EXHIBIT 13.1
The Charles Schwab Corporation
2002 Annual Report to Stockholders
(Only those portions specifically incorporated by reference into
The Charles Schwab Corporation 2002 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 Revenue Per Revenue Trade, and as Noted)
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Growth Rates
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Compounded Annual
5-Year 1-Year
1997-2002 2001-2002 2002 2001 2000 1999 1998
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Operating Results
Revenues 9% (5%) $ 4,135 $ 4,353 $ 5,788 $ 4,486 $ 3,178
Expenses excluding interest 13% (6%) $ 3,967 $ 4,218 $ 4,557 $ 3,387 $ 2,500
Net income (19%) (45%) $ 109 $ 199 $ 718 $ 666 $ 410
Basic earnings per share (1) (20%) (43%) $ .08 $ .14 $ .53 $ .51 $ .32
Diluted earnings per share (1) (20%) (43%) $ .08 $ .14 $ .51 $ .49 $ .31
Adjusted operating income (2) 3% (3%) $ 396 $ 407 $ 849 $ 666 $ 410
Dividends declared per common share (3) 7% $ .0440 $ .0440 $ .0407 $ .0373 $ .0360
Weighted-average common shares outstanding - diluted 1,375 1,399 1,404 1,373 1,343
Non-trading revenues as a percentage of revenues (4) 66% 63% 51% 47% 49%
Trading revenues as a percentage of revenues (4) 34% 37% 49% 53% 51%
Effective income tax rate 42.6% 44.1% 41.7% 39.4% 39.5%
Capital expenditures - cash purchases of equipment, office
facilities, property, and internal-use software
development costs, net 1% (47%) $ 160 $ 301 $ 705 $ 370 $ 199
Capital expenditures as a percentage of revenues 3.9% 6.9% 12.2% 8.3% 6.3%
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Performance Measures
Revenue growth (decline) (5%) (25%) 29% 41% 19%
Pre-tax profit margin - reported 4.6% 8.2% 21.3% 24.5% 21.3%
After-tax profit margin - reported 2.6% 4.6% 12.4% 14.9% 12.9%
After-tax profit margin - operating (2) 9.6% 9.4% 14.7% 14.9% 12.9%
Return on stockholders' equity 3% 5% 21% 31% 27%
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Financial Condition (at year end)
Total assets 14% (2%) $39,705 $40,464 $38,154 $34,322 $26,407
Long-term debt 8% (12%) $ 642 $ 730 $ 770 $ 518 $ 419
Stockholders' equity 24% (4%) $ 4,011 $ 4,163 $ 4,230 $ 2,576 $ 1,673
Assets to stockholders' equity ratio 10 10 9 13 16
Long-term debt to total financial capital
(long-term debt plus stockholders' equity) 14% 15% 15% 17% 20%
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Client Information (at year end)
Active client accounts (5) 11% 3% 8.0 7.8 7.5 6.6 5.6
Client assets (in billions) 12% (10%) $ 764.8 $ 845.9 $ 871.7 $ 846.0 $ 594.3
Total mutual fund assets (in billions) 14% (6%) $ 323.8 $ 342.8 $ 330.3 $ 294.0 $ 218.1
Active independent investment advisors (in thousands) 2% 2% 5.9 5.8 5.7 5.8 5.4
Independent investment advisor client accounts (in thousands) 17% 9% 1,182.4 1,081.7 986.5 848.3 689.9
Independent investment advisor client assets (in billions) 16% (5%) $ 222.4 $ 235.0 $ 231.3 $ 213.1 $ 146.4
Number of Schwab domestic branch offices 7% (2%) 388 395 384 340 291
Number of U.S. Trust offices 12% 34 34 31 28 24
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Employee Information
Full-time equivalent employees (at year end, in thousands) 3% (15%) 16.7 19.6 26.3 20.1 15.1
Revenues per average full-time equivalent employee
(in thousands) 2% 15% $ 220 $ 192 $ 239 $ 249 $ 214
Compensation and benefits expense as a percentage of revenues 44.8% 43.1% 41.7% 42.1% 43.3%
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Clients' Daily Average Trading Volume (in thousands)
Daily average revenue trades 13% (16%) 134.1 159.7 242.0 163.1 97.2
Mutual Fund OneSource and other asset-based trades 10% 4% 56.1 54.0 58.1 45.6 40.3
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Daily average trades 12% (11%) 190.2 213.7 300.1 208.7 137.5
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Average Revenue Per Revenue Trade (10%) 8% $ 37.78 $ 35.02 $ 37.38 $ 45.55 $ 53.44
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(1) Both basic and diluted earnings per share include an extraordinary gain of $.01 per share in 2002 and $.08 per share in 2001.
(2) Represents a non-GAAP income measure, which in 2002 excludes an extraordinary gain, restructuring charges, goodwill and other
impairment charges, and merger- and acquisition-related costs totaling $287 million after-tax. 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.
(3) Dividends declared per common share do not include dividends declared by USTC prior to the completion of the merger in 2000.
(4) Non-trading revenues include asset management and administration fees, net interest revenue, and other revenues. Trading
revenues include commission and principal transaction revenues.
(5) 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.
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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
Revenue 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 8.0 million active client accounts(a). Client assets in these
accounts totaled $764.8 billion at December 31, 2002. Charles Schwab & Co., Inc.
(Schwab) is a securities broker-dealer with 388 domestic branch offices in 48
states, as well as a branch in the Commonwealth of Puerto Rico. U.S. Trust
Corporation (USTC, and with its subsidiaries collectively referred to as U.S.
Trust) is a wealth management firm that through its subsidiaries also provides
fiduciary services and private banking services with 34 offices in 12 states.
Other subsidiaries include 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 primarily to broker-dealers and institutional clients, and
CyberTrader, Inc. (CyberTrader), an electronic trading technology and brokerage
firm providing services to highly active, online traders.
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 advisors (IAs), serves company 401(k) plan sponsors
and third-party administrators, and supports company stock option plans. 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,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients.
Business Strategy
The Company's primary strategy is to serve the needs of individual
investors either directly or indirectly through intermediaries, IAs, or
corporate retirement plan sponsors. Meeting these investment needs entails
offering a variety of financial services including retail brokerage, investment
and wealth management, custody and fiduciary services, support services for IAs,
investment services to companies and their employees (including 401(k) defined
contribution plans), equity securities market-making, and banking and other
financial services. Additionally, the Company provides institutional clients
with equity trade execution services, mutual fund clearing services, investment
management, and fiduciary services.
To pursue its strategy and its objective of long-term profitable growth,
the Company plans to leverage its competitive advantages, which include:
- - a broad range of products, services, and advice offerings,
- - multi-channel delivery systems,
- - an ongoing investment in technology, and
- - nationally recognized brands.
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's
infrastructure and resources are focused on pursuing six strategic priorities:
- - 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;
- - continuing to provide high-quality service to emerging affluent clients -
those with less than $250,000 in assets;
- - 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; and
- - retaining a strong capital markets business to address investors' financial
product and trade execution needs.
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
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(a) Accounts with balances or activity within the preceding eight months.
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for more guidance 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 2002, the Company launched
nationwide its full-service advice and relationship service offering, including
the Schwab Advisor Network (the successor to the Schwab AdvisorSource(R)
referral program), Schwab Private Client, and Schwab Equity Ratings.
The IAs in the Schwab Advisor Network provide customized and personalized
portfolio management and financial planning services to investors who want the
assistance of an independent professional in managing their financial affairs.
The Schwab Advisor Network strengthens the Schwab/advisor/client relationship
through a pricing model that allows for sharing fee income on referred accounts
and features IAs more prominently in advertising that targets affluent
investors. Including the over 340 participating IAs in the Schwab Advisor
Network, there are 5,900 IAs who use Schwab for custody, trading, technology,
and other support services. Schwab is focused on enhancing the support services
it offers to IAs, 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 2002, Schwab
established several new services to help IAs manage and build their practices,
including improving the Managed Account Select offering (which enables IAs to
provide their clients with access to pre-screened money managers under a
single-fee structure), by adding fixed income managers. Schwab also upgraded its
Centerpiece portfolio management software to help IAs with fixed income
tracking, analytics, and enhanced reporting capabilities. Also in 2002, Schwab
conducted advisor education workshops on operational, trading, and technology
solutions to help IAs grow their businesses efficiently.
Schwab Private Client is a fee-based service designed to help clients who
want access to an ongoing, face-to-face advice relationship with a designated
Schwab consultant while retaining day-to-day responsibility for their investment
decisions. Schwab Private Client provides access to dedicated support resources,
expanded asset management capabilities, and enhanced portfolio tracking and
performance reporting.
Schwab Equity Ratings provide clients with an objective stock rating system
on more than 3,000 stocks, assigning each equity a single grade: A, B, C, D, or
F. On average, A-rated stocks are expected to strongly outperform the overall
market over the next 12 months, while F-rated stocks are expected to strongly
underperform the market. Rated stocks are ranked and the number of 'buy
consideration' ratings - As and Bs - equals the number of 'sell consideration'
ratings - Ds and Fs. Schwab Equity Ratings leverages Schwab's November 2000
acquisition of Chicago Investment Analytics, Inc. (CIA) by applying CIA's
research and technology strengths to a systematic ratings methodology that
complements the variety of perspectives already available to clients from
Goldman Sachs, Standard & Poor's, Argus, and First Call.
In 2002, the Company introduced the Schwab Signature Platinum program, the
successor to the Schwab Signature Services(R) program, for self-directed
affluent investors. Schwab Signature Platinum enables Schwab to provide a select
group of its affluent clients with enhanced benefits such as priority service,
expanded resources, and preferred pricing.
The Company's most affluent clients and their families may utilize U.S.
Trust's broad array of wealth management services, including investment
management, trust, custody, financial and estate planning, and private banking,
which includes a full array of personal lending and deposit products. Affluent
investors may receive referrals to U.S. Trust from Schwab. 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 to serve affluent investors, as well as IAs and their
clients.
Services for Active Traders: The Company strives to deliver information,
technology, service and pricing which meets the needs of active traders. For
highly active traders, a CyberTrader Pro(TM) account offers an integrated
software-based trading platform which provides enhanced trade information and
order execution. Schwab's StreetSmart Pro desktop trading software for active
trader clients also leverages CyberTrader Pro technology. During 2002, the
Company made several technological, pricing, and service enhancements to its
offerings for active traders. The Company enhanced its CyberTrader Web Trading
platform to include real-time market data, direct access technology, intelligent
order routing, options trading, and premium stock research. The Company also
reduced pricing across all of CyberTrader's platforms, including reduced prices
of $9.95 per trade available on all CyberTrader platforms depending on trading
levels. Additionally, CyberTrader's enhanced pricing and technology are
available to clients who trade as few as ten times per month. To support
representatives' conversations with active traders, the Company introduced
Active Trader Street, an internal Web site that provides Schwab representatives
with a comprehensive suite of investing perspectives, trading strategies, and
educational tools. The Company expects to continue expanding its services for
active traders and providing them with access to advanced technology.
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Services for Emerging Affluent Clients: 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 emerging affluent clients, including
advice that clients can access when the need arises. 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 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 help clients
manage and administer their investments independently.
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(R), 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. Additionally,
the Company offers stock option plan and restricted stock services to companies,
as well as trade execution and education services to their employees. The
Company made several improvements to its retirement and stock option plan
offerings during 2002. In 2002, the Company created a Corporate Services
division, integrating the Company's investment and brokerage services for
corporations under a single division. The Company introduced Schwab Retirement
Solutions to address the diverse investing styles of 401(k) plan participants.
The program includes four new Schwab Managed Retirement Trust Funds(TM), which
are professionally managed target retirement fund portfolios. These new funds
complement a traditional menu of plan sponsor-selected investment choices and
self-directed brokerage accounts to meet the needs of a variety of types of plan
participants. The Company also introduced SchwabPlan Select, a comprehensive
bundled 401(k) plan for retirement plans with assets between $2 million to $20
million. Further, a variety of tools designed to assist plan sponsors in
monitoring activity and investment performance and to assist clients in
evaluating their retirement plan holdings were launched during 2002. The Company
intends to continue to enhance its investing and advice services offered to
individuals through employers, including employee retirement and option plan
capabilities.
Banking and Other Financial Products: In addition to the banking services
which U.S. Trust offers its clients, the Company is working to provide all of
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. During 2002, the Company
filed applications with the Office of the Comptroller of the Currency and the
Federal Deposit Insurance Corporation (FDIC) to establish a national bank and to
obtain deposit insurance for the bank. The Company received preliminary approval
from the Office of the Comptroller of the Currency and the FDIC in early
February 2003 and has filed related applications with the Board of Governors of
the Federal Reserve System (Federal Reserve Board). Subject to regulatory
approvals, the Company expects to commence banking operations in 2003. Upon
commencement of banking operations, the Company expects to begin offering a
broader array of cash management and credit products. The Company intends for
the first phase of its product expansion to be focused on building and launching
residential mortgage loans and checking and savings account products. 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
Archipelago, an electronic communication network (ECN); and the ability to
analyze and trade a variety of fixed income securities through Schwab's
multi-channel delivery systems. The Capital Markets segment earns commission
revenues when it executes trades as agent and principal transaction revenues
when it executes trades as principal.
The Company expanded its trade execution capabilities and financial product
offerings during 2002. Most Nasdaq orders up to 2,000 shares received by Schwab
for execution are routed using SmartEx(R), its proprietary order routing
technology that combines intelligent order routing with market maker liquidity
enhancements. SmartEx, which was formally launched by the Company in 2002,
automatically seeks the best available price to complete orders, whether it is
from an ECN or a market maker. SmartEx is available for Schwab client orders in
securities in which SCM makes a market. Through an agreement with Goldman Sachs,
clients have access to OptEx (a service mark of Goldman, Sachs & Co.), which
uses advanced technology to scan the entire options marketplace and route orders
automatically based on
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the best price available nationwide and other execution quality factors.
In 2002, the Company expanded its equity trading capabilities by assembling
a team of 40 professionals to focus on improving execution services for
institutional clients. Revenues from institutional equities trading were $80
million in 2002, up 42% from 2001.
