similar facility to replace this one when it expires.
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 tangible
net worth, and Schwab and SCM to maintain specified levels of net capital, as
defined. This facility was unused at December 31, 2001 and 2000.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank
credit lines with a group of
- 34 -
seven banks totaling $845 million at December 31, 2001. CSC has access to $665
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, while the credit line provided
by another one of these banks includes a sub-limit on credit available to CSC.
There were no borrowings outstanding under these lines at December 31, 2001 and
2000.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with eleven banks in favor of the OCC aggregating $805 million at
December 31, 2001. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2001 and 2000.
Other short-term borrowings include Federal Home Loan Bank System borrowings,
federal funds purchased, securities sold under agreements to repurchase and
other borrowed funds. At December 31, 2001 and 2000, these other short-term
borrowings totaled $578 million and $339 million, respectively, with
weighted-average interest rates ranging from 1.71% to 3.69% and 5.81% to 6.76%,
respectively.
14. Long-term Debt
Long-term debt consists of the following:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 679 $ 718
8.414% Trust Preferred Capital Securities 50 50
Other 1 2
- --------------------------------------------------------------------------------
Total $ 730 $ 770
================================================================================
The aggregate principal amount of Senior Medium-Term Notes, Series A
(Medium-Term Notes) outstanding at December 31, 2001 had maturities ranging from
2002 to 2010 and fixed interest rates ranging from 6.04% to 8.05%. The aggregate
principal amount of Medium-Term Notes outstanding at December 31, 2000 had fixed
interest rates ranging from 5.96% to 8.05%. At December 31, 2001 and 2000, the
Medium-Term Notes carried a weighted-average interest rate of 7.27% and 7.26%,
respectively.
The Trust Preferred Capital Securities qualify as tier 1 capital under
guidelines of the 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.
The estimated fair value of long-term debt was $765 million and $785 million
at December 31, 2001 and 2000, respectively.
Annual maturities on long-term debt outstanding at December 31, 2001 are as
follows:
- --------------------------------------------------------------------------------
2002 $ 114
2003 100
2004 81
2005 56
2006 68
Thereafter 311
- --------------------------------------------------------------------------------
Total $ 730
================================================================================
15. Taxes on Income
Income tax expense is as follows:
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Current:
Federal $201 $475 $376
State 35 65 60
- --------------------------------------------------------------------------------
Total current 236 540 436
- --------------------------------------------------------------------------------
Deferred:
Federal (70) (24) (2)
State (9) (3) (1)
- --------------------------------------------------------------------------------
Total deferred (79) (27) (3)
- --------------------------------------------------------------------------------
Taxes on income 157 513 433
Current tax expense on
extraordinary gain (100)
- --------------------------------------------------------------------------------
Taxes on income before
extraordinary gain $ 57 $513 $433
================================================================================
The above amounts do not include tax benefits from the exercise of stock
options and the vesting of restricted stock awards, which for accounting
purposes are credited directly to additional paid-in capital. Such tax benefits
reduced income taxes paid by $37 million in 2001, $190 million in 2000 and $215
million in 1999. The above amounts also do not include a tax benefit of $140
million in 2000 from the conversion of unexercised USTC stock options into
shares of CSC's common stock. Additionally, the above deferred amounts do not
include tax expenses or benefits related to intangible assets recorded in
connection with the acquisition of CyberTrader, and other comprehensive income
(loss).
- 35 -
The temporary differences that created deferred tax assets and liabilities,
included in other assets, and accrued expenses and other liabilities, are
detailed below:
December 31, 2001 2000
- --------------------------------------------------------------------------------
Deferred tax assets:
Deferred compensation and employee benefits $152 $147
Reserves and allowances 128 47
Net loss on cash flow hedging instruments 23
Trust and fiduciary activities 10 8
Property and equipment leasing 7 6
Other 9 7
- --------------------------------------------------------------------------------
Total deferred assets 329 215
- --------------------------------------------------------------------------------
Deferred tax liabilities:
Capitalized internal-use software development
costs (70) (61)
Net unrealized (gains) losses on securities
available for sale (5) 2
Depreciation and amortization (5) (11)
State and local taxes (3) (2)
Asset valuation (1) 7
- --------------------------------------------------------------------------------
Total deferred liabilities (84) (65)
- --------------------------------------------------------------------------------
Net deferred tax asset $245 $150
================================================================================
The Company determined that no valuation allowance against deferred tax
assets at December 31, 2001 and 2000 was necessary.
The effective income tax rate on income before extraordinary gain differs
from the amount computed by applying the federal statutory income tax rate as
follows:
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Federal statutory income tax rate 35.0% 35.0% 35.0%
State income taxes, net of
federal tax benefit 1.6 3.4 3.5
Goodwill amortization 14.8 1.3 .2
Variable life insurance (6.5)
Restructuring of international operations (4.9)
Merger-related costs 1.3
Non-deductible penalties 2.6
Other charges (.4) .7 .7
- --------------------------------------------------------------------------------
Effective income tax rate 42.2% 41.7% 39.4%
================================================================================
In 2001, the effective income tax rate including the extraordinary gain was
44.1%.
16. Employee Incentive and Deferred Compensation Plans
The Company's employee incentive and deferred compensation plans consist of
CSC's and U.S. Trust's plans that were in effect prior to the merger with USTC.
The following summarizes such 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 ten years from the date of grant. Options
generally vest over a four-year period from the date of grant.
The Company granted to all non-officer employees 26 million, 11 million and 6
million options in 2001, 2000 and 1999(a), respectively.