To meet growing client demand for fixed income information and products,
the Company enhanced its fixed income services, including its Web site and
Schwab BondSource platform. The BondSource service links Schwab with 50 other
broker-dealers, allowing clients to choose fixed income securities from a
network that supports trading in all U.S. Treasury securities, over 450 U.S.
agency securities, 1,200 corporate bonds, and 3,500 municipal bond issues.
Additionally, the Schwab CDSource service allows clients to invest in time
deposits from over 110 participating banks.
In 2002, Schwab's fixed income division achieved a record $159 million in
revenues, up 28% from 2001. Client assets held in fixed income securities
equaled $121.8 billion at December 31, 2002, up 20% from a year ago.
The Company intends to continue strengthening its capital markets
capabilities in the future through further automation, increased scale in its
market-making business, and expanded product offerings for both individuals and
institutions.
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, growth of non-trading revenues as a percentage of total revenues (see
CFO Financial Overview); the impact of the restructuring initiatives on the
Company's results of operations (see CFO Financial Overview and Results of
Operations - Financial Overview); long-term debt to total capital ratio (see CFO
Financial Overview); capital expenditures and capital structure (see CFO
Financial Overview and Liquidity and Capital Resources - Cash and Capital
Resources); revenue growth, after-tax operating profit margin, and return on
stockholders' equity (see CFO Financial Overview); the Company's ability to
pursue its strategy of attracting and retaining client assets as well as achieve
its six strategic priorities (see Description of Business - Business Strategy);
the impact of changes in management's estimates on the Company's results of
operations (see Description of Business - Critical Accounting Policies); sources
of liquidity and capital (see Liquidity and Capital Resources - Liquidity and -
Commitments); the impact of the consolidation of the special purpose trust on
the Company's financial position, results of operations, and earnings per share
(see note "2 - Significant Accounting Policies" in the Notes to Consolidated
Financial Statements); and contingent liabilities (see note "22 - 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 Company's success in building fee-based relationships with its
clients; the effect of client trading patterns on Company revenues and earnings;
changes in revenues and profit margin due to cyclical securities markets and
fluctuations in interest rates; the level and continuing volatility of equity
prices; a significant downturn in the securities markets over a short period of
time or a sustained decline in securities prices, trading volumes, and investor
confidence; geopolitical developments affecting the securities markets, the
economy, and investor sentiment; the size and number of the Company's insurance
claims; and a significant decline in the real estate market, including the
Company's ability to sublease certain properties. Other more general factors
that may cause such differences include, but are not limited to: the Company's
inability to attract and retain key personnel; the timing and impact of changes
in the Company's level of investments in personnel, technology, or advertising;
changes in technology; computer system failures and security breaches; evolving
legislation, regulation and changing industry practices adversely affecting the
Company; adverse results of litigation; the inability to obtain external
financing at acceptable rates; the effects of competitors' pricing, product and
service decisions; and intensified industry competition and consolidation.
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, generally on an accrual basis or upon completion of the Company's
required performance. The majority of the Company's revenues, expenses, assets
and liabilities are not based on 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.
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Valuation of Goodwill: Statement of Financial Accounting Standards (SFAS) No.
142 - Goodwill and Other Intangible Assets was issued in June 2001. Under the
provisions of SFAS No. 142, companies are no longer permitted to amortize
goodwill and certain intangible assets with an indefinite useful life. The
Company adopted SFAS No. 142 and accordingly discontinued the amortization of
goodwill as of January 1, 2002.
SFAS No. 142 also requires that goodwill and certain intangible assets be
tested for impairment at least annually, or whenever indications of impairment
exist. In testing for a potential impairment of goodwill, SFAS No. 142 requires
management to estimate the fair value of each of the Company's reporting units
(generally defined as the Company's businesses for which financial information
is available and reviewed regularly by management) and compare it to their
carrying value. If the estimated fair value of a reporting unit is less than its
carrying value, management is required to estimate the fair value of all assets
and liabilities of the reporting unit, including goodwill. If the carrying value
of the reporting unit's goodwill is greater than the estimated fair value, an
impairment charge is recognized for the excess. Accordingly, the process of
evaluating a potential impairment of goodwill is subjective and is based on
estimates. The Company's goodwill balances, net of accumulated amortization,
were $603 million and $628 million at December 31, 2002 and 2001, respectively.
The decline in 2002 was primarily due to an impairment charge of $24 million
related to Charles Schwab Europe (CSE), a subsidiary located in the United
Kingdom, which is included in goodwill and other impairment charges on the
Company's consolidated statement of income. This policy is implemented in each
of the Company's four segments. The Company has elected April 1 as its annual
impairment testing date.
Pension and Other Postretirement Benefits: Under U.S. Trust's trusteed,
noncontributory, qualified defined benefit pension plan, the benefit obligation
and related plan assets are based on certain estimates - years of employee
service, rate of increase in salary, discount rate and expected rate of return
on plan assets - which are made by management with recommendations by actuaries.
In addition to the years of employee service, rate of increase in salary, and
discount rate, U.S. Trust's postretirement medical and life insurance benefit
obligation is based on the health care cost trend rate which is an actuarial
estimated rate of future increases in per capita cost of health care benefits.
The Company's benefit obligation at December 31, 2002 and 2001 was $281 million
and $248 million, respectively. The related pension expense (credit) is included
in compensation and benefits on the Company's consolidated statement of income
and was immaterial for both 2002 and 2001. This policy is implemented in the
U.S. Trust segment.
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. The Company's capitalized internal-use software development
costs, net of accumulated amortization, were $175 million and $181 million at
December 31, 2002 and 2001, respectively, and are included in equipment, office
facilities and property on the Company's consolidated balance sheet.
Internal-use software development costs capitalized were $71 million in 2002 and
$79 million in 2001. These costs are amortized over three years and are included
in depreciation and amortization on the Company's consolidated statement of
income. This policy is implemented in each of the Company's four segments.
Derivative Instruments and Hedging Activities: As part of its asset and
liability management process, the Company has entered into interest rate swap
agreements (Swaps) to hedge the interest rate risk associated with the Company's
variable rate deposits from banking clients. The Company has designated these
Swaps as cash flow hedges, as allowed by SFAS No. 133 - Accounting for
Derivative Instruments and Hedging Activities. Therefore, principally all of the
cumulative change in the fair value of these Swaps from inception, totaling an
aggregate $64 million liability at December 31, 2002, has been recorded in
accumulated other comprehensive loss, which is a component of stockholders'
equity that is not recognized in current earnings. Any actual hedge
ineffectiveness, which was immaterial for 2002, is recorded in interest expense
on the Company's consolidated statement of income. In order to maintain hedge
accounting treatment, management performs a quarterly assessment of its
expectation that these Swaps are effective in achieving the desired hedging
results. This policy is implemented in the U.S. Trust segment.
Additionally, the Company has entered into Swaps that effectively convert
the interest rate characteristics of a portion of the Company's Senior
Medium-Term Notes, Series A (Medium-Term Notes) from fixed to variable. The
Company has designated such Swaps as fair value hedges, as allowed by SFAS No.
133. Since the notional amount, fixed interest rate, and maturity of these Swaps
exactly match the terms of the corresponding Medium-Term Notes, the Company has
concluded that these Swaps are completely effective in achieving the desired
hedging results, as permitted under SFAS No. 133. Consequently, changes in the
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fair value of these Swaps, totaling an aggregate $26 million asset at December
31, 2002, are completely offset by changes in the fair value of the hedged
Medium-Term Notes. Accordingly, there has not been any impact on earnings as a
result of this hedging program except for the conversion from a fixed to a
floating rate of interest on a portion of the Medium-Term Notes. This policy is
implemented in each of the Company's four segments.
Restructuring Reserves: A portion of the reserves under the Company's
restructuring initiatives are based on assumptions, including the Company's
ability to successfully sublease certain real estate properties. These estimates
are included in restructuring and other charges on the Company's consolidated
statement of income. Factors and uncertainties which may adversely affect the
estimates of sublease income include further deterioration in the respective
properties' real estate markets, including Northern California, Texas, and New
Jersey, and prolonged vacancy periods prior to execution of tenant subleases.
The Company's total facilities reserves related to its restructuring initiatives
were $227 million and $97 million at December 31, 2002 and 2001, respectively.
For a further discussion on the Company's restructuring reserves, see "Results
of Operations - Financial Overview."
Allowance for Credit Losses: The Company regularly evaluates its portfolio of
loans to banking clients and provides allowances for the portion management
believes may be uncollectible. Several factors are taken into consideration in
this evaluation including current economic conditions, the composition of the
loan portfolio, past loss experience, and risks inherent in the loan portfolio.
At December 31, 2002 and 2001, the Company's allowance for credit losses was $24
million and $21 million, respectively, on loan portfolios of $4.6 billion and
$4.0 billion, respectively. Total charge-offs and total recoveries were
immaterial for 2002 and 2001. This policy is implemented in the U.S. Trust
Segment.
The Company's management has discussed the development and selection of
these critical accounting estimates with the Audit Committee of the Board of
Directors (Audit Committee). Additionally, the Audit Committee has reviewed the
Company's disclosures relating to the estimates discussed in this Management's
Discussion and Analysis of Results of Operations and Financial Condition.
For further information on the Company's accounting policies, see note "2 -
Significant Accounting Policies" in the Notes to Consolidated Financial
Statements.
RESULTS OF OPERATIONS
Financial Overview
The Company's 2002 financial performance was significantly affected by
persistent declines in securities market valuations, as investor confidence
continued to be weighed down by concerns about corporate governance and
geopolitical developments. The Nasdaq Composite and Standard & Poor's 500
indices declined 31% and 23%, respectively, in 2002. Assets in client accounts
at the Company totaled $764.8 billion at December 31, 2002, down $81.1 billion,
or 10%, from a year ago, as net new assets of $47.6 billion were more than
offset by net market losses of $128.7 billion. In the difficult market
environment that prevailed during 2002, daily average revenue trades decreased
16% from 2001 and the Company's trading revenues declined 14%, as clients scaled
back their trading activity. Despite pressure on securities market valuations,
the Company's non-trading revenues in 2002 were comparable to 2001 as a result
of the Company's ongoing efforts to build client relationships. Total revenues
for 2002 were $4.1 billion, down $218 million, or 5%, from 2001.
Total expenses excluding interest for 2002 were $4.0 billion, down $251
million, or 6%, from 2001. Since 2001, the Company has implemented a number of
expense reduction measures, including its restructuring initiatives, to reduce
operating expenses in light of prevailing market conditions. Primarily as a
result of these expense reduction measures, most expense categories in 2002
decreased when compared to 2001.
In June 2001, USTC sold its Corporate Trust business to The Bank of New
York Company, Inc. (Bank of NY). In 2001, the Company recognized a pre-tax
extraordinary gain of $221 million, or $121 million after tax, on this sale.
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. During 2002, the Company recorded an extraordinary
gain of $22 million, or $12 million after tax, which represented the remaining
gain from this sale that was recognized upon satisfaction of certain client
retention requirements.
Income before taxes on income and extraordinary gain for 2002 was $168
million, up $33 million, or 24%, from 2001. This increase was primarily due to
the combination of factors discussed separately above - declines in almost all
expense categories, partially offset by lower trading revenues and goodwill and
other impairment charges recorded in 2002. Net income for 2002 was $109 million,
or $.08 per share, down 45% from $199 million, or $.14 per share, for 2001. This
decline was primarily due to a lower extraordinary gain in 2002 and the changes
in income before taxes on income and extraordinary gain as previously discussed.
The Company's after-tax profit margin for 2002 was 2.6%, down from 4.6%
- 7 -
for 2001. Return on stockholders' equity was 3% for 2002, compared to 5% in
2001.
In evaluating the Company's financial performance, management uses adjusted
operating income, a non-GAAP income measure which excludes items as detailed in
the following table. Management believes that adjusted operating income is a
useful indicator of its ongoing financial performance, and a tool that can
provide meaningful insight into financial performance without the effects of
certain material items that are not expected to be an ongoing part of operations
(e.g., extraordinary gains, restructuring and other charges, goodwill and other
impairment charges, and merger- and acquisition-related charges). The Company's
after-tax adjusted operating income for 2002 was $396 million, down 3% from
2001, and its after-tax operating profit margin for 2002 was 9.6%, up from 9.4%
for 2001. A reconciliation of the Company's adjusted operating income to net
income is shown in the following table:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Adjusted operating income, after tax $396 $407 $ 849
Excluded items:
Extraordinary gain (1) 22 221
Other income (2) 26
Restructuring charges (3) (373) (391)
Other charges (4) (28)
Goodwill and other impairment charges (5) (61)
Merger- and acquisition-related charges (6) (27) (119) (157)
- --------------------------------------------------------------------------------
Total excluded items (439) (291) (157)
Tax effect 152 83 26
- --------------------------------------------------------------------------------
Total excluded items, after tax (287) (208) (131)
- --------------------------------------------------------------------------------
Net income $109 $199 $ 718
================================================================================
(1) The Company recorded an extraordinary pre-tax gain, net of closing and exit
costs, from the sale of USTC's Corporate Trust business to the Bank of NY
in June 2001. In March 2002, the Company recorded an extraordinary pre-tax
gain upon satisfaction of certain client retention requirements related to
this sale.
(2) Primarily consists of a gain recorded on the sale of an investment.
(3) Restructuring charges primarily include costs relating to workforce,
facilities, systems hardware, software, and equipment reductions.
(4) Includes a regulatory fine, professional service fees for operational and
risk management remediation, and the write-off of certain software
development costs.
(5) Includes charges associated with the Company's European operations for the
impairment of goodwill and an investment write-down.
(6) Includes retention program compensation related to the merger with USTC,
and intangible asset amortization and retention program compensation
related to the acquisition of CyberTrader. The retention programs related
to the acquisition of CyberTrader and the merger with USTC ended in 2002.
For 2001 and 2000, amount also includes goodwill amortization, which ceased
on January 1, 2002 upon the adoption of SFAS No. 142.