A summary of option activity follows:
2001 2000 1999 (a)
-------------------------- -------------------------- ----------------------------
Weighted- Weighted- Weighted-
Average Average Average
Number Exercise Number Exercise Number Exercise
of Options Price of Options Price of Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 97 $ 16.46 90 $ 10.31 100 $ 5.10
Granted (1) 68 $ 15.43 29 $ 26.27 19 $ 27.10
Exercised (6) $ 4.73 (20) $ 2.74 (26) $ 2.15
Canceled (6) $ 24.10 (2) $ 20.15 (3) $ 12.26
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
end of year 153 $ 16.20 97 $ 16.46 90 $ 10.31
====================================================================================================================================
Exercisable at
end of year 54 $ 11.31 38 $ 7.02 40 $ 3.71
====================================================================================================================================
Available for
future grant at
end of year 50 22 37
====================================================================================================================================
Weighted-average
fair value of
options granted
during the year (1) $7.26 $15.44 $12.34
====================================================================================================================================
(1) In 2000, 3 million options were granted and exchanged for outstanding options of CyberTrader. The exercise prices for
individual options granted retained the excess of the market value over the exercise price on each CyberTrader option canceled. The
weighted-average exercise price of these options is $1.04 and the weighted-average fair value is $28.27. The remaining 26 million
options were granted with an exercise price equal to the fair market value of the Company's common stock on the date of grant. The
weighted-average exercise price of these options is $29.23 and the weighted-average fair value is $13.93.
- --------
(a)1999 stock options were granted prior to the merger with USTC, and therefore
did not include U.S. Trust employees.
- 36 -
Options outstanding and exercisable are as follows:
December 31, 2001
- ------------------------------------------------------------------------------------------------------------------------------------
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
- ------------------------------------------------------------------------------------------------------------------------------------
$ 1.00 to $ 7.00 21 4.0 $ 3.97 21 $ 3.96
$ 7.01 to $ 10.00 20 6.0 $ 8.33 14 $ 8.30
$ 10.01 to $ 15.00 25 9.0 $11.97 4 $12.13
$ 15.01 to $ 19.00 31 9.4 $15.41 $16.25
$ 19.01 to $ 26.00 26 7.8 $21.86 10 $21.82
$ 26.01 to $ 40.00 30 8.3 $29.62 5 $29.95
- ------------------------------------------------------------------------------------------------------------------------------------
$ 1.00 to $ 40.00 153 7.7 $16.20 54 $11.31
====================================================================================================================================
The following tables summarize U.S. Trust's option activities. On the closing
date of the merger with USTC, 8 million USTC stock options were converted into
shares of CSC's common stock based upon the excess of the market value over the
exercise price of the unexercised stock options as of that date, net of the
number of shares required to satisfy the participant's payroll tax withholding
obligation.
2000 1999
------------------------------ -------------------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
- ----------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 13 $ 8.39 12 $ 6.96
Granted 2 $ 14.86
Exercised (5) $ 7.06 (1) $ 5.37
Converted
into CSC's
common stock (8) $ 9.15
- ----------------------------------------------------------------------------------------------------------------------------
Outstanding at
end of year 13 $ 8.39
============================================================================================================================
Exercisable at
end of year 5 $ 6.19
============================================================================================================================
Available for
future grant at
end of year 3
============================================================================================================================
Weighted-average
fair value of
options granted
during the year $4.53
============================================================================================================================
The fair value of each option granted is estimated as of the grant date using
the Black-Scholes option-pricing model with the following assumptions:
Company(b) USTC
--------------------- ------
2001 2000 1999 1999
- --------------------------------------------------------------------------------
Expected dividend yield .30% .40% .50% 1.10%
Expected volatility 50% 48% 46% 29%
Risk-free interest rate 4.3% 6.0% 5.5% 4.6%
Expected life (in years) 5 5 5 5
- --------------------------------------------------------------------------------
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations in accounting for its
stock option plans under which there is generally no charge to earnings, except
for restructuring-related expense for officers' stock option compensation. Had
compensation expense for the Company's options been determined based on the fair
value at the grant dates for awards under those plans consistent with the fair
value method of SFAS No. 123 - Accounting for Stock-Based Compensation, the
Company's net income and earnings per share would have been reduced to the pro
forma amounts presented below:
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Net Income: As reported $ 199 $ 718 $ 666
Pro forma $ 32 $ 606 $ 605
================================================================================
Basic Earnings
Per Share: As reported $ .14 $ .53 $ .51
Pro forma $ .02 $ .45 $ .46
Diluted Earnings
Per Share: As reported $ .14 $ .51 $ .49
Pro forma $ .02 $ .43 $ .44
================================================================================
Restricted Stock Plans
The Company's stock incentive plans provide for granting restricted stock
awards to employees and officers. Restricted stock awards are restricted from
sale and generally vest over a four-year period, but some vest based upon the
Company achieving certain financial or other measures. The fair market value of
shares associated with the restricted stock awards is recorded as unamortized
stock-based compensation in stockholders' equity and is amortized to
compensation expense over the vesting periods.
Restricted stock information is as follows(c):
2001 2000 1999
- --------------------------------------------------------------------------------
Restricted stock awards 1 2
Average market price of awarded shares $18.15 $27.73 $24.99
Restricted shares outstanding (at year end) 5 8 9
Restricted stock expense and amortization $ 27 $ 32 $ 25
================================================================================
- --------
(b)The assumptions for 1999 relate to options granted prior to the merger with
USTC which did not include U.S. Trust Employees.
(c)1999 restricted stock awards were granted prior to the merger with USTC, and
therefore did not include U.S. Trust employees.
- 37 -
Other Deferred Compensation Plans
The Company sponsors deferred compensation plans for both officers and
non-employee directors. The Company's unfunded deferred compensation plan for
officers permits participants to defer the payment of certain cash compensation.
The deferred compensation liability was $199 million and $195 million at
December 31, 2001 and 2000, respectively. The Company's unfunded 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.
In 1999, the Company issued 111,000 shares of CSC's common stock and placed
such shares into a trust to settle the directors' deferred compensation
liability. In accordance with EITF No. 97-14 - Accounting for Deferred
Compensation Arrangements Where Amounts Earned are Held in a Rabbi Trust and
Invested, assets of the trust are consolidated with those of the Company and the
value of CSC's common stock held in the stock trust is classified in
stockholders' equity in a manner similar to treasury stock. The shares and the
corresponding obligation to directors are shown as separate components of
stockholders' equity in the Company's consolidated statement of stockholders'
equity.
17. 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. 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
401(k) Retirement Savings and Investment Plan (SchwabPlan). The Company matches
certain employee contributions; additional contributions to this plan are at the
discretion of the Company. Total company contribution expense was $49 million in
2001, $78 million in 2000 and $74 million in 1999.
In 2000, the final payment on the Company's note receivable from the employee
stock ownership plan (ESOP) was received and all remaining shares were allocated
to eligible participants. The fair value of shares released for allocation to
employees through the ESOP was recognized by the Company as compensation and
benefits expense - $31 million in 2000 and $3 million in 1999. At December 31,
2000, the ESOP held a total of 42 million shares of common stock. In 2001,
substantially all shares held in the Company's ESOP were converted into units
and transferred to the Schwab Equity Unit Fund in the SchwabPlan.
U.S. Trust sponsors a 401(k) Plan and ESOP covering all U.S. Trust employees
who have met the specified service requirement. Effective January 1, 1999, U.S.
Trust began matching certain employees' U.S. Trust 401(k) plan contributions in
the form of common stock. Total contribution expense under the U.S. Trust 401(k)
Plan was $7 million in 2001 and $4 million in 2000. At December 31, 2001 and
2000, the U.S. Trust ESOP held a total of 7 million and 8 million shares of
common stock, respectively.
Pension and Other Postretirement Benefits
U.S. Trust provides a trusteed, noncontributory, qualified defined benefit
pension plan to substantially all U.S. Trust employees. Benefits are based upon
years of service, average compensation over the final years of service and the
social security covered compensation. U.S. Trust uses the projected unit credit
cost method to compute the vested benefit obligation, where the vested benefit
obligation is the actuarial present value of the vested benefits to which the
employee is entitled based on the employee's expected date of separation or
retirement.
In addition, U.S. Trust provides certain health care and life insurance
benefits which are unfunded for all employees, 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.
The assumed rate of future increases in per capita cost of health care
benefits (the health care cost trend rate) is 13.0% in 2001, decreasing
gradually to 5.5% in the year 2009. A one percentage point change in the assumed
health care cost trend rates would not have a material effect on the
postretirement benefit obligation.
- 38 -
2001 2000 1999
---------------------------------- -------------------------------- ---------------------------------
Pension Health & Pension Health & Pension Health &
Plan Life Total Plan Life Total Plan Life Total
- ------------------------------------------------------------------------------------------------------------------------------------
Components of expense
(credit):
Service cost and
expenses $ 9 $ 9 $ 8 $ 8 $ 9 $ 9
Interest cost 17 $ 1 18 16 $ 1 17 15 $ 1 16
Actual (gain) loss on
plan assets 78 78 (9) (9) (84) (84)
Other net amortizations
and deferrals (116) (116) (25) (25) 59 59
- ------------------------------------------------------------------------------------------------------------------------------------
Net expense (credit) (1) $ (12) $ 1 $ (11) $ (10) $ 1 $ (9) $ (1) $ 1
- ------------------------------------------------------------------------------------------------------------------------------------
Change in plan assets:
Fair value of plan
assets at
beginning of year $ 369 $ 367 $ 291
Actual gain (loss) on
plan assets (78) 9 85
Employer
contribution $ 1 $ 1 $ 2
Benefits and expenses
paid (10) (1) (7) (1) (9) (2)
- ------------------------------------------------------------------------------------------------------------------------------------
Fair value of plan assets
at end of year $ 281 $ 369 $ 367
- ------------------------------------------------------------------------------------------------------------------------------------
Change in benefit
obligation:
Benefit obligation at
beginning of year $ 211 $ 20 $ 200 $ 19 $ 220 $ 21
Service cost 9 8 9
Interest cost 17 1 16 2 15 2
Actuarial (gain) loss 16 (6) (35) (2)
Benefits paid (9) (1) (7) (1) (9) (2)
Amendments 4
- ------------------------------------------------------------------------------------------------------------------------------------
Benefit obligation at
end of year $ 248 $ 20 $ 211 $ 20 $ 200 $ 19
- ------------------------------------------------------------------------------------------------------------------------------------
Prepaid (accrued) cost:
Excess of plan assets
over benefit
obligation $ 34 $ (20) $ 158 $ (20) $ 166 $ (19)
Unrecognized cumulative
net (gains) losses 10 (1) (120) (1) (136) (1)
Unrecognized prior
service cost 5 (1) 1 (1) 1 (2)
Unrecognized net
liability (asset) at
date of initial
application (2) (5)
- ------------------------------------------------------------------------------------------------------------------------------------
Prepaid (accrued) cost $ 49 $ (22) $ 37 $ (22) $ 26 $ (22)
- ------------------------------------------------------------------------------------------------------------------------------------
Discount rate 7.50% 7.50% 8.00% 8.00% 8.00% 8.00%
Rate of increase in
salary (2) 6.10% 6.10% 6.10% 6.10% 6.00% 6.00%
Health care cost trend N/A 13.00% N/A 8.00% N/A 8.50%
rate
Expected rate of return
on plan assets 9.00% N/A 9.00% N/A 9.00% N/A
- -----------------------------------------------------------------------------------------------------------------------------------
(1) The pension expense (credit) and postretirement benefit expense (credit) 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.
(2) The rate of increase in compensation is based on an age-related table with assumed rates of increase in compensation ranging
from 9.0% to 3.5%. The amount shown is the average assumed rate of increase for the given plan year.
N/A Not applicable.