As detailed in note "25 - Segment Information" in the Notes to Consolidated
Financial Statements, the Company's adjusted operating income before taxes for
2002 was $629 million, down $18 million, or 3%, from 2001 due to increases of
$31 million, or 14%, in the Individual Investor segment, and $5 million, or 4%,
in the U.S. Trust segment, partially offset by decreases of $34 million, or 12%,
in the Institutional Investor segment, and $20 million, or 56%, in the Capital
Markets segment. The increase in the Individual Investor segment was primarily
due to lower expenses resulting from the Company's workforce reduction under its
restructuring initiatives. As certain technology, corporate, and general
administrative expenses are allocated to segments based upon their full-time
equivalent employees, a proportionately larger allocation of expenses was
assigned to the Institutional Investor segment, which, along with an increase in
certain direct costs, resulted in the adjusted operating income decline in that
segment. The decrease in the Capital Markets segment was due to lower average
revenue per equity share traded and lower levels of trading activity in 2002.
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.
Restructuring: The Company recorded pre-tax restructuring charges for 2002
and 2001 as follows:
- --------------------------------------------------------------------------------
Restructuring Charges 2002 2001
- --------------------------------------------------------------------------------
2002 Initiatives:
Workforce reduction $ 141
Facilities reduction 132
Systems removal 4
- --------------------------------------------------------------------------------
Total 2002 Initiatives 277
- --------------------------------------------------------------------------------
2001 Initiatives:
Workforce reduction 19 $ 87
Facilities reduction 76 141
Systems removal 1 63
- --------------------------------------------------------------------------------
Total 2001 Initiatives 96 391
- --------------------------------------------------------------------------------
Total $ 373 $ 391
================================================================================
2002 Initiatives
In the third quarter of 2002, the Company commenced additional
restructuring initiatives due to continued difficult market conditions. These
initiatives are intended to reduce operating expenses and adjust the Company's
organizational structure to improve productivity, enhance efficiency, and
increase profitability. The restructuring initiatives primarily included further
reductions in the Company's workforce and facilities. The Company recorded
pre-tax restructuring charges of $277 million in 2002 related to these
restructuring initiatives. The Company estimates that its 2002 restructuring
initiatives will reduce pre-tax operating expenses for 2003 by approximately
$250 million compared to annualized second quarter 2002 operating expenses.
Expected reductions include approximately $170 million in compensation and
benefits for staff reductions which occurred in 2002, and approximately $80
million in spending for development
- 8 -
projects, advertising, occupancy, and professional services. A portion of these
reductions in operating expenses, however, will likely be used to enhance
employee discretionary incentives.
2001 Initiatives
The Company's 2001 restructuring initiatives 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. In 2002, the Company recorded pre-tax restructuring
charges related to its 2001 restructuring initiatives of $96 million, primarily
resulting from facilities charges for changes in estimates of sublease income
due to a continued deterioration of the commercial real estate market. In 2001,
the Company recorded pre-tax charges for restructuring costs of $391 million.
Facilities Restructuring Reserves
As of December 31, 2002, the remaining facilities restructuring reserve of
$124 million related to the Company's 2001 initiatives is net of estimated
future sublease income of approximately $270 million. Additionally, as of
December 31, 2002, the remaining facilities restructuring reserve of $103
million related to the Company's 2002 initiatives is net of estimated future
sublease income of approximately $110 million. These estimated future sublease
income amounts are determined based upon a number of factors, including current
and expected commercial real estate lease rates in the respective properties'
real estate markets, and estimated vacancy periods prior to execution of tenant
subleases. In 2002, following a continued deterioration of the commercial real
estate market, the Company recorded additional facilities restructuring charges
related to its 2001 initiatives primarily due to decreases in estimated sublease
rates and increases in the estimated vacancy periods prior to sublease. At
December 31, 2002, approximately 30% of the total square footage covered under
the 2001 restructuring initiatives has been subleased. At December 31, 2002,
less than 5% of the total square footage covered under the 2002 restructuring
initiatives has been subleased. The actual costs of these initiatives could
differ from the Company's estimates, depending primarily on the Company's
ability to successfully sublease certain properties. Factors and uncertainties
which may adversely affect the estimates of sublease income include further
deterioration in the respective properties' real estate markets, including
Northern California, Texas, and New Jersey, and prolonged vacancy periods prior
to execution of tenant subleases.
For further information on the Company's restructuring initiatives, see
note "3 - Restructuring and Other Charges" in the Notes to Consolidated
Financial Statements.
REVENUES
Revenues declined $218 million, or 5%, to $4.1 billion in 2002, mainly due
to an 11% decrease in commission revenues, a 9% decrease in interest revenue,
net of interest expense (referred to as net interest revenue), and a 28%
decrease in principal transaction revenues. These declines were partially offset
by a 5% increase in asset management and administration fees, and a 3% increase
in other revenues.
[Chart Omitted]
As trading volumes decreased during 2002, non-trading revenues represented 66%
of total revenues, up from 63% of total revenues for 2001 and 51% for 2000 as
shown in the following table.
- --------------------------------------------------------------------------------
Composition of Revenues 2002 2001 2000
- --------------------------------------------------------------------------------
Asset management and administration fees 43% 38% 27%
Net interest revenue 20 21 21
Other 3 4 3
- --------------------------------------------------------------------------------
Total non-trading revenues 66 63 51
- --------------------------------------------------------------------------------
Commissions 29 31 39
Principal transactions 5 6 10
- --------------------------------------------------------------------------------
Total trading revenues 34 37 49
- --------------------------------------------------------------------------------
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 $218 million decline in revenues from 2001 was due to
decreases of $118 million, or 5%, in the Individual Investor segment, $83
million, or 24%, in the Capital Markets segment, and $3 million in the U.S.
Trust segment, slightly offset by an increase of $12 million, or 1%, in the
Institutional Investor segment. Additionally, the Company recognized $26 million
in non-operating revenues in 2001, consisting primarily of a gain on the sale of
an investment. The decrease in the Capital Markets segment was primarily due to
lower average revenue per equity share traded and lower equity share volume
handled by SCM, partially offset by higher revenues from client fixed income
securities trading activity. See note "25 - Segment Information" in the Notes to
Consolidated Financial Statements for financial information by segment for the
last three years.
[Chart Omitted]
- 9 -
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 through the Individual Investor, Institutional Investor, and
U.S. Trust segments. The Company also earns asset management and administration
fees for financial services, including investment management and consulting,
trust and fiduciary services, custody 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 through the U.S. Trust, Individual Investor, and
Institutional Investor segments.
Asset management and administration fees were $1.8 billion in 2002,
compared to $1.7 billion in 2001 and $1.6 billion in 2000, as shown in the
following table:
- --------------------------------------------------------------------------------
Asset Management and Administration Fees 2002 2001 2000
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds
and Excelsior) $ 874 $ 818 $ 673
Mutual Fund OneSource 264 282 331
Other 42 41 35
Asset management and related services 581 534 544
- --------------------------------------------------------------------------------
Total $1,761 $1,675 $1,583
================================================================================
The increase from 2001 to 2002 was primarily due to higher account fees,
increases in average assets in and service fees earned on Schwab's proprietary
funds (collectively referred to as the SchwabFunds), and higher service fees
earned on assets in Schwab's Mutual Fund OneSource service. These increases were
partially offset by decreases in average assets in Schwab's Mutual Fund
OneSource service and average U.S. Trust client assets primarily due to declines
in market valuations. 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 service.
Commissions
The Company earns revenues by executing client trades primarily through the
Individual Investor and Institutional Investor segments, as well as the Capital
Markets segment. These revenues are affected by the number of client accounts
that trade, the average number of revenue-generating trades per account, and the
average revenue earned per revenue trade. Commission revenues were $1.2 billion
in 2002, compared to $1.4 billion in 2001 and $2.3 billion in 2000, as shown in
the following table:
- --------------------------------------------------------------------------------
Commissions 2002 2001 2000
- --------------------------------------------------------------------------------
Exchange-listed securities $ 552 $ 540 $ 832
Nasdaq and other equity securities 444 606 1,126
Mutual funds 111 95 132
Options 99 114 204
- --------------------------------------------------------------------------------
Total $1,206 $1,355 $2,294
================================================================================
Total commission revenues include $67 million in 2002, $59 million in 2001,
and $54 million in 2000 related to certain securities serviced by Schwab's fixed
income division, including exchange-traded unit investment trusts, real estate
investment trusts, preferred debt, and preferred equities. Schwab's fixed income
division also generates principal transaction revenues. Additionally, commission
revenues include $52 million in 2002, $29 million in 2001, and $25 million in
2000, related to Schwab's institutional trading business. Schwab's institutional
trading business also generates principal transaction revenues, as well as other
revenues.
- 10 -
The Company's client trading activity is shown in the following table (in
thousands):
- --------------------------------------------------------------------------------
Daily Average Trades 2002 2001 2000
- --------------------------------------------------------------------------------
Revenue Trades (1)
Online 111.9 133.5 204.1
TeleBroker(R) and Schwab by Phone(TM) 5.7 7.5 8.2
Regional client telephone service
centers, branch offices, and other 16.5 18.7 29.7
- --------------------------------------------------------------------------------
Total 134.1 159.7 242.0
================================================================================
Mutual Fund OneSource(R) and
Other Asset-Based Trades
Online 46.7 37.0 36.8
TeleBroker and Schwab by Phone .4 .5 1.0
Regional client telephone service
centers, branch offices, and other 9.0 16.5 20.3
- --------------------------------------------------------------------------------
Total 56.1 54.0 58.1
================================================================================
Total Daily Average Trades
Online 158.6 170.5 240.9
TeleBroker and Schwab by Phone 6.1 8.0 9.2
Regional client telephone service
centers, branch offices, and other 25.5 35.2 50.0
- --------------------------------------------------------------------------------
Total 190.2 213.7 300.1
================================================================================
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
As illustrated in the following table, the total number of client revenue
trades executed by the Company decreased 15% in 2002 as both the number of
client accounts that traded and the average number of trades per account have
declined. Average revenue earned per revenue trade increased 8% from 2001 to
2002, mainly due to higher client fixed income securities trades and increased
pricing of equity trades made through automated telephone channels and
broker-assisted trades. Average revenue earned per revenue trade decreased 6%
from 2000 to 2001, mainly due to reduced pricing for online equity trades placed
by more active traders, as well as reduced pricing of equity trades made through
automated telephone channels. In 2002, the decrease in trading activity more
than offset the effect of higher average revenue earned per revenue trade.
However, in 2001 both trading activity and average revenue earned per revenue
trade declined from 2000.
- --------------------------------------------------------------------------------
Trading Activity 2002 2001 2000
- --------------------------------------------------------------------------------
Total revenue trades (in thousands) (1) 33,791 39,625 60,972
Accounts that traded during the year
(in thousands) 2,871 3,028 3,787
Average revenue trades
per account that traded 11.8 13.1 16.1
Trading frequency proxy (2) 3.8 4.2 6.2
Number of trading days 252 248 252
Average revenue earned
per revenue trade $ 37.78 $ 35.02 $ 37.38
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents revenue trades per $100,000 in total client assets.
Net Interest Revenue
Net interest revenue is the difference between interest earned on assets
(mainly margin loans to clients, investments of segregated client cash balances,
private banking loans, and securities available for sale) and interest paid on
liabilities (mainly brokerage client cash balances and deposits from banking
clients). 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.
Substantially all 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 75% 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 both 2002 and 2001, and 59 days
for 2000. 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.
- 11 -
Net interest revenue was $841 million in 2002, compared to $929 million in
2001, and $1.2 billion in 2000, as shown in the following table:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 459 $ 832 $1,772
Investments, client-related 337 555 338
Private banking loans 236 240 219
Securities available for sale 76 79 69
Other 78 151 191
- --------------------------------------------------------------------------------
Total 1,186 1,857 2,589
- --------------------------------------------------------------------------------
Interest Expense:
Brokerage client cash balances 173 696 1,076
Deposits from banking clients 98 128 155
Long-term debt 46 55 55
Short-term borrowings 23 27 20
Other 5 22 46
- --------------------------------------------------------------------------------
Total 345 928 1,352
- --------------------------------------------------------------------------------
Net interest revenue $ 841 $ 929 $1,237
================================================================================
The Company's interest-earning assets are financed primarily by
interest-bearing brokerage client cash balances and deposits from banking
clients. Other funding sources include noninterest-bearing brokerage client cash
balances, proceeds from stock-lending activities, short-term borrowings and
long-term debt, and stockholders' equity. Client-related daily average balances,
interest rates, and average net interest spread are summarized as follows:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $18,645 $14,198 $ 6,170
Average interest rate 1.81% 3.91% 5.48%
Margin loans to clients:
Average balance outstanding $ 8,020 $11,432 $19,764
Average interest rate 5.72% 7.28% 8.96%
Private banking loans:
Average balance outstanding $ 4,125 $ 3,469 $ 2,867
Average interest rate 5.73% 6.91% 7.65%
Securities available for sale:
Average balance outstanding $ 1,520 $ 1,317 $ 1,133
Average interest rate 4.98% 5.98% 6.08%
Average yield on interest-earning assets 3.43% 5.61% 8.01%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $23,087 $22,295 $20,961
Average interest rate .75% 3.12% 5.14%
Interest-bearing banking deposits:
Average balance outstanding $ 3,905 $ 3,365 $ 3,071
Average interest rate 2.51% 3.80% 5.05%
Other interest-bearing sources:
Average balance outstanding $ 1,094 $ 1,117 $ 1,831
Average interest rate 2.03% 3.99% 4.53%
Average noninterest-bearing portion $ 4,224 $ 3,639 $ 4,071
Average interest rate on funding sources .91% 2.85% 4.39%
Summary:
Average yield on interest-earning assets 3.43% 5.61% 8.01%
Average interest rate on funding sources .91% 2.85% 4.39%
- --------------------------------------------------------------------------------
Average net interest spread 2.52% 2.76% 3.62%
================================================================================
The decrease in net interest revenue from 2001 to 2002 was primarily due to
lower levels of, and lower rates received on, margin loans to clients, as well
as lower rates received on client-related investments, partially offset by lower
rates paid on brokerage client cash balances and higher average balances of
client-related investments. 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.
Since the Company establishes the rates paid on brokerage client cash
balances and certain banking deposits and the
- 12 -
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 2001 to 2002 as the average
yield on interest-earning assets, primarily client-related investments, declined
more than the average interest rate on funding sources. 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 average interest rate on funding sources.
Principal Transactions
Principal transaction revenues are primarily comprised of revenues from
client fixed income securities trading activity, which are included in the
Capital Markets, Individual Investor, and Institutional Investor segments, and
net gains from market-making activities in Nasdaq and other equity securities,
which are included in the Capital Markets segment. Factors that influence
principal transaction revenues include the volume of client trades, market price
volatility, average revenue per equity share traded, and changes in regulations
and industry practices. 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% of the total shares traded on Nasdaq in both
2002 and 2001(b).
Principal transaction revenues were $184 million in 2002, compared to $255
million in 2001 and $570 million in 2000, as shown in the following table:
- --------------------------------------------------------------------------------
Principal Transactions 2002 2001 2000
- --------------------------------------------------------------------------------
Fixed income securities $ 92 $ 65 $ 53
Nasdaq and other equity securities 80 173 470
Other 12 17 47
- --------------------------------------------------------------------------------
Total (1) $ 184 $ 255 $ 570
================================================================================
(1) Includes $23 million in each of 2002 and 2001, and $33 million in 2000,
related to Schwab's institutional trading business.
The decreases in principal transaction revenues from 2000 to 2002 were
primarily due to lower average revenue per equity share traded and lower equity
share volume handled by SCM, partially offset by higher revenues from client
fixed income securities trading activity. SCM's average revenue per equity share
traded decreased from 1.8(cents) in 2000 to .8(cents) in 2001, and to .4(cents)
in 2002, primarily due to market conditions as well as the change to decimal
pricing, which was fully implemented by April 2001.
Other Revenues
Other revenues include fees for services, such as order handling fees,
account service fees, net gains and losses on certain investments, and software
maintenance fees. Other revenues are earned primarily through the Individual
Investor, Institutional Investor and U.S. Trust segments. These revenues were
$143 million in 2002, compared to $139 million in 2001 and $104 million in 2000.
The increase from 2001 to 2002 was primarily due to higher fees for services,
substantially offset by lower gains recorded on sales of investments. The
increase from 2000 to 2001 was primarily due to gains recorded on sales of
investments.
EXPENSES EXCLUDING INTEREST
Total expenses excluding interest declined $251 million, or 6%, in 2002.
The Company's restructuring initiatives and other expense reduction measures
resulted in decreases in most expense categories during 2002 when compared to
2001. The Company monitors each of its expense categories as a percentage of
revenues, as detailed in the table below.
- --------------------------------------------------------------------------------
Expenses Excluding Interest as a Percentage
of Revenues 2002 2001 2000
- --------------------------------------------------------------------------------
Compensation and benefits 45% 43% 42%
Other compensation - merger retention programs 1 1 1
Occupancy and equipment 11 11 7
Depreciation and amortization 8 8 4
Communications 6 8 6
Advertising and market development 5 6 6
Professional services 4 4 4
Commissions, clearance and floor brokerage 2 2 2
Restructuring and other charges 9 10
Goodwill and other impairment charges 2
Goodwill amortization 2 1
Merger-related 1
Other 3 2 5
- --------------------------------------------------------------------------------
Total 96% 97% 79%
================================================================================
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, related
employee benefits and taxes, and variable compensation. 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. Additionally, at management's discretion, employees may receive
incentive compensation relating to progress on the Company's strategic
priorities. Therefore, a significant portion of compensation and benefits
expense will fluctuate with these measures.
Compensation and benefits expense was $1.9 billion in 2002, down 1% from
2001 and 23% from 2000. The decrease from 2001 to 2002 was primarily due to a
reduction in full-time equivalent employees, partially offset by the
- --------
(b) Source: The Nasdaq Stock Market, Inc.
- 13 -
accrual of higher discretionary and incentive compensation, and higher employee
benefits. 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
following table shows a comparison of certain compensation and benefits
components and employee data:
- --------------------------------------------------------------------------------
Compensation and Benefits 2002 2001 2000
- --------------------------------------------------------------------------------
Salaries and wages $1,267 $1,380 $1,409
Employee benefits and other 306 285 340
Incentive and variable compensation 281 210 665
- --------------------------------------------------------------------------------
Total $1,854 $1,875 $2,414
================================================================================
Incentive and variable compensation as a
% of compensation and benefits expense 15% 11% 28%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 6% 6% 9%
Full-time equivalent employees (1)
(at year end, in thousands) 16.7 19.6 26.3
Revenues per average full-time equivalent
employee (in thousands) $ 220 $ 192 $ 239
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis.
Employee benefits and other expense increased by $21 million, or 7%, from
2001 primarily due to higher health insurance costs and employee claims.
Additionally, employee benefits and other expense includes net pension income
(which is a reduction to this expense line item) related to U.S. Trust's defined
benefit pension plan. Net pension income totaled less than $1 million for 2002,
$12 million for 2001, and $10 million for 2000. The decrease in net pension
income in 2002 was primarily due to a decline in the fair value of pension plan
assets, as well as an increase in the service cost resulting from a greater
number of employees covered under the pension plan, and a lower assumed discount
rate used in the expense calculation. Following market declines in 2001 and
2002, U.S. Trust changed certain assumptions used to calculate its pension
expense. The impact of these changes will be effective in 2003. U.S. Trust
decreased its expected rate of return on pension plan assets from 9.00% to 8.25%
and its discount rate from 7.50% to 6.75%. The Company expects that the impact
of these changes will increase pension expense by approximately $8 million in
2003.
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 11 million, 26
million and 11 million stock options in 2002, 2001 and 2000, respectively. In
2003, management expects to reduce the level of stock option grants to employees
and to provide officers a new long-term incentive program, which includes both
cash and restricted stock.
At December 31, 2002, 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 12% of the Company's outstanding common stock at December 31,
2002.
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 received cash compensation, contingent upon continued employment for
the two-year periods ended May 31, 2002 and March 1, 2002, respectively. The
aggregate cost of the U.S. Trust and CyberTrader retention programs was $117
million and was amortized over the programs' respective two-year periods. The
combined expense for the programs was $22 million in 2002, $56 million in 2001,
and $39 million in 2000. The decrease from 2001 to 2002 and the increase from
2000 to 2001 were due to the fact that the retention programs were in place for
a full year in 2001 compared to partial years in 2002 and 2000.
Occupancy and Equipment
Occupancy and equipment expense includes the costs of leasing and
maintaining the Company's office space, four regional client telephone service
centers, two primary data centers, 388 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 $471 million in 2002,
compared to $490 million in 2001 and $415 million in 2000. The decrease in
occupancy and equipment expense from 2001 to 2002 was primarily due to the
Company's restructuring initiatives and other expense reduction measures. The
increase in occupancy and equipment expense from 2000 to 2001 reflects the
Company's growth and expansion in 1999 and 2000, as well as higher lease and
maintenance expenses for information technology equipment. Schwab opened 1 new
domestic branch office in 2002, 22 in 2001, and 44 in 2000. The Company's 2002
restructuring initiatives included charges for the consolidation of 18 Schwab
branch offices and 2 U.S. Trust offices planned for 2003.
- 14 -
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 $321 million in 2002, compared to $338
million in 2001 and $255 million in 2000. The decrease from 2001 to 2002 was
primarily due to the Company's restructuring initiatives and other expense
reduction measures. The increase from 2000 to 2001 was 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 both 2002 and 2001, and $10 million in 2000.
Communications
Communications expense includes telephone, postage and printing, and news
and quotation costs. This expense was $262 million in 2002, compared to $339
million in 2001 and $353 million in 2000. The decreases from 2000 to 2002 were
primarily due to lower client trading volumes and the Company's expense
reduction measures. In 2001, this decrease was partially offset by increased
client use of automated telephonic and online channel news, quotation and
information services.
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 $211 million in 2002, compared to $246 million in 2001 and $332
million in 2000. The decreases from 2000 to 2002 were primarily due to
reductions, as part of the Company's expense reduction measures, in
brand-focused television and other media spending. In 2002, this decrease was
partially offset by an increase in print media spending to promote the launch of
the Company's full-service advice and relationship service offering.
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 related
to the merger with USTC. This expense was $177 million in 2002, compared to $193
million in 2001 and $255 million in 2000. The decreases from 2000 to 2002 were
primarily due to the Company's expense reduction measures.
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 $71 million in 2002, compared to
$92 million in 2001 and $138 million in 2000. The decreases from 2000 to 2002
were primarily due to decreases in trading volume processed by SCM and Schwab.
Goodwill and Other Impairment Charges
Goodwill represents the cost of acquired businesses in excess of fair value
of the related net assets at acquisition. On January 1, 2002, the Company
adopted SFAS No. 142 - Goodwill and Other Intangible Assets. The Company did not
record any goodwill impairment charges upon completion of the initial
transitional impairment test under SFAS No. 142 in the second quarter of 2002.
During the fourth quarter of 2002, the Company developed plans for the possible
sale of CSE. Accordingly, the Company performed a goodwill impairment test
relating to CSE at that time pursuant to SFAS No. 142. In December 2002, the
Company recorded goodwill and other impairment charges of $61 million associated
with the Company's European operations, including $24 million for goodwill
impairment related to CSE and $37 million for an investment write-down of Aitken
Campbell, the Company's market-making joint venture in the United Kingdom. For
further information, see note "4 - Goodwill and Other Impairment Charges" in the
Notes to Consolidated Financial Statements.
Goodwill Amortization
Upon adoption of SFAS No. 142, amortization of the existing goodwill ceased
and therefore there was no such expense in 2002. Goodwill amortization expense
was $66 million in 2001, compared to $53 million in 2000. The increase from 2000
to 2001 was 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 related to the merger with USTC.
This expense was $69 million in 2000. There were no such expenses in 2002 or
2001.
Other Expenses
Other expenses include trading volume-related regulatory expenses, travel
and entertainment, trade-related errors, and other miscellaneous expenses. These
other expenses were $144 million in 2002, compared to $104 million in 2001 and
$234 million in 2000. The increase from 2001 to 2002 was partially due to
minority interest losses of certain subsidiaries which were closed during 2001.
These minority interest losses represent the proportionate amount of operating
losses related to third-party shareholders and are netted against other
expenses. Accordingly, the absence of these minority interest losses has the
effect of increasing expense in 2002.
- 15 -
Additionally, the increase from 2001 to 2002 was due to an increase in error and
bad debt expense, and higher travel and related costs associated with new
product offerings, partially offset by lower trading volume-related regulatory
expenses. The decrease from 2000 to 2001 was primarily due to significantly
lower levels of trade-related errors, travel and related costs, and trading
volume-related regulatory expenses.
Taxes on Income
The Company's effective income tax rate was 42.6% in 2002, 44.1% in 2001,
and 41.7% in 2000. The decrease from 2001 to 2002 was primarily due to the
cessation of goodwill amortization, which was primarily non-deductible for tax
purposes. The increase from 2000 to 2001 was primarily due to the greater impact
of goodwill amortization as a percentage of income before taxes on income.
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 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 "21 - 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, 2002 and 2001, the Company
and its depository institution subsidiaries are considered well capitalized.
CSC has liquidity needs that arise from its issued and outstanding $566
million Medium-Term Notes, as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes have maturities
ranging from 2003 to 2010 and fixed interest rates ranging from 6.04% to 8.05%
with interest payable semiannually. During 2002, CSC entered into Swaps that
effectively convert the interest rate characteristics of a portion of the
Medium-Term Notes from fixed to variable. For a complete discussion of the
Swaps, see note "23 - Financial Instruments Subject to Off-Balance-Sheet Risk,
Credit Risk or Market Risk" in the Notes to Consolidated Financial Statements.
The Medium-Term Notes are rated A2 by Moody's Investors Service (Moody's), A- by
Standard & Poor's Ratings Group (S&P), and A by Fitch IBCA, Inc. (Fitch).
CSC has a prospectus supplement on file with the SEC enabling CSC to issue
up to an additional $750 million in Medium-Term Notes. At December 31, 2002, all
of these notes remained unissued.
CSC has authorization from its Board of Directors (Board) to issue up to
$1.0 billion in commercial paper. At December 31, 2002, no commercial paper has
been issued. CSC's ratings for these short-term borrowings are P-1 by Moody's,
A-2 by S&P, and F1 by Fitch.
CSC maintains a $1.0 billion committed, unsecured credit facility with a
group of twenty-two banks which is scheduled to expire in June 2003. CSC plans
to establish a similar facility to replace this one when it expires. This
facility was unused in 2002. 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.
CSC also has direct access to $670 million of a total of $770 million
uncommitted, unsecured bank credit lines, provided by 8 banks, that are
primarily utilized by Schwab to manage short-term liquidity. The amount
available to CSC under these lines is lower than the amount available to Schwab
because the credit line provided by one of these banks is only available to
Schwab. These lines were not used by CSC in 2002.
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.
- 16 -
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$24.9 billion, $25.0 billion and $25.2 billion at December 31, 2002, 2001 and
2000, 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 requirement of $1 million. At
December 31, 2002, Schwab's net capital was $1.2 billion (18% of aggregate debit
balances), which was $1.1 billion in excess of its minimum required net capital
and $869 million in excess of 5% of aggregate debit balances. Schwab has
historically targeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2003. The amount outstanding under this facility at December
31, 2002 was $220 million. At year end, Schwab also had outstanding $25 million
in fixed-rate subordinated term loans from CSC maturing in 2004. 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 eight banks totaling $770 million at December
31, 2002 (as noted previously, $670 million of these lines are also available
for CSC to use). The need for short-term borrowings arises primarily from timing
differences between cash flow requirements and the scheduled liquidation of
interest-bearing investments. Schwab used such borrowings for 15 days in 2002,
with the daily amounts borrowed averaging $47 million. There were no borrowings
outstanding under these lines at December 31, 2002.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2002. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2002.
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, 2002, 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 $701 million. At December 31, 2002, there were no
borrowings outstanding under these facilities. Additionally, at December 31,
2002, U.S. Trust had $181 million of federal funds purchased and $326 million of
repurchase agreements outstanding.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2003. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $35 million at December 31, 2002.
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 previous discussion). At December 31, 2002, SCM's net capital was
$99 million, which was $98 million in excess of its minimum required net
capital.