- 39 -
18. 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:
2001 2000 1999
- --------------------------------------------------------------------------------
Net loss on cash flow
hedging instruments, net of tax:
Cumulative effect of accounting
change for adoption of
SFAS No. 133 $ (12)
Change during the year (19)
- --------------------------------------------------------------------------------
Ending balance $ (31)
================================================================================
Foreign currency translation
adjustment:
Beginning balance $ (11) $ 5 $ 2
Change during the year (2) (16) 3
- --------------------------------------------------------------------------------
Ending balance $ (13) $ (11) $ 5
================================================================================
Net unrealized gain (loss)on
securities available for sale,
net of tax:
Beginning balance $ (3) $ (13) $ 4
Net unrealized gain (loss)
arising during the year 5 10 (17)
Reclassification adjustment
for realized loss included
in net income 5
- --------------------------------------------------------------------------------
Ending balance $ 7 $ (3) $ (13)
================================================================================
Total accumulated other
comprehensive income (loss),
net of tax:
Beginning balance $ (14) $ (8) $ 6
Change during the year (23) (6) (14)
- --------------------------------------------------------------------------------
Ending balance $ (37) $ (14) $ (8)
================================================================================
19. Earnings Per Share
Basic earnings per share (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. Earnings per share under the basic and diluted computations
are as follows:
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Net income $ 199 $ 718 $ 666
================================================================================
Weighted-average common
shares outstanding - basic 1,373 1,360 1,310
Common stock equivalent shares
related to stock incentive plans 26 44 63
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,399 1,404 1,373
================================================================================
Basic earnings per share:
Income before
extraordinary gain $ .06 $ .53 $ .51
Extraordinary gain, net of tax $ .08
Net income $ .14 $ .53 $ .51
================================================================================
Diluted earnings per share:
Income before
extraordinary gain $ .06 $ .51 $ .49
Extraordinary gain, net of tax $ .08
Net income $ .14 $ .51 $ .49
================================================================================
The computation of diluted EPS for the years ended December 31, 2001, 2000
and 1999, respectively, excludes outstanding stock options to purchase 83
million, 13 million and 8 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.
20. 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 Gramm-Leach-Bliley Act (the GLB 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 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 and the Federal Reserve Board may 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.
- 40 -
CSC's primary depository institution subsidiary is U.S. Trust NY. 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, including requirements governing:
transactions with CSC and its non-depository institution subsidiaries, loans and
other extensions of credit, investments or asset purchases, or otherwise
financing or supplying funds to CSC; dividends; investments; and aspects of
CSC's operations. 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, U.S. Trust 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.
On July 11, 2001 USTC and U.S. Trust NY (collectively, USTC/USTNY) entered
into a cease and desist order (the order) with the Federal Reserve Board and the
Superintendent of Banks of the State of New York (State). Under the order,
USTC/USTNY neither admitted nor denied that it had violated any law, but was
required to pay a $5 million penalty to the Federal Reserve Board and a $5
million penalty to the State for alleged violations of various reporting and
recordkeeping requirements. There was no allegation that client assets were
exposed to any risk of loss, nor that there were any evidence or
misappropriation or misuse of client funds on the part of any USTC/USTNY
employee. In addition, the order required USTC/USTNY to take a number of steps
to review and improve its risk management processes and systems with respect to
the Bank Secrecy Act and banking and securities laws and to provide regular
reports to regulators concerning the progress of such measures.
USTC/USTNY reached an agreement with the regulators on a plan to improve risk
management processes and systems in response to the order. Although the order
remains in effect, the Company believes the measures USTC/USTNY have taken, and
have committed to take in the future, will be sufficient to address
substantially all of the issues identified in the order in a timely manner.
Under the Act, the Federal Reserve Board has established consolidated capital
requirements for bank holding companies. CSC is subject to those guidelines. The
GLB 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.
The Company's, U.S. Trust's and U.S. Trust NY's regulatory capital and ratios
are as follows:
2001 2000
----------------- -----------------
December 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $3,606 19.8% $ 3,678 14.6%
U.S. Trust $ 564 16.0% $ 556 20.3%
U.S. Trust NY $ 319 11.2% $ 370 16.7%
Total Capital:
Company $3,632 19.9% $ 3,710 14.7%
U.S. Trust $ 585 16.6% $ 577 21.0%
U.S. Trust NY $ 337 11.8% $ 388 17.5%
Leverage:
Company $3,606 9.7% $ 3,678 10.4%
U.S. Trust $ 564 8.9% $ 556 11.1%
U.S. Trust NY $ 319 6.3% $ 370 9.4%
- --------------------------------------------------------------------------------
(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.
Well-capitalized tier 1 capital, total capital and tier 1 leverage ratios are
6%, 10% and 5%, respectively. Each of CSC's other depository institution
subsidiaries exceed the well-capitalized standards set forth by the banking
regulatory authorities.
Based on their respective regulatory capital ratios at December 31, 2001 and
2000, the Company, U.S. Trust and U.S. Trust NY are considered well capitalized
(the highest category). There are no conditions or events that management
believes have changed the Company's, U.S. Trust's and U.S. Trust NY's
well-capitalized status.
To remain a financial holding company, each of CSC's depository institution
subsidiaries must be well capitalized and well managed. In addition, each of
CSC's insured depository institution subsidiaries must be rated "satisfactory"
or better on the institutions' records of meeting the credit needs of their
communities under the Community Reinvestment Act of 1977 in order for CSC to
engage in new financial activities or, with certain limited exceptions, acquire
a company engaged in financial activities.
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 $62 million in 2001 and $55 million in 2000.
Schwab and SCM are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule). Schwab and SCM compute net capital
under the alternative method permitted by this Rule. This method requires the
maintenance of minimum net capital, as defined, of the greater of 2% of
aggregate debit balances arising from client transactions or a minimum dollar
amount, which is based on the type of business conducted by the broker-dealer.
The minimum dollar amount for both Schwab and SCM is $1 million. Under the
alternative method, a broker-dealer may not repay subordinated borrowings, pay
cash dividends,
- 41 -
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 amount requirement. At December 31,
2001, Schwab's net capital was $1.2 billion (12% of aggregate debit balances),
which was $968 million in excess of its minimum required net capital and $673
million in excess of 5% of aggregate debit balances. At December 31, 2001, SCM's
net capital was $14 million, which was $13 million in excess of its minimum
required net capital.
Schwab, SCM and CSE had portions of their cash and investments segregated for
the exclusive benefit of clients at December 31, 2001, in accordance with
applicable regulations.