SCM may borrow up to $150 million under a subordinated lending arrangement
with CSC which is scheduled to expire in August 2003. Borrowings under this
arrangement qualify as regulatory capital for SCM. The amount outstanding under
this facility at December 31, 2002 was $50 million. The advances under this
facility satisfy increased intra-day capital needs at SCM to support the
expansion of its institutional equities and trading businesses. 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 this facility at December 31, 2002.
- 17 -
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.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on the
Company's consolidated balance sheet) and cash flows are affected by changes in
brokerage client cash balances and the associated amounts required to be
segregated under federal or other regulatory guidelines. Timing differences
between cash and investments actually segregated on a given date and the amount
required to be segregated for that date may arise in the ordinary course of
business and are addressed by the Company in accordance with applicable
regulations. Other factors which affect the Company's cash position and cash
flows include investment activity in securities owned, levels of capital
expenditures, banking client deposit and loan activity, financing activity in
short-term borrowings and long-term debt, payments of dividends, and repurchases
of CSC's common stock.
In 2002, cash and cash equivalents decreased $1.3 billion, or 29%, to $3.1
billion primarily due to movements of brokerage client-related funds to meet
segregation requirements, increases in loans to banking clients, and decreases
in brokerage client cash balances. Management does not believe that this decline
in cash and cash equivalents is an indication of a trend.
The Company's capital expenditures were $160 million in 2002 and $301
million in 2001, or 4% and 7% of revenues, respectively. In 2002, 82% of capital
expenditures were for information technology and 18% for facilities expansion
and improvements. The $141 million, or 47%, decrease in capital expenditures in
2002 was primarily due to the Company's response to continued declines in client
trading volumes and difficult market conditions which characterized most of the
year. Capital expenditures as described above include the capitalized costs for
developing internal-use software of $71 million in 2002 and $79 million in 2001.
Schwab opened 1 new domestic branch office during 2002, compared to 22 in 2001.
The Company continues to view its office network as important to pursuing its
strategy of attracting client assets.
Management currently anticipates that 2003 capital expenditures will be
approximately equal to 2002 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 2002, the Company:
- - Issued $100 million and repaid $214 million of long-term debt;
- - Received cash proceeds of $34 million on the exercise of 6 million of the
Company's stock options, with a weighted-average exercise price of $6.59,
and a related tax benefit of $7 million; and
- - Paid common stock dividends of $60 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, 2002 was $4.7 billion, down $240
million, or 5%, from a year ago, due to an increase in common stock repurchases
and a net decline in long-term debt. At December 31, 2002, the Company had
long-term debt of $642 million, or 14% of total financial capital, bearing
interest at a weighted-average rate of 7.4%. At December 31, 2002, the Company's
stockholders' equity was $4.0 billion, or 86% of total financial capital.
Management currently anticipates that long-term debt will remain below 30% of
total financial capital.
- 18 -
Commitments
A summary of the Company's principal contractual obligations and other
commitments as of December 31, 2002 is shown in the following table. Management
believes that funds generated by its operations, as well as cash provided by
external financing, will continue to be the primary funding sources in meeting
these obligations and commitments.
Less than 1 - 3 4 - 5 After 5
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
Operating leases (1) $ 257 $ 798 $ 306 $ 649 $2,010
Long-term debt (2) 100 205 53 258 616
Credit-related financial
instruments (3) 565 128 693
Other commitments (4) 6 6
- --------------------------------------------------------------------------------
Total $ 928 $1,131 $ 359 $ 907 $3,325
================================================================================
(1) Includes minimum rental commitments, net of sublease commitments, and
maximum guaranteed residual values under noncancelable leases for office
space and equipment. See Note 22 to the Consolidated Financial Statements.
(2) See Note 15 to the Consolidated Financial Statements.
(3) Includes U.S. Trust firm commitments to extend credit primarily for
mortgage loans to private banking clients and standby letters of credit.
See Note 23 to the Consolidated Financial Statements.
(4) Includes committed capital contributions to venture capital funds. See Note
22 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 canceled by the Company if notice is given according
to the terms specified in the agreements.
Share Repurchases
On September 20, 2001, the Board 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's repurchase authorization
on March 21, 2001 for up to 20 million shares of CSC's common stock. CSC
repurchased 32 million shares of its common stock for $299 million in 2002 and
27 million shares of its common stock for $368 million in 2001. At December 31,
2002, the authorization granted by the Board allows for future repurchases of
CSC's common stock totaling up to $100 million.
Dividend Policy
Since the initial dividend in 1989, CSC has paid 55 consecutive quarterly
dividends and has increased the dividend 12 times. Since 1989, dividends have
increased by a 27% compounded annual growth rate. CSC paid common stock
dividends of $.0440 per share in each of 2002 and 2001, and $.0407 per share in
2000. 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 Board, 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.
OFF-BALANCE SHEET ARRANGEMENTS
During 2001, the Company began occupying and making lease payments on a
newly renovated office building in San Francisco, California. The lease for the
building was arranged by working with a bank to create an unconsolidated special
purpose trust (Trust). For a discussion of the Trust and other contingent
liabilities, see note "22 - Commitments and Contingent Liabilities" in the Notes
to Consolidated Financial Statements. The Company plans to adopt Financial
Accounting Standards Board Interpretation No. 46 - Consolidation of Variable
Interest Entities in the first quarter of 2003. Under this interpretation, the
Company will be required to consolidate the Trust by recording the Trust's
assets and liabilities on the Company's consolidated balance sheet. For a
discussion on the expected impact of this interpretation, see note "2 -
Significant Accounting Policies" in the Notes to Consolidated Financial
Statements.
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.
Risk management and oversight at the Company begins with the Board. The
Audit Committee reviews major risk exposures and the steps management has taken
to monitor and control such exposures, and reports on these issues to the full
Board. The Audit Committee delegates the formulation of policies and day-to-day
risk oversight and management to the Executive Committee of the Company. The
Executive Committee provides guidance regarding strategies and risk tolerance
and is responsible for an integrated approach to risk exposures. The Executive
Committee both delegates to and has several members who actively participate in
risk management at the Company through the Global Risk Steering Committee. The
Global Risk Steering Committee is responsible for reviewing and monitoring the
Company's risk exposures, leading in the continued development of the Company's
risk management policies and practices, reviewing changes in regulations and
other risk-related developments, and reporting to the Audit Committee. Various
other functional risk committees consisting of
- 19 -
members of senior management report into the Global Risk Steering Committee on a
frequent basis. These committees include:
- - Technology and Operations Risk Committee, which focuses on the integrity of
operational controls and operating capacity of the Company's technology and
operations systems;
- - Credit, Finance, 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, corporate credit activities (i.e.,
counterparty and corporate investing activities), the Company's liquidity,
capital resources, interest rate risk, and the market risk resulting from
securities positioning activities;
- - Fiduciary Risk Committee, which focuses on overseeing the activities of the
Company that are deemed to have a fiduciary component;
- - Disclosure Committee, which focuses on the implementation and oversight of
disclosure and internal controls as recommended pursuant to the
Sarbanes-Oxley Act of 2002; and
- - U.S. Trust Risk Policy Committee, which has broad responsibilities for the
oversight of risk management at U.S. Trust; also reports to the Board of
Directors of U.S. Trust.
Additionally, the Finance, Risk Management, 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.
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.
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 "23 - Financial Instruments Subject to Off-Balance-Sheet Risk,
Credit Risk or Market Risk" in the Notes to Consolidated Financial Statements
for additional discussion on credit risk and market risk.
Technology and Operating Risk
Technology and operating risk is the potential for loss due to deficiencies
in control processes or technology systems that constrain the Company's ability
to gather, process and communicate information efficiently and securely, without
interruptions. The Company's operations are highly dependent on the integrity of
its technology systems and the Company's success depends, in part, on its
ability to make timely enhancements and additions to its technology in
anticipation of 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, a terrorist
attack, and natural disaster. The Company attempts to mitigate technology and
operating risk by maintaining a comprehensive internal control system and by
employing experienced personnel. In 2002, as part of its restructuring
initiatives, the Company centralized certain of its operations, mitigating the
risks associated with decentralization of functions. 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. During 2002, the
Company enhanced its procedures related to its risk self assessments. The
Company's risk committees and various policies and procedures, combined with
these risk self assessments, are used in part to provide a vehicle for the
Co-Chief Executive Officers and Chief Financial Officer to attest to the
adequacy of the Company's controls. 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 "21 - 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 (e.g.,
patents) 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
- 20 -
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 Allowance for
Credit Losses" and "23 - Financial Instruments Subject to Off-Balance-Sheet
Risk, Credit Risk or Market 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, 2002 or 2001. As
of December 31, 2002, management is not aware of any significant potential
problem loans other than the amounts disclosed 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 various fiduciary risk committees.
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 Swaps to
mitigate interest rate exposure associated with short-term floating
interest-rate deposits. As the Company looks ahead to 2003, the interest rate
environment remains at cyclical lows and the Federal Reserve Board has adopted a
neutral stance toward monetary policy. Additional interest rate declines could
adversely affect the Company's ability to maintain its net interest spread as
well as the revenue yields on its money funds.
The Company is exposed to equity price risk through its role as a financial
intermediary in client-related transactions,
- 21 -
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 mitigate market risk on these inventories. During 2002, the
Company expanded its institutional equity capabilities to focus on improving
execution capabilities for institutional clients. To accommodate the growth,
certain trading limits were expanded. The Company mitigates the risk associated
with the increased limits by using those limits primarily on an intra-day basis.
While not material, the Company is also exposed to currency exchange risks
through its international operations.
Additional qualitative and quantitative disclosures about market risk are
summarized in the following paragraphs. See note "23 - Financial Instruments
Subject to Off-Balance-Sheet Risk, Credit Risk or Market Risk" in the Notes to
Consolidated Financial Statements for an additional discussion on market risk.
Financial Instruments Held For Trading Purposes
The Company holds municipal, other fixed income and government securities,
and certificates of deposit in inventory to meet clients' trading needs. The
fair value of such inventory was approximately $34 million and $36 million at
December 31, 2002 and 2001, 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 is shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Equity Securities:
Long positions $ 79 $ 167
Short positions (7) (27)
- --------------------------------------------------------------------------------
Net long positions $ 72 $ 140
================================================================================
Using a hypothetical 10% increase or decrease in prices, the potential loss
or gain in fair value is estimated to be approximately $7 million and $14
million at December 31, 2002 and 2001, respectively.
In addition, the Company generally enters into exchange-traded futures and
options contracts based on equity market indices to hedge potential losses in
equity inventory positions. The notional amounts and fair values of these
futures and options contracts are shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Exchange-traded Contracts:
Net Short Futures (1):
Notional Amount $ 61 $ 125
Fair Value $ 63 $ 125
Long Put Options:
Notional Amount $ 4 $ 23
Fair Value (2)
- --------------------------------------------------------------------------------
(1) Notional amount represents original contract price of the futures. Fair
value represents the index price. The difference between the notional and
fair value amounts are settled daily in accordance with futures market
requirements.
(2) Amount was less than $1 million at both December 31, 2002 and 2001.
Using a hypothetical 10% increase or decrease in the underlying indices,
the potential loss or gain in fair value is estimated to be approximately $6
million and $13 million at December 31, 2002 and December 31, 2001,
respectively, which would substantially offset the potential loss or gain on the
equity securities previously discussed.
In view of the continued expansion of the Company's businesses, the Company
plans to transition its market risk disclosures to incorporate a value-at-risk
(VAR) methodology in 2003. VAR is an increasingly utilized industry tool that
provides a process for assessing and aggregating market risk across the
Company's trading activities. The methodology will draw on market data to
estimate the potential price volatility of financial instruments held for
trading purposes and then measure the potential decline in their value, under a
variety of market conditions over a discrete period of time. By assessing
disparate risks on a consistent basis, VAR will further the integration of risk
management across the Company's different businesses.
Financial Instruments Held For Purposes Other Than Trading
The Company maintains investments in mutual funds related to its deferred
compensation plan, which is available to certain employees. These investments
were approximately $49 million and $61 million at December 31, 2002 and 2001,
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, 2002 and 2001, CSC had $566 million and $679 million
aggregate principal amount of Medium-Term Notes outstanding, respectively, with
fixed interest rates ranging from 6.04% to 8.05%. At December 31, 2002 and 2001,
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, U.S. Trust had
$1 million
- 22 -
FHLB long-term debt outstanding with a fixed interest rate of 6.69%.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The fair value of these
obligations at December 31, 2002 and 2001, based on estimates of market rates
for debt with similar terms and remaining maturities, was $674 million and $765
million, respectively, which approximated their carrying amounts of $642 million
and $730 million, respectively.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes Swaps to manage interest rate risk. For a discussion of such
Swaps, see note "23 - Financial Instruments Subject to Off-Balance-Sheet Risk,
Credit Risk or Market Risk" in the Notes to Consolidated Financial Statements.
Net Interest Revenue Simulation
The Company uses net interest revenue simulation modeling techniques to
evaluate and manage the effect of changing interest rates. The simulation model
(the model) includes all interest-sensitive assets and liabilities, as well as
Swaps utilized by the Company to hedge its interest rate risk. Key variables in
the model include assumed margin loan and brokerage client cash balance growth
or decline, changes in 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). The Swaps entered
into during 2002 have the effect of increasing the repricing frequency of
interest-bearing liabilities, thereby reducing the Company's consolidated
interest-rate sensitivity.
The simulations in the following table assume that the asset and liability
structure of the consolidated balance sheet would not be changed as a result of
the simulated changes in interest rates. As the Company actively manages its
consolidated balance sheet and interest rate exposure, in all likelihood the
Company would take steps to manage any additional interest rate exposure that
could result from changes in the interest rate environment. The following table
shows the results of a gradual 100 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at December 31, 2002 and 2001. The
simulations demonstrate a greater sensitivity to changes in interest rates as of
December 31, 2002 than in the prior year. This is primarily due to the continued
decline in interest rates from year to year and its impact on the Company's
ability to earn net interest revenue on client cash balances.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue
Percentage Increase (Decrease)
December 31, 2002 2001
- --------------------------------------------------------------------------------
Increase of 100 basis points 5.3% 3.8%
Decrease of 100 basis points (12.1%) (7.0%)
================================================================================
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. Claims
against the Company may increase as clients suffer losses due to deteriorating
equity market conditions, as the Company increases the level of advice it
provides to clients, and as the Company strengthens its relationship with IAs.