21. Commitments and Contingent Liabilities
The Company has noncancelable operating leases for office space and
equipment. Future minimum rental commitments, including guaranteed residual
values, under these leases at December 31, 2001 are as follows:
- --------------------------------------------------------------------------------
2002 $ 267
2003 240
2004 203
2005 349
2006 122
Thereafter 632
- --------------------------------------------------------------------------------
Total $ 1,813
================================================================================
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 $365 million in 2001, $298 million in 2000 and $218 million in
1999. At December 31, 2001, the Company had other commitments totaling $20
million, which include a guarantee on a bank credit facility and committed
capital contributions to venture capital funds.
During 2001, the Company began occupying and making lease payments on a newly
renovated office building. The lease for the building was arranged by working
with a bank to create an unconsolidated special purpose trust (Trust). The
Trust, through an agent, raised the $245 million needed to acquire and renovate
the building by issuing long-term debt ($235 million) and raising equity capital
($10 million). The Company's lease payments to the Trust vary with fluctuations
in interest rates and are structured to cover the interest on the debt
obligations and a specified return on the equity. This financing arrangement is
known as a synthetic lease. Upon the expiration of the lease in June 2005, the
Company may renew the lease for an additional five years subject to certain
approvals and conditions, or arrange a sale of the office building to a third
party. The Company also has an option to purchase the office building for $245
million at any time after June 18, 2003. The Company has provided the Trust with
a residual value guarantee, which means that if the building is sold to a third
party the Company is responsible for making up any shortfall between the actual
sales price and the $245 million funded by the Trust, up to a maximum of $202
million. The Company has recently obtained a preliminary appraisal of $200
million for the estimated value of the building at the end of the lease term.
The shortfall in estimated value below $245 million will be recorded as expense
using the straight-line method over the remaining term of the lease.
In March 2000, three purported class action complaints were filed against
U.S. Trust Company, N.A. (USTC, N.A.) in the U.S. District Court in Louisiana.
All three suits are brought on behalf of participants in an employee stock
ownership plan (UC ESOP) sponsored by United Companies Financial Corporation
(United Companies), which is currently in bankruptcy proceedings in Delaware.
Plaintiffs allege that USTC, N.A., as directed trustee of UC ESOP, breached its
fiduciary duties under the Employee Retirement Income Security Act of 1974 by
failing to diversify the assets of UC ESOP. Damages were not specified. In
November 2000, the plaintiffs filed a consolidated complaint for all three
purported class actions, which USTC, N.A. answered, denying all liability. In
December 2001, plaintiffs and USTC, N.A. reached a tentative settlement. Under
the terms of this settlement, plaintiffs would release USTC, N.A. of all
liability. Other than an insignificant deductible, the settlement payment would
be paid from insurance coverage. The settlement is expected to be presented to
the court for its approval after notice to members of the class.
In 2001, three purported class action complaints and a number of related
individual cases were filed against U.S. Trust NY and other defendants. In some
of these cases, USTC, N.A. was also named as a defendant. The plaintiffs in all
of these cases are former personal injury plaintiffs (Payees) who are entitled
to future payments under "structured settlement" agreements. The settlement
payments are obligations of Stanwich Financial Services Corp. (Stanwich), as
Trustor of certain Trusts, and Stanwich has defaulted on certain of those
obligations. USTC, N.A. served as Trustee of the Trusts from approximately
December of 1992 to March of 1994, and U.S. Trust NY served as Trustee from
approximately September 1998 until its recent resignation. At some time during
the period from March of 1994 to September of 1998, while an unrelated trust
company was the Trustee of the Trusts, the U.S. Treasury securities held by the
trusts were pledged as collateral for a loan or loans and then lost through
foreclosure. The class actions and all but two of the individual cases have been
filed in California, and have been consolidated. The other two individual cases
have been filed in Montana. In the complaints now applicable to the cases, the
plaintiffs allege that, as Trustee during their respective tenures, U.S. Trust
NY and USTC, N.A. owed certain duties to the Payees, and
- 42 -
breached those duties in various ways. The plaintiffs in these cases seek
unspecified compensatory damages, punitive damages and other relief. In the
cases, U.S. Trust NY and USTC, N.A. have answered the complaints, denying the
material allegations and raising affirmative defenses, and have filed
cross-complaints for indemnity against other defendants in the cases. U.S. Trust
NY and USTC, N.A. intend to defend the cases vigorously.
On October 24, 2001, partnership and individual plaintiffs filed a complaint
in the United States District Court in California (Betker Action) against U.S.
Trust Company of Texas, N.A. (US Trust Texas) and other defendants, including
USTC, in which the plaintiffs seek to hold the defendants liable for losses that
the plaintiffs sustained in connection with the defaults of certain bond
offerings (Heritage Bond Offerings). On November 26, 2001, the receiver for
certain bond funds (Heartland Funds), filed a complaint in the U.S. District
Court of Illinois (Heartland Action) against US Trust Texas, seeking to hold it
liable for losses allegedly sustained by the Heartland Funds in connection with
the Heritage Bond Offerings. On November 30, 2001, a plaintiff filed a purported
class action complaint in California state court (Kivenson Class Action),
against US Trust Texas, and other defendants, including USTC. The Kivenson Class
Action seeks to hold defendants liable for losses allegedly sustained by the
putative class in connection with the Heritage Bond Offerings.
US Trust Texas was indenture trustee under various Indentures executed in
connection with the Heritage Bond Offerings. Although USTC sold its corporate
trust business in 2001, under the sale agreement, USTC retains responsibility
for certain litigation, including these cases. In the complaints, the plaintiffs
allege that, as indenture trustee, US Trust Texas breached certain duties owed
to the plaintiffs. The plaintiffs in the Betker Action and the Kivenson Class
Action seek unspecified compensatory damages, punitive damages and other relief.
The representative plaintiff in the Heartland Action seeks compensatory damages
in excess of $4.8 million, punitive damages and other relief. US Trust Texas and
USTC have not yet answered any of these complaints. They intend to defend all of
these cases vigorously.