In addition, the Company is subject to extensive regulation by the SEC, the
National Association of Securities Dealers, Inc., the New York Stock Exchange
(NYSE), the Commodity Futures Trading Commission, the Federal Reserve Board, the
FDIC, 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 "22 - 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.
Competition
The Company faces significant competition from companies seeking to attract
client financial assets, including traditional, discount and online brokerage
firms, mutual fund
- 23 -
companies, banks, and asset management and wealth management companies. Certain
of these competitors have greater financial resources than the Company. As the
Company makes progress in its development of banking and other financial
products as well as advice offerings to 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, 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.
CORPORATE GOVERNANCE
On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of
2002 (S.O. Act) in response to corporate and accounting scandals that were
adversely affecting public confidence in the securities markets. Among other
things, the S.O. Act imposes stringent requirements to ensure independence of
public accounting firms, independence of audit committees, full and fair
disclosure of financial and other information in public reports, and
accountability of chief executive officers and chief financial officers for such
reports. The SEC has issued final and proposed rules for implementing certain
requirements of the S.O. Act.
In addition, on August 16, 2002, the NYSE submitted to the SEC proposed new
corporate governance rules for companies listed on the NYSE. These rules are
intended, among other things, to enhance director independence standards,
empower non-management directors to play a more active role on companies'
boards, increase the authority and responsibilities of audit committees, and
otherwise augment corporate governance processes and enhance disclosures of
those processes. The proposed NYSE rules are under consideration by the SEC.
The Company supports the goals of these new requirements, and has
undertaken a comprehensive review of its corporate governance processes to help
achieve compliance with the S.O. Act and promote a strong culture of corporate
governance and ethical decision-making. The Company has also taken action to
comply with the new SEC rules issued under the S.O. Act and to be in position to
comply with proposed rules under the S.O. Act and the NYSE listing standards if
and when adopted. The Company has announced that effective May 9, 2003, the date
of the annual meeting of shareholders, David S. Pottruck will become President
and Chief Executive Officer (CEO), and Charles R. Schwab will remain as Chairman
of the Board. The Company believes that separating the roles of Chairman and CEO
is an important corporate governance measure. Additionally, the Company has,
among other things:
- - Created a Nominating and Corporate Governance Committee of the Board
responsible for identifying candidates for the Board and recommending
corporate governance guidelines, policies and procedures for the Company.
- - Revised the charters for the Audit Committee and Compensation Committee.
- - Adopted a Code of Business Conduct and Ethics applicable to directors and
all employees.
- - Adopted Corporate Governance Guidelines for the Company.
- - Created a Corporate Governance Office, headed by the General Counsel, to
assist the Board in fulfilling its oversight responsibilities.
- - Revised the charters for the Audit Committee and Compensation Committee to
clarify the responsibilities of these committees in light of the new and
proposed rules.
- - Adopted procedures for reporting to the Audit Committee complaints
regarding accounting, internal accounting controls and auditing matters, as
well as any significant deficiencies or material weaknesses in internal
controls or fraud involving management or employees who have significant
roles in internal controls.
- - Adopted an interim policy regarding the approval of non-audit services to
be performed by the Company's independent auditors.
- - Created a Disclosure Committee to carry out the development, implementation
and oversight of disclosure controls and procedures to ensure that the
Company's public disclosures are accurate, timely, and complete in
accordance with applicable legal and regulatory requirements. The
Disclosure Committee provides written attestation to the Co-Chief Executive
Officers, Chief Financial Officer, and the Audit Committee as to the
adequacy of disclosure controls and procedures.
As of December 31, 2002, with the exception of Charles R. Schwab and David
S. Pottruck, all of the directors on the Board are independent. All of the
directors on the Board's Audit, Compensation, and Nominating and Corporate
Governance Committees are independent.
- 24 -
Consolidated Statement of Income The Charles Schwab Corporation
(In Millions, Except Per Share Amounts)
Year Ended December 31, 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 1,761 $ 1,675 $ 1,583
Commissions 1,206 1,355 2,294
Interest revenue 1,186 1,857 2,589
Interest expense (345) (928) (1,352)
-------- -------- --------
Net interest revenue 841 929 1,237
Principal transactions 184 255 570
Other 143 139 104
- ------------------------------------------------------------------------------------------------------------------------------------
Total 4,135 4,353 5,788
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 1,854 1,875 2,414
Other compensation - merger retention programs 22 56 39
Occupancy and equipment 471 490 415
Depreciation and amortization 321 338 255
Communications 262 339 353
Advertising and market development 211 246 332
Professional services 177 193 255
Commissions, clearance and floor brokerage 71 92 138
Restructuring and other charges 373 419
Goodwill and other impairment charges 61
Goodwill amortization 66 53
Merger-related 69
Other 144 104 234
- ------------------------------------------------------------------------------------------------------------------------------------
Total 3,967 4,218 4,557
- ------------------------------------------------------------------------------------------------------------------------------------
Income before taxes on income and extraordinary gain 168 135 1,231
Taxes on income 71 57 513
- ------------------------------------------------------------------------------------------------------------------------------------
Income before extraordinary gain 97 78 718
Extraordinary gain on sale of corporate trust business, net of tax 12 121
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 109 $ 199 $ 718
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,375 1,399 1,404
====================================================================================================================================
Earnings Per Share - Basic
Income before extraordinary gain $ .07 $ .06 $ .53
Extraordinary gain, net of tax $ .01 $ .08
Net income $ .08 $ .14 $ .53
Earnings Per Share - Diluted
Income before extraordinary gain $ .07 $ .06 $ .51
Extraordinary gain, net of tax $ .01 $ .08
Net income $ .08 $ .14 $ .51
====================================================================================================================================
Dividends Declared Per Common Share $ .0440 $ .0440 $ .0407
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 25 -
Consolidated Balance Sheet The Charles Schwab Corporation
(In Millions, Except Share and Per Share Amounts)
December 31, 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 3,114 $ 4,407
Cash and investments segregated and on deposit for federal or other regulatory
purposes (1) (including resale agreements of $16,111 in 2002 and $14,811 in 2001) 21,005 17,741
Securities owned - at market value (including securities pledged of $337 in 2002
and $185 in 2001) 1,716 1,700
Receivables from brokers, dealers and clearing organizations 222 446
Receivables from brokerage clients - net 6,845 9,620
Loans to banking clients - net 4,555 4,046
Equipment, office facilities and property - net 868 1,058
Goodwill - net 603 628
Other assets 777 818
- ------------------------------------------------------------------------------------------------------------------------------------
Total $39,705 $40,464
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 5,231 $ 5,448
Drafts payable 134 396
Payables to brokers, dealers and clearing organizations 1,476 833
Payables to brokerage clients 26,401 26,989
Accrued expenses and other liabilities 1,302 1,327
Short-term borrowings 508 578
Long-term debt 642 730
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 35,694 36,301
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share; none issued
Common stock - 3 billion shares authorized; $.01 par value per share;
1,391,991,180 and 1,391,673,494 shares issued in 2002 and 2001, respectively 14 14
Additional paid-in capital 1,744 1,726
Retained earnings 2,769 2,794
Treasury stock - 47,195,631 and 23,110,972 shares in 2002 and 2001, respectively, at cost (465) (295)
Unamortized stock-based compensation (33) (39)
Accumulated other comprehensive loss (18) (37)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,011 4,163
- ------------------------------------------------------------------------------------------------------------------------------------
Total $39,705 $40,464
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $21,252 million and $18,261 million at December 31, 2002 and 2001, respectively. On January 2,
2003, the Company deposited $655 million into its segregated reserve bank accounts. As of January 3, 2002, the Company had
deposited $710 million into its segregated reserve bank accounts.
See Notes to Consolidated Financial Statements.
- 26 -
Consolidated Statement of Cash Flows The Charles Schwab Corporation
(In Millions)
Year Ended December 31, 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 109 $ 199 $ 718
Adjustments to reconcile net income to net cash provided
by (used for) operating activities:
Depreciation and amortization 321 338 255
Goodwill and other impairment charges 61
Goodwill amortization 66 53
Compensation payable in common stock 27 32 82
Deferred income taxes 4 (79) (27)
Tax benefits from stock options exercised and other stock-based
compensation 4 37 330
Non-cash restructuring and other charges 42 80
Net gain on sale of an investment (26)
Extraordinary gain on sale of corporate trust business, net of tax (12) (121)
Other (1) 22 8
Net change in:
Cash and investments segregated and on deposit for federal
or other regulatory purposes (3,302) (8,334) (942)
Securities owned (excluding securities available for sale) 105 14 (54)
Receivables from brokers, dealers and clearing organizations 220 (89) 131
Receivables from brokerage clients 2,745 6,709 727
Other assets 7 (35) (94)
Drafts payable (261) (150) 75
Payables to brokers, dealers and clearing organizations 643 (335) (662)
Payables to brokerage clients (527) 1,291 2,329
Accrued expenses and other liabilities (16) (203) (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities 169 (584) 2,916
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,147) (1,025) (545)
Proceeds from sales of securities available for sale 636 473 93
Proceeds from maturities, calls and mandatory redemptions of
securities available for sale 415 611 227
Net increase in loans to banking clients (705) (835) (458)
Proceeds from sale of banking client loans 196
Purchase of equipment, office facilities and property - net (160) (301) (705)
Cash payments for business combinations and investments,
net of cash received (52) (35)
Proceeds from sale of an investment 49
Proceeds from sale of Canadian operations 26
Proceeds from sale of corporate trust business 273
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (739) (807) (1,423)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients (217) 1,139 4
Net change in short-term borrowings (70) 224 198
Proceeds from long-term debt 100 311
Repayment of long-term debt (214) (40) (59)
Dividends paid (60) (61) (62)
Purchase of treasury stock (299) (368)
Proceeds from stock options exercised and other 34 30 85
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities (726) 924 477
- ------------------------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents 3 (2) (4)
- ------------------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents (1,293) (469) 1,966
Cash and Cash Equivalents at Beginning of Year 4,407 4,876 2,910
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 3,114 $ 4,407 $ 4,876
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 27 -
Consolidated Statement of Stockholders' Equity The Charles Schwab Corporation
(In Millions)
Common
Stock Accumu-
Issued lated
Deferred to Other
Addi- Compen- Employee Unamortized Deferred Compre-
tional sation Stock Stock-based Compen- hensive
Common Paid-In Retained Stock Treasury Ownership Compen- sation Income
Stock Capital Earnings Trust (1) Stock Plans sation Trust (1) (Loss) Total
- ------------------------------------------------------------------------------------------------------------------------------------
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
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income 109 109
Net loss on cash flow hedging
instruments, net of tax (6) (6)
Foreign currency translation adjustment 8 8
Net unrealized gain (loss) on
securities available for sale, net
of reclassification adjustment and tax 17 17
------
Total comprehensive income 128
Dividends declared on common stock (60) (60)
Purchase of treasury stock (299) (299)
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans 5 (74) 129 (22) 38
Non-cash stock-based compensation
expense related to restructuring 9 1 10
Issuance of shares for acquisitions 4 4
Amortization of stock-based
compensation awards 27 27
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 $ 14 $1,744 $ 2,769 $ 3 $ (465) $ (33) $ (3) $ (18) $4,011
====================================================================================================================================
(1) Deferred compensation stock trust amounts are presented net on the Consolidated Balance Sheet.
See Notes to Consolidated Financial Statements.
- 28 -
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
388 domestic branch offices in 48 states, as well as a branch in the
Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 34 offices in 12 states. Other subsidiaries include
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 primarily to
broker-dealers and institutional clients, and CyberTrader, Inc. (CyberTrader),
an electronic trading technology and brokerage firm providing services to highly
active, online traders.
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, and property, valuation of goodwill and other intangible assets and
equity investments, 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 2002 presentation. All material intercompany balances and transactions have
been eliminated.
On May 31, 2000, CSC completed its merger (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. 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. The consolidated financial
statements, included in this Annual Report, give retroactive effect to the
Merger, which was accounted for as a pooling of interests.
On March 1, 2000, the Company acquired CyberTrader for $517 million in a
non-taxable stock-for-stock exchange. 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.
2. Significant Accounting Policies
Securities transactions: Clients' securities transactions are recorded on the
date that they settle, while the related commission revenues and expenses are
recorded on the date that the trade occurs. Principal transactions are recorded
on a trade date basis.
Cash and cash equivalents: The Company considers all highly liquid investments,
including money market funds, interest-bearing deposits with banks, federal
funds sold, commercial paper and treasury securities, with original maturities
of three months or less that are not segregated and on deposit for federal or
other regulatory purposes to be cash equivalents.
Cash and investments segregated and on deposit for federal or other regulatory
purposes consist primarily of securities purchased under agreements to resell
(resale agreements), which are collateralized by U.S. government securities, and
certificates of deposit. Resale agreements are collateralized investing
transactions that are recorded at their contractual amounts plus accrued
interest. The Company obtains possession of collateral (U.S. government
securities) with a market value equal to or in excess of the principal amount
loaned and accrued interest under resale agreements. Collateral is valued daily
by the Company, with additional collateral obtained when necessary. Certificates
of deposit are stated at cost, which approximates market.
- 29 -
Securities borrowed, securities loaned, and securities sold under agreements to
repurchase (repurchase agreements) are collateralized investing and 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 to brokers,
dealers and clearing organizations. The Company monitors the market value of
securities borrowed and loaned, with additional collateral obtained or refunded
when necessary. Repurchase agreements are recorded at their contractual amounts
plus accrued interest and are included in short-term borrowings.
Securities owned include securities available for sale that are recorded at
estimated fair value 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 initiatives, which included the removal of assets from
service, see note "3 - Restructuring and Other Charges."
Derivative financial instruments are accounted for under Statement of Financial
Accounting Standards (SFAS) No. 133 - Accounting for Derivative Instruments and
Hedging Activities. This statement requires that all derivatives be recorded on
the balance sheet at fair value.