The nature of the Company's business subjects it to claims, lawsuits,
regulatory examinations and other proceedings in the ordinary course of
business. The ultimate outcome of the legal proceedings described above and the
various other lawsuits, arbitration proceedings, and claims pending against the
Company cannot be determined at this time, and the results of these legal
proceedings cannot be predicted with certainty. There can be no assurance that
these legal proceedings will not have a material adverse effect on the Company's
results of operations in any future period, depending partly on the results for
that period, and a substantial judgment could have a material adverse impact on
the Company's financial condition and results of operations. However, it is the
opinion of management, after consultation with legal counsel, that the ultimate
outcome of these actions will not have a material adverse impact on the
financial condition or operating results of the Company.
22. Financial Instruments Subject to Off-Balance-Sheet Risk or Credit Risk
Through Schwab and SCM, 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 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.
Schwab provides margin loans to its clients which are collateralized by
securities in their brokerage accounts. These clients have agreed to allow
Schwab to sell or repledge those securities in accordance with federal
regulations. Schwab was allowed, under such regulations, to sell or repledge
securities with a market value of $13.1 billion and $22.3 billion at December
31, 2001 and 2000, respectively. The market value of Schwab's client securities
pledged to fulfill the short sales of its clients was $894 million and $477
million at December 31, 2001 and 2000, respectively, and the market value of
Schwab's client securities pledged in securities lending transactions to other
broker-dealers was $554 million and $864 million at December 31, 2001 and 2000,
respectively. The market value of Schwab's client securities pledged to fulfill
Schwab's and SCM's proprietary short sales was $15 million and $27 million at
December 31, 2001 and 2000, respectively. Additionally, Schwab borrows
securities from other broker-dealers to fulfill short sales of its clients. The
market value of these pledged securities was $247 million and $6 million at
December 31, 2001 and 2000, respectively. Schwab has also pledged a portion of
its securities owned in
- 43 -
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 $1 million and $3 million at December 31, 2001 and 2000,
respectively.
In the normal course of its margin lending activities, Schwab may be liable
for the margin requirement of 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.
In its capacity as market maker, SCM maintains inventories in Nasdaq and
other securities on both a long and short basis. While long inventory positions
represent SCM's ownership of securities, short inventory positions represent
SCM's obligations to deliver specified securities at a contracted price, which
may differ from market prices prevailing at the time of completion of the
transaction. Accordingly, both long and short inventory positions may result in
losses or gains to SCM as market values of securities fluctuate. Also, the
Company maintains inventories on both a long and short basis in exchange-listed
securities relating to its specialist operations and proprietary equity trading
operations. The Company also maintains inventories in securities on a long 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.
Additionally, the Company may purchase or sell exchange-traded futures and
options to offset market risk on these inventories. The notional amount of such
derivatives was $148 million and $66 million at December 31, 2001 and 2000,
respectively. The estimated fair value of such derivatives was not material to
the Company's consolidated balance sheets at December 31, 2001 and 2000.
Schwab and U.S. Trust enter 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, 2001 and 2000,
the market value of collateral received in connection with resale agreements
that is available to be repledged or sold is $15.3 billion and $7.3 billion,
respectively.
At December 31, 2001 and 2000, financial instruments in the amount of $809
million and $421 million, respectively, were pledged to secure public deposits,
to qualify for fiduciary powers and for other purposes or as collateral for
borrowings. Included in the above amounts at December 31, 2001 and 2000, the
fair value of collateral pledged under repurchase agreements that is available
to be repledged or sold by the counterparties is $184 million and $101 million,
respectively.
In the normal course of business, U.S. Trust enters into various transactions
involving off-balance sheet financial instruments to meet the needs of its
clients and to reduce its 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 standby letters of credit. 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's firm commitments are related to mortgage lending to private banking
clients. Firm commitments totaled $586 million and $429 million at December 31,
2001 and 2000, respectively. Standby letters of credit are conditional
commitments issued by U.S. Trust to guarantee the performance of a client to a
third party. Standby letters of credit outstanding at December 31, 2001 and 2000
amounted to $77 million and $78 million, respectively. Standby letters of credit
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.
As part of its overall asset and liability management process, U.S. Trust
utilizes Swaps as hedges of the interest rate risk associated with variable rate
deposits from banking clients. 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. U.S. Trust
evaluates the creditworthiness of its counterparties as part of its normal
credit review procedures. At December 31, 2001 and 2000, the Company was a
counterparty to Swaps with a total notional principal amount of $930 million and
$1.0 billion, respectively. Outstanding Swaps had a weighted-average
- 44 -
maturity of approximately 2.6 years at December 31, 2001 and 3.3 years at
December 31, 2000. The estimated fair value of the Swaps was not material to the
Company's consolidated balance sheets at December 31, 2001 and 2000.
23. 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 four
reportable segments - Individual Investor, Institutional Investor, Capital
Markets and U.S. Trust. The Individual Investor segment includes Schwab's
domestic and international retail operations. The Institutional Investor segment
provides custodial, trading and support services to independent investment
managers, serves company 401(k) plan sponsors and third-party administrators,
and supports company stock option plans and stock purchase programs. (The
Company's mutual fund services are considered a product and not a segment.
Mutual fund service fees are included in both the Individual Investor and
Institutional Investor segments.) The Capital Markets segment provides trade
execution services in Nasdaq, exchange-listed and other securities primarily to
broker-dealers, including Schwab, and institutional clients. The U.S. Trust
segment provides investment and wealth management, fiduciary services and
private banking services to individual and institutional clients.
The accounting policies of the segments are the same as those described in
note "2 - Significant Accounting Policies." The Company evaluates the
performance of its segments based on adjusted operating income before taxes,
which excludes non-operating revenue, restructuring and other charges, merger-
and acquisition-related charges and extraordinary gains. 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. Except for
the U.S. Trust segment, for which expenses are directly incurred, technology,
corporate and general administrative expenses are allocated to the remaining
segments generally in proportion to either their respective revenues or average
full-time equivalent employees.
Financial information for the Company's reportable segments is presented in
the table below. Total revenues, net interest revenue, income 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.
- 45 -
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Revenues
Individual Investor $2,531 $3,657 $2,762
Institutional Investor 827 844 635
Capital Markets 315 644 547
U.S. Trust 654 643 542
- --------------------------------------------------------------------------------
Operating revenues 4,327 5,788 4,486
Non-operating revenue (1) 26
- --------------------------------------------------------------------------------
Total $4,353 $5,788 $4,486
================================================================================
Interest Revenue, Net of
Interest Expense
Individual Investor $ 616 $ 940 $ 593
Institutional Investor 134 165 106
Capital Markets 2 6 4
U.S. Trust 177 126 117
- --------------------------------------------------------------------------------
Total $ 929 $1,237 $ 820
================================================================================
Operating Income Before Taxes
Individual Investor $ 245 $ 834 $ 680
Institutional Investor 272 290 180
Capital Markets 18 106 111
U.S. Trust (2) 112 158 128
- --------------------------------------------------------------------------------
Operating Income Before Taxes 647 1,388 1,099
Non-operating revenue (1) 26
Restructuring and other charges (3) (419)
Merger- and acquisition-
related charges (4) (119) (157)
- --------------------------------------------------------------------------------
Income before taxes on income
and extraordinary gain 135 1,231 1,099
Tax expense on income (57) (513) (433)
Extraordinary gain on sale of
corporate trust business,
net of tax of $100 121
- --------------------------------------------------------------------------------
Net Income $ 199 $ 718 $ 666
================================================================================
Capital Expenditures
Individual Investor $ 203 $ 483 $ 264
Institutional Investor 51 95 52
Capital Markets 25 83 38
U.S. Trust 36 44 19
- --------------------------------------------------------------------------------
Total $ 315 $ 705 $ 373
================================================================================
Depreciation and Amortization (5)
Individual Investor $ 294 $ 226 $ 114
Institutional Investor 51 34 26
Capital Markets 26 23 17
U.S. Trust 33 25 24
- --------------------------------------------------------------------------------
Total $ 404 $ 308 $ 181
================================================================================
(1)Primarily consists of a gain on the sale of an investment.
(2)Excludes an extraordinary pre-tax gain of $221 million from the sale of
USTC's Corporate Trust business for 2001.
(3)Restructuring charges primarily include costs relating to workforce,
facilities, systems hardware, software and equipment reductions. Other
charges include a regulatory fine, professional service fees for operational
and risk management remediation, and the write-off of certain software
development costs.
(4)Includes professional fees, change-in-control and retention program
compensation, and other expenses related to the merger with USTC, and
goodwill and intangible asset amortization and retention program compensation
related to the acquisition of CyberTrader.
(5)Includes goodwill amortization.
Fees received from Schwab's proprietary mutual funds represented
approximately 18% of the Company's consolidated revenues in 2001 and 11% in both
2000 and 1999. 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 2001, 2000
and 1999. 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 27% at both December 31, 2001 and 2000
and 25% at December 31, 1999.
24. Supplemental Cash Flow Information
Year Ended December 31, 2001 2000 1999
- --------------------------------------------------------------------------------
Income taxes paid $218 $ 240 $ 182
================================================================================
Interest paid:
Brokerage clients cash balances $706 $1,068 $ 701
Deposits from banking clients 128 155 116
Long-term debt 56 47 30
Stock-lending activities 20 42 31
Short-term borrowings 25 19 7
Other 5 3 7
- --------------------------------------------------------------------------------
Total interest paid $940 $1,334 $ 892
================================================================================
Non-cash investing and financing
activities:
Common stock and options issued
for purchases of businesses $ 71 $ 529 $ 45
================================================================================
- 46 -
Management's Report
To Our Stockholders:
Management of the Company is responsible for the preparation, integrity and
objectivity of the consolidated financial statements and the other financial
information presented in this annual report. To meet these responsibilities we
maintain a system of internal control that is designed to provide reasonable
assurance as to the integrity and reliability of the financial statements, the
protection of Company and client assets from unauthorized use, and the execution
and recording of transactions in accordance with management's authorization. The
system is augmented by careful selection of our managers, by organizational
arrangements that provide an appropriate division of responsibility and by
communications programs aimed at assuring that employees adhere to the highest
standards of personal and professional integrity. The Company's internal audit
function monitors and reports on the adequacy of and compliance with our
internal controls, policies and procedures. Although no cost-effective internal
control system will preclude all errors and irregularities, we believe the
Company's system of internal control is adequate to accomplish the objectives
set forth above.
The consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America and
necessarily include some amounts that are based on estimates and our best
judgments. The financial statements have been audited by the independent
accounting firm of Deloitte & Touche LLP, who were given unrestricted access to
all the Company's financial records and related data. We believe that all
representations made to Deloitte & Touche LLP during their audit were valid and
appropriate.
The Board of Directors through its Audit Committee, which is comprised
entirely of nonmanagement directors, has an oversight role in the area of
financial reporting and internal control. The Audit Committee periodically meets
with Deloitte & Touche LLP, our internal auditors and Company management to
discuss accounting, auditing, internal controls over financial reporting and
other matters.
/s/Charles R. Schwab
Chairman of the Board and Co-Chief Executive Officer
/s/David S. Pottruck
President and Co-Chief Executive Officer
/s/Christopher V. Dodds
Executive Vice President and Chief Financial Officer
Independent Auditors' Report
To the Stockholders and Board of Directors 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, 2001 and
2000, and the related consolidated statements of income, stockholders' equity
and cash flows for each of the three years in the period ended December 31,
2001. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of The Charles Schwab Corporation and
subsidiaries at December 31, 2001 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2001 in conformity with accounting principles generally accepted in the
United States of America.