As part of its consolidated asset and liability management process, the
Company utilizes interest rate swap agreements (Swaps) to manage interest rate
risk. Other derivative activities primarily consist of exchange-traded futures
and options to hedge potential losses in equity inventory positions. 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. For further discussion on these derivative financial
instruments, see note "23 - Financial Instruments Subject to Off-Balance-Sheet
Risk, Credit Risk or Market Risk."
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
- 30 -
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.
Stock-based compensation: The Company applies Accounting Principles Board
Opinion (APB) No. 25 - Accounting for Stock Issued to Employees, and related
interpretations, for its stock-based employee compensation plans. Because the
Company grants stock option awards at market value, there is no compensation
expense recorded, except for restructuring-related expense for modifications of
officers' stock options. Compensation expense for restricted stock awards is
based on the market value of the shares awarded at the date of grant and is
amortized on a straight-line basis over the vesting period. The unamortized
portion of the award is recorded as unamortized stock-based compensation in
stockholders' equity.
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes 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 would have recorded
additional compensation expense and its net income and earnings per share (EPS)
would have been reduced to the pro forma amounts presented in the following
table:
- --------------------------------------------------------------------------------
Year Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after tax):
As reported $ 6 $ 13
Pro forma $ 154 $ 181 $ 81
- --------------------------------------------------------------------------------
Net Income (Loss):
As reported $ 109 $ 199 $ 718
Pro forma $ (39) $ 31 $ 637
- --------------------------------------------------------------------------------
Basic EPS:
As reported $ .08 $ .14 $ .53
Pro forma $(.03) $ .02 $ .47
Diluted EPS:
As reported $ .08 $ .14 $ .51
Pro forma $(.03) $ .02 $ .45
- --------------------------------------------------------------------------------
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:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Expected dividend yield .30% .30% .40%
Expected volatility 51% 50% 48%
Risk-free interest rate 3.5% 4.3% 6.0%
Expected life (in years) 5 5 5
- --------------------------------------------------------------------------------
During 2002, the Company changed its methodology for amortizing pro forma
stock option compensation. Pro forma stock option compensation is amortized
monthly on a straight-line basis over the vesting period beginning with the
month when the option was granted. In prior periods, a full year of amortization
was recognized regardless of when an option was granted during the year. Pro
forma amounts have been revised to reflect this change in methodology on a
retroactive basis.
Goodwill represents the cost of acquired businesses in excess of the fair value
of the related net assets acquired. Goodwill is accounted for under SFAS No. 142
- - Goodwill and Other Intangible Assets. This statement requires that goodwill be
tested for impairment at least annually or whenever indications of impairment
exist. In testing for a potential impairment of goodwill, SFAS No. 142 requires
management to estimate the fair value of each of the Company's reporting units
(generally defined as the Company's businesses for which financial information
is available and reviewed regularly by management), and compare it to their
carrying value. If the estimated fair value of a reporting unit is less than its
carrying value, management is required to estimate the fair value of all assets
and liabilities of the reporting unit, including goodwill. If the carrying value
of the reporting unit's goodwill is greater than the estimated fair value, an
impairment charge is recognized for the excess. The Company has elected April 1
as its annual impairment testing date. See "Accounting Change" below and note "4
- - Goodwill and Other Impairment Charges."
Accounting change: The Company adopted SFAS No. 142 on January 1, 2002. Under
SFAS No. 142, companies are no longer permitted to amortize goodwill and certain
intangible assets with an indefinite useful life. Instead, these assets must be
reviewed for impairment as discussed above. The Company completed its
transitional testing for goodwill impairment during the second quarter of 2002
as required, and did not record any impairment charges at that time.
The following table compares net income and EPS for 2002, which excludes
goodwill amortization, with net income and EPS for 2001 and 2000, which has been
adjusted to exclude goodwill amortization.
- 31 -
- --------------------------------------------------------------------------------
2002 2001 2000
(Reported) (Adjusted) (Adjusted)
- --------------------------------------------------------------------------------
Net income:
Reported income
before extraordinary gain $ 97 $ 78 $ 718
Add: Goodwill amortization,
net of tax 62 51
- --------------------------------------------------------------------------------
Reported/adjusted
income before
extraordinary gain 97 140 769
Extraordinary gain, net of tax 12 121
- --------------------------------------------------------------------------------
Reported/adjusted
net income $ 109 $ 261 $ 769
================================================================================
Basic EPS:
Reported EPS before
extraordinary gain $ .07 $ .06 $ .53
Add: Goodwill amortization .05 .04
- --------------------------------------------------------------------------------
Reported/adjusted EPS before
extraordinary gain .07 .11 .57
Extraordinary gain, net of tax .01 .08
- --------------------------------------------------------------------------------
Reported/adjusted EPS $ .08 $ .19 $ .57
================================================================================
Diluted EPS:
Reported EPS before
extraordinary gain $ .07 $ .06 $ .51
Add: Goodwill amortization .04 .04
- --------------------------------------------------------------------------------
Reported/adjusted EPS before
extraordinary gain .07 .10 .55
Extraordinary gain, net of tax .01 .08
- --------------------------------------------------------------------------------
Reported/adjusted EPS $ .08 $ .18 $ .55
================================================================================
The Company's goodwill balance declined during 2002 primarily due to the
write-off of goodwill associated with Charles Schwab Europe (CSE), a subsidiary
located in the United Kingdom. The decline in goodwill during 2002 was also due
to the sale of the Company's Canadian operations, partially offset by the
effects of foreign currency translation adjustments. The carrying amount of
goodwill, net of accumulated amortization, attributable to each of the Company's
reportable segments is presented in the following table:
- --------------------------------------------------------------------------------
2002 2001
- --------------------------------------------------------------------------------
Individual Investor $ 415 $ 440
Institutional Investor 3 3
Capital Markets 27 27
U.S. Trust 158 158
- --------------------------------------------------------------------------------
Total $ 603 $ 628
================================================================================
New accounting standards: 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 APB
No. 30 - Reporting the Results of Operations. The Company adopted this statement
on January 1, 2002. The adoption of SFAS No. 144 did not have a material impact
on the Company's financial position, results of operations, EPS, or cash flows.
SFAS No. 146 - Accounting for Costs Associated with Exit or Disposal
Activities was issued in June 2002 and addresses accounting for restructuring
and similar costs. SFAS No. 146 supersedes previous accounting guidance,
principally Emerging Issues Task Force Issue No. 94-3 - Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). SFAS No. 146 may affect
the timing of recognizing future restructuring costs, as well as the amounts
recognized. The Company is required to adopt this statement for exit or disposal
activities initiated after December 31, 2002.
Financial Accounting Standards Board Interpretation (FIN) No. 45 -
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, was issued in November 2002. This
interpretation addresses the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees that it has issued. FIN No. 45 also clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the fair
value of the obligation undertaken in issuing the guarantee. In accordance with
FIN No. 45, the Company adopted the disclosure requirements on December 31, 2002
and is required to adopt the recognition requirements effective on January 1,
2003. The Company is evaluating the impact of the recognition requirements of
this interpretation and does not expect it to have a material impact on its
financial position, results of operations, EPS, or cash flows.
SFAS No. 148 - Accounting for Stock-Based Compensation - Transition and
Disclosure was issued in December 2002. This statement amends SFAS No. 123 -
Accounting for Stock-Based Compensation to provide companies with alternative
methods of transition for a voluntary change to the fair value method of
accounting for stock-based employee compensation. Additionally, SFAS No. 148
amends certain disclosure requirements of SFAS No. 123. The Company adopted the
disclosure requirements of SFAS No. 148 as of December 31, 2002. The
transitional provisions of SFAS No. 148 did not have an impact on the Company's
financial position, results of operations, EPS, or cash flows, as the fair value
method has not been adopted.
FIN No. 46 - Consolidation of Variable Interest Entities, an Interpretation
of Accounting Research Bulletin No. 51 - Consolidated Financial Statements, was
issued in January 2003. FIN No. 46 is effective for all new variable interest
entities created or acquired after January 31, 2003. For variable interest
entities created or acquired prior to
- 32 -
February 1, 2003, the provisions of FIN No. 46 must be adopted by the third
quarter of 2003. The Company plans to adopt FIN No. 46 in the first quarter of
2003. This interpretation provides new criteria for determining whether a
company is required to consolidate (i.e., record the assets and liabilities on
the balance sheet) a variable interest entity such as the Company's
participation in the unconsolidated special purpose trust (Trust) formed in 2000
to finance an office building. Because the Trust meets the definition of a
variable interest entity and the criteria to consolidate, upon adoption of this
interpretation in the first quarter of 2003, the Company will record the
building at cost, net of depreciation, on the consolidated balance sheet.
Specifically, the impact is expected to increase equipment, office facilities
and property by approximately $230 million, increase long-term debt by
approximately $235 million, and reduce accrued expenses and other liabilities by
approximately $5 million. Further, the expected annual impact on the Company's
consolidated statement of income will be to cease both amortizing the shortfall
of the residual value guarantee and recording rent expense on the lease and to
begin recording both the depreciation on the building and the interest expense
associated with the debt. Upon adoption and in future periods, the Company
expects the impact on its consolidated statement of income will be immaterial.
See note "22 - Commitments and Contingent Liabilities" for a further discussion
of the Trust.
3. Restructuring and Other Charges
Restructuring
The Company recorded pre-tax restructuring charges in 2002 and 2001 as
follows:
- --------------------------------------------------------------------------------
2002 2001
- --------------------------------------------------------------------------------
2002 Initiatives $ 277
2001 Initiatives 96 $ 391
- --------------------------------------------------------------------------------
Total restructuring charges $ 373 $ 391
================================================================================
2002 Initiatives
In 2002, the Company commenced and substantially completed additional
restructuring initiatives due to continued difficult market conditions. These
initiatives are intended to reduce operating expenses and adjust the Company's
organizational structure to improve productivity, enhance efficiency, and
increase profitability. The restructuring initiatives primarily included further
reductions in the Company's workforce and facilities. The Company recorded
pre-tax restructuring charges of $277 million in 2002 related to these
restructuring initiatives. The actual costs of these restructuring initiatives
could differ from the estimated costs, depending primarily on the Company's
ability to sublease properties.
Workforce: During 2002, the Company reduced full-time equivalent employees by
2,900, or 15%, including 2,040 through mandatory staff reductions, 130 related
to a reduction in contractors, and 730 mainly related to voluntary attrition.
The workforce reductions encompassed employees from each of the Company's
segments.
Facilities: The restructuring charges recognized in 2002 included facility exit
costs which are net of estimated sublease income. Facilities restructuring
charges related to reductions of administrative office space primarily in
Northern California, Texas, New York, and the United Kingdom, as well as the
consolidation of 18 Schwab branch offices and 2 U.S. Trust offices in 2003. The
restructuring charges also included write-downs of leasehold improvements,
telecommunications infrastructure, and fixed assets removed from service at
these facilities.
Systems: The restructuring charges recognized in 2002 included the removal of
certain computer systems software and equipment from service at certain of the
Company's facilities.
A summary of pre-tax restructuring charges related to the Company's 2002
restructuring initiatives is as follows:
- --------------------------------------------------------------------------------
2002
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 134
Non-cash compensation expense for officers' stock options 7
- --------------------------------------------------------------------------------
Total workforce reduction 141
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated sublease income 104
Write-downs of leasehold improvements, telecommunications
infrastructure, and fixed assets removed from service 28
- --------------------------------------------------------------------------------
Total facilities reduction 132
- --------------------------------------------------------------------------------
Systems removal 4
- --------------------------------------------------------------------------------
Total restructuring charges $ 277
================================================================================
- 33 -
A summary of the activity in the restructuring reserve related to the
Company's 2002 restructuring initiatives for the year ended December 31, 2002 is
as follows:
- --------------------------------------------------------------------------------
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Restructuring charges $ 141 $ 132 $ 4 $ 277
Utilization:
Cash payments (79) (1) (80)
Non-cash charges (1) (7) (28) (4) (39)
- --------------------------------------------------------------------------------
Balance at December 31, 2002 $ 55 (2) $ 103 (3) $ 158
================================================================================
(1) Primarily includes charges for write-downs of leasehold improvements,
telecommunications infrastructure, fixed assets, and systems equipment
removed from service, as well as officers' stock-based compensation.
(2) The Company expects to substantially utilize the remaining workforce
restructuring reserve through cash payments for severance pay and benefits
over the respective severance periods through 2004.
(3) The Company expects to substantially utilize the remaining facilities
restructuring reserve through cash payments for the net lease expense over
the respective lease terms through 2013.
2001 Initiatives
In 2001, the Company initiated a restructuring plan to reduce operating
expenses due to continued economic uncertainties and difficult market
conditions. The restructuring plan was completed in 2002 and included a
workforce reduction, a reduction in operating facilities, and the removal of
certain systems hardware, software and equipment from service. Included in these
initiatives are costs associated with the withdrawal from certain international
operations. During 2002, the Company recorded pre-tax restructuring charges
related to its 2001 restructuring initiatives of $96 million, primarily
resulting from facilities charges for changes in estimates of sublease income
due to a continued deterioration of the commercial real estate market. The
Company recorded pre-tax charges for restructuring costs of $391 million in
2001. The actual costs of these restructuring initiatives could differ from the
estimated costs, depending primarily on the Company's ability to sublease
properties.
A summary of the activity in the restructuring reserve related to the
Company's 2001 restructuring initiatives for the years ended December 31, 2002
and 2001 is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Initial restructuring
charges in 2001 $ 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 $ 97 $ 4 $ 175
Restructuring charges 19 76 (2) 1 96
Utilization:
Cash payments (77) (49) (5) (131)
Non-cash charges (1) (3) (3)
- --------------------------------------------------------------------------------
Balance at
December 31, 2002 $ 13 (3) $ 124 (4) $ 137
================================================================================
(1) In 2002, primarily includes charges for officers' stock-based compensation.
In 2001, includes charges for officers' stock-based compensation,
write-downs, and accelerated depreciation.
(2) Includes $65 million primarily due to changes in estimates of sublease
income resulting from a continued deterioration of the commercial real
estate market.