/s/DELOITTE & TOUCHE LLP
San Francisco, California
March 8, 2002
Quarterly Financial Information (Unaudited) The Charles Schwab Corporation
(In Millions, Except Per Share Data and Ratios)
Weighted Basic Diluted Dividends
Average Earnings Earnings Declared Range
Expenses Net Common (Loss) (Loss) Per of Common Range of
Excluding Income Shares- Per Per Common Stock Price Price/Earnings
Revenues Interest (Loss)(1) Diluted Share(2) Share(2) Share(3) Per Share Ratio(4)
- -----------------------------------------------------------------------------------------------------------------------------------
2001 by Quarter (5)
Fourth $1,059 $1,088 $ (13) 1,362 $(.01) $(.01) $.0110 $16.30 - 10.38 116 - 74
Third 1,023 997 13 1,395 .01 .01 .0110 16.18 - 8.13 65 - 33
Second 1,071 1,097 102 1,405 .07 .07 .0110 23.18 - 13.14 68 - 39
First 1,200 1,036 97 1,410 .07 .07 .0110 33.00 - 14.50 92 - 40
- -----------------------------------------------------------------------------------------------------------------------------------
2000 by Quarter (6)
Fourth $1,335 $1,109 $ 139 1,414 $ .10 $ .10 $.0110 $35.88 - 25.69 70 - 50
Third dividend increase 1,323 1,083 142 1,415 .10 .10 .0110 40.50 - 30.00 74 - 55
Second stock split 1,404 1,151 137 1,407 .10 .09 .0094 40.58 - 24.00 72 - 43
First 1,726 1,214 300 1,390 .23 .22 .0093 44.75 - 22.46 76 - 38
- -----------------------------------------------------------------------------------------------------------------------------------
1999 by Quarter
Fourth $1,274 $ 959 $ 190 1,374 $ .15 $ .14 $.0094 $31.17 - 17.96 64 - 37
Third stock split 1,015 779 144 1,376 .11 .11 .0093 37.67 - 21.33 84 - 47
Second 1,117 835 171 1,377 .13 .12 .0093 51.67 - 26.67 123 - 64
First 1,080 814 161 1,366 .12 .12 .0093 32.67 - 16.96 88 - 46
- -----------------------------------------------------------------------------------------------------------------------------------
1998 by Quarter
Fourth dividend increase /
stock split $ 905 $ 703 $ 122 1,349 $ .10 $ .10 $.0093 $22.83 - 7.03 74 - 23
Third 819 630 114 1,339 .08 .08 .0089 10.22 - 6.17 38 - 23
Second 746 595 91 1,338 .08 .07 .0089 8.89 - 6.58 36 - 26
First 708 572 83 1,345 .06 .06 .0089 9.32 - 7.58 39 - 32
- -----------------------------------------------------------------------------------------------------------------------------------
1997 by Quarter (7)
Fourth dividend increase $ 721 $ 595 $ 76 1,346 $ .06 $ .06 $.0089 $ 9.83 - 6.50 41 - 27
Third stock split 706 557 90 1,339 .07 .06 .0074 8.13 - 5.93 34 - 25
Second 621 495 76 1,333 .06 .06 .0074 6.35 - 4.50 28 - 20
First 624 494 79 1,332 .06 .06 .0074 6.22 - 4.50 27 - 20
- -----------------------------------------------------------------------------------------------------------------------------------
(1)2001, 2000 and 1999 include an accounting change, for certain internal-use software development costs to conform with Statement
of Position 98-1, totaling $16 million, $55 million and $41 million after-tax, respectively. Excluding this accounting change,
net income would have been $183 million in 2001, $663 million in 2000 and $625 million in 1999.
(2)2001 includes the effect of an extraordinary gain of $.08 per share.
(3)Dividends declared per common share do not include dividends declared by U.S. Trust Corporation prior to the completion of the
merger in 2000.
(4)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.
(5)2001 includes an extraordinary gain, non-operating revenue (which primarily consists of a gain on the sale of an investment),
restructuring and other charges and merger- and acquisition-related costs totaling $208 million after-tax. Excluding this amount,
net income would have been $407 million and the after-tax profit margin would have been 9.4%.
(6)2000 includes merger- and acquisition-related costs totaling $131 million after-tax. Excluding this amount, net income would
have been $849 million and the after-tax profit margin would have been 14.7%.
(7)1997 includes charges for a litigation settlement of $24 million after-tax. Excluding this amount, net income would have been
$345 million and the after-tax profit margin would have been 12.9%.
- 48 -
THE CHARLES SCHWAB CORPORATION
Chart Appendix List
In this appendix, the following descriptions of certain charts in portions of
the Company's 2001 Annual Report to Stockholders that are omitted from the EDGAR
Version are more specific with respect to the actual numbers, amounts and
percentages than is determinable from the charts themselves. The Company submits
such more specific descriptions only for the purpose of complying with the
requirements for transmitting portions of this Annual Report on Form 10-K
electronically via EDGAR; such more specific descriptions are not intended in
any way to provide information that is additional to the information otherwise
provided in portions of the Company's 2001 Annual Report to Stockholders.
EDGAR
Version
Page Number Chart Description
2 Bar chart titled "Assets in Client Accounts" representing total
assets in client accounts at year end 2001, 2000, 1999, 1998 and
1997 (years shown on the bottom axis) as follows (billions of
dollars) (bar labeled): $845.9, $871.7, $846.0, $594.3 and
$437.2, respectively; and annual percentage change for 2001,
2000, 1999, and 1998 (percentages shown in area between bars) as
follows: (3%), 3%, 42% and 36%, respectively.
8 Stacked bar chart titled "Revenues by Segment" representing the
composition of revenues by segment for the years ended December
31, 2001, 2000, and 1999 (years shown on the bottom axis) as
follows (billions of dollars): Individual Investor $2.5, $3.7
and $2.8, respectively; Institutional Investor $.9, $.9 and $.6,
respectively; Capital Markets $.3, $.6 and $.6, respectively;
U.S. Trust $.7, $.6 and $.5, respectively; Revenues by Segment
(bar labeled) $4.4, $5.8 and $4.5, respectively.
16 Bar chart titled "Net Income Plus Depreciation and Amortization
(including Goodwill Amortization)" representing the net income
plus depreciation and amortization (including goodwill
amortization) for the years ended December 31, 2001, 2000 and
1999 (years shown on the bottom axis) as follows (millions of
dollars) (bar labeled): $603, $1,026 and $847, respectively.
- 49 -