(3) The Company expects to substantially utilize the remaining workforce
restructuring reserve through cash payments for severance pay and benefits
over the respective severance periods through 2003.
(4) The Company expects to substantially utilize the remaining facilities
restructuring reserve through cash payments for the net lease expense over
the respective lease terms through 2017.
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 2002
or 2000.
4. Goodwill and Other Impairment Charges
During the fourth quarter of 2002, the Company developed plans for the
possible sale of CSE. Accordingly, the Company performed a goodwill impairment
test at that time pursuant to SFAS No. 142 - Goodwill and Other Intangible
Assets. The fair value of CSE, a reporting unit within the Individual Investor
segment, was estimated when performing the impairment test using a combination
of the expected present value of future cash flows and an indicative sales
price. As a result of this test, the Company recorded an impairment charge of
$24 million pre tax during the fourth quarter of 2002. See note "27 - Subsequent
Event" for a discussion of CSE.
During the fourth quarter of 2002, the Company also evaluated whether its
investment in Aitken Campbell, a market-making joint venture in the United
Kingdom accounted for under the equity method, had incurred a loss in value, and
- 34 -
whether such loss was other than a temporary decline. Taking into consideration
the possible sale of CSE and the potential reduction of its client order flow,
the Company determined that its ability to retain its investment in Aitken
Campbell for a period of time sufficient to allow for recovery in fair value was
no longer reasonably assured. The fair value of the investment was estimated
principally using the expected present value of future cash flows and was
compared to the carrying value of the investment. As a result of this analysis,
an impairment charge of $37 million pre tax was recorded in the fourth quarter
of 2002.
5. Sale of Corporate Trust Business
In 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. During 2002, the Company recorded an extraordinary
gain of $22 million, or $12 million after tax, which represented the remaining
proceeds from this sale that were realized upon satisfaction of certain client
retention requirements.
6. Securities Owned
A summary of securities owned is as follows:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Securities available for sale $1,322 $1,200
SchwabFunds money market funds 197 171
Equity, fixed income and other securities 126 223
Equity and bond mutual funds 71 106
- --------------------------------------------------------------------------------
Total $1,716 $1,700
================================================================================
The amortized cost, estimated fair value, and gross unrealized gains and
losses on securities available for sale are as follows:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
U.S. treasury securities:
Amortized cost $ 290 $ 159
Aggregate fair value $ 296 $ 160
Gross unrealized gains $ 6 $ 1
Gross unrealized losses
U.S. government sponsored agencies and corporations:
Amortized cost 701 748
Aggregate fair value 727 754
Gross unrealized gains 26 7
Gross unrealized losses 1
State and municipal obligations:
Amortized cost 169 154
Aggregate fair value 178 158
Gross unrealized gains 9 4
Gross unrealized losses
Collateralized mortgage obligations (1):
Amortized cost 88 84
Aggregate fair value 87 84
Gross unrealized gains
Gross unrealized losses 1
Other securities:
Amortized cost 33 43
Aggregate fair value 34 44
Gross unrealized gains 1 1
Gross unrealized losses
- --------------------------------------------------------------------------------
Total securities available for sale:
Amortized cost $ 1,281 $ 1,188
Aggregate fair value $ 1,322 $ 1,200
Gross unrealized gains $ 42 $ 13
Gross unrealized losses $ 1 $ 1
================================================================================
(1) Collateralized by either GNMA, FNMA or FHLC obligations.
- 35 -
The maturities of debt securities available for sale at December 31, 2002,
and the related weighted-average yield on such debt securities are as follows:
- --------------------------------------------------------------------------------
Within 1 - 5 5 - 10
1 Year Years Years Total
- --------------------------------------------------------------------------------
U.S. treasury securities $145 $ 145 $ 290
U.S. government sponsored
agencies and corporations 8 690 $ 3 701
State and municipal obligations 20 149 169
Collateralized mortgage
obligations (1) 12 76 88
Other debt securities 21 12 33
- --------------------------------------------------------------------------------
Total at amortized cost 206 1,072 3 1,281
Estimated fair value 208 1,111 3 1,322
- --------------------------------------------------------------------------------
Net unrealized gains $ 2 $ 39 $ 41
================================================================================
Weighted-average yield (2) 3.62% 5.08% 7.13% 4.85%
================================================================================
(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, 2002.
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 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 and
U.S. government and corporate obligations held to meet clients' trading
activities. Equity and bond mutual funds include investments made by the Company
relating to its deferred compensation plan and inventory maintained to
facilitate certain SchwabFunds and third-party mutual fund clients'
transactions.
Securities sold, but not yet purchased, of $26 million and $27 million at
December 31, 2002 and 2001, respectively, consist primarily of mutual fund
shares that are distributed to clients to satisfy their dividend reinvestment
requests and subsequently purchased by the Company from the mutual funds, as
well as equity and other securities. These securities 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 $6.6 billion and $9.2 billion at December 31, 2002 and
2001, 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 $4 million and $5 million at December 31, 2002 and 2001,
respectively.
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, 2002 2001
- --------------------------------------------------------------------------------
Private banking:
Residential real estate mortgages $ 3,594 $ 3,085
Other 976 943
- --------------------------------------------------------------------------------
Total private banking loans 4,570 4,028
- --------------------------------------------------------------------------------
Loans to financial institutions for purchasing
and carrying securities 32
All other 9 7
- --------------------------------------------------------------------------------
Total $ 4,579 $ 4,067
================================================================================
Nonperforming assets consist of non-accrual loans of $1 million and $5
million at December 31, 2002 and 2001, respectively. The Company considers all
non-accrual loans impaired. For 2002 and 2001, 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, 2002 and 2001.
The allowance for credit losses on the loan portfolio was $24 million at
December 31, 2002, $21 million at December 31, 2001 and $20 million at December
31, 2000. Total charge-offs and total recoveries were immaterial for each of
2002, 2001 and 2000.
9. Loan Securitization
During the second quarter of 2002, U.S. Trust securitized and sold $193
million of residential mortgage loans originated through its private banking
business. This transaction was accounted for as a sale under the requirements of
SFAS No. 140 - Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities. U.S. Trust received $196 million in proceeds
from the sale and, after payment of $2 million of transaction expenses,
recognized a net gain of $1 million. The senior mortgage pass-through
certificates that were created by the securitization process were sold to third
parties. U.S. Trust retained all other securities created by the process,
primarily comprised of subordinated securities with total par value of $5
million, and servicing rights. The gain on securitization of $1 million was
determined based upon the previous carrying amount of the
- 36 -
securitized loans, allocated between the loans sold and the retained securities
based on their relative fair values at the date of sale. The fair values of
retained securities were primarily determined based on quoted market prices,
incorporating key economic assumptions as follows:
- --------------------------------------------------------------------------------
At December 31,
Securitization 2002
- --------------------------------------------------------------------------------
Average discount rate 8.33% 10.84%
Average annual constant prepayment rate 16.00% 57.50%
Expected weighted-average life (in years) 8.0 4.3
Expected credit losses 0% 0%
- --------------------------------------------------------------------------------
Any credit losses on the securitized loans will be assigned to U.S. Trust,
as holder of the subordinated securities, up to the $5 million par value. There
were no delinquencies in the securitized mortgage loans at December 31, 2002,
and there were no losses for 2002. U.S. Trust has not guaranteed the mortgage
loans as this transaction was structured without recourse to U.S. Trust or the
Company. The estimated fair value of the retained securities was $5 million at
December 31, 2002 and was included in securities owned on the Company's
consolidated balance sheet. A hypothetical change of 50 or 100 basis points in
any of the above key assumptions would not have a material impact on the
Company's financial condition at December 31, 2002. Cash flows received from the
retained securities, including servicing fees, were immaterial in 2002.
10. Equipment, Office Facilities and Property
Equipment, office facilities and property are detailed below:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Land $ 24 $ 22
Buildings 265 264
Leasehold improvements 400 410
Furniture and equipment 233 247
Telecommunications equipment 172 184
Information technology equipment and software 938 875
Construction and software development
in progress 82 72
- --------------------------------------------------------------------------------
Subtotal 2,114 2,074
Accumulated depreciation and amortization (1,246) (1,016)
- --------------------------------------------------------------------------------
Total $ 868 $ 1,058
================================================================================
11. 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, 2002 2001
- --------------------------------------------------------------------------------
Interest-bearing deposits $ 4,471 $ 4,046
Noninterest-bearing deposits 760 1,402
- --------------------------------------------------------------------------------
Total $ 5,231 $ 5,448
================================================================================
During the years ended December 31, 2002 and 2001, the Company paid an
average rate of 2.4% and 3.8%, respectively, on its interest-bearing deposits
from banking clients.
12. Payables to Brokers, Dealers and Clearing Organizations
Payables to brokers, dealers and clearing organizations consist primarily
of securities loaned of $1.4 billion and $628 million at December 31, 2002 and
2001, respectively. The cash collateral received from counterparties under
securities lending transactions was equal to or greater than the market value of
the securities loaned.
13. Payables to Brokerage Clients
The principal source of funding for Schwab's margin lending is cash
balances in brokerage client accounts. At December 31, 2002, Schwab was paying
interest at .4% on $23.0 billion of cash balances in brokerage client accounts,
which were included in payables to brokerage clients. At December 31, 2001,
Schwab was paying interest at 1.1% on $23.1 billion of such cash balances.
14. Short-term Borrowings
CSC may borrow under its $1.0 billion committed, unsecured credit facility
with a group of twenty-two banks which is scheduled to expire in June 2003. 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, 2002 and 2001.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of
- 37 -
eight banks totaling $770 million at December 31, 2002. CSC has access to $670
million of these credit lines. The amount available to CSC under these lines is
lower than the amount available to Schwab because the credit line provided by
one of these banks is only available to Schwab. There were no borrowings
outstanding under these lines at December 31, 2002 and 2001.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2002. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2002 and 2001.
Other short-term borrowings include Federal Home Loan Bank System
borrowings, federal funds purchased, repurchase agreements, and other borrowed
funds. At December 31, 2002 and 2001, these other short-term borrowings totaled
$508 million and $578 million, respectively, with weighted-average interest
rates ranging from 1.13% to 2.00% and 1.71% to 3.69%, respectively.
15. Long-term Debt
Long-term debt consists of the following:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 566 $ 679
8.414% Trust Preferred Capital Securities 50 50
Fair value adjustment (1) 26
Other 1
- --------------------------------------------------------------------------------
Total $ 642 $ 730
================================================================================
(1) Represents the fair value adjustment related to hedged Medium-Term Notes.
See note "23 - Financial Instruments Subject to Off-Balance-Sheet Risk,
Credit Risk or Market Risk."
The aggregate principal amount of Senior Medium-Term Notes, Series A
(Medium-Term Notes) outstanding at December 31, 2002 had maturities ranging from
2003 to 2010. The aggregate principal amount of Medium-Term Notes outstanding at
both December 31, 2002 and 2001 had fixed interest rates ranging from 6.04% to
8.05%. At December 31, 2002 and 2001, the Medium-Term Notes carried a
weighted-average interest rate of 7.29% and 7.27%, respectively.
The Trust Preferred Capital Securities qualify as tier 1 capital under
guidelines of the Board of Governors of the Federal Reserve System (Federal
Reserve Board) and have no voting rights. Holders of the Trust Preferred Capital
Securities are entitled to receive cumulative cash distributions semi-annually.
The Company has the right to redeem the Trust Preferred Capital Securities prior
to their stated maturity of February 1, 2027, on or after February 1, 2007, upon
approval (if then required) of the Federal Reserve Board.
Annual maturities on long-term debt outstanding at December 31, 2002 are as
follows:
- --------------------------------------------------------------------------------
2003 $ 100
2004 81
2005 56
2006 68
2007 38
Thereafter 273
- --------------------------------------------------------------------------------
Total maturities 616
Fair value adjustment 26
- --------------------------------------------------------------------------------
Total $ 642
================================================================================
16. Taxes on Income
Income tax expense is as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Current:
Federal $ 78 $ 201 $ 475
State (1) 35 65
- --------------------------------------------------------------------------------
Total current 77 236 540
- --------------------------------------------------------------------------------
Deferred:
Federal (11) (70) (24)
State 15 (9) (3)
- --------------------------------------------------------------------------------
Total deferred 4 (79) (27)
- --------------------------------------------------------------------------------
Taxes on income 81 157 513
Current tax expense on
extraordinary gain (10) (100)
- --------------------------------------------------------------------------------
Taxes on income before
extraordinary gain $ 71 $ 57 $ 513
================================================================================
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 $4 million in 2002, $37 million in 2001, and $190
million in 2000. 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).
- 38 -
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, 2002 2001
- --------------------------------------------------------------------------------
Deferred tax assets:
Reserves and allowances $ 143 $ 128
Deferred compensation and employee benefits 95 152
Property and equipment leasing 28 14
Net loss on cash flow hedging instruments 25 23
Foreign investments 19 4
Trust and fiduciary activities 9 10
Other 6 (3)
- --------------------------------------------------------------------------------
Total deferred assets 325 328
- --------------------------------------------------------------------------------
Deferred tax liabilities:
Capitalized internal-use software development
costs (65) (70)
Net unrealized gains on securities
available for sale (16) (5)
Depreciation and amortization (7) (5)
State and local taxes (4) (3)
- --------------------------------------------------------------------------------
Total deferred liabilities (92) (83)
- --------------------------------------------------------------------------------
Net deferred tax asset $ 233 $ 245
================================================================================
The Company determined that no valuation allowance against deferred tax
assets at December 31, 2002 and 2001 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, 2002 2001 2000
- --------------------------------------------------------------------------------
Federal statutory income tax rate 35.0% 35.0% 35.0%
State income taxes, net of
federal tax benefit 1.5 1.6 3.4
Goodwill amortization 14.8 1.3
Variable life insurance 1.3 (6.5)
Restructuring of international operations (4.9)
Merger-related costs 1.3
Non-deductible penalties 2.6
Write-down of investment in Aitken Campbell 7.6
Other charges (3.1) (.4) .7
- --------------------------------------------------------------------------------
Effective income tax rate 42.3% 42.2% 41.7%
================================================================================
The effective income tax rate including the extraordinary gain was 42.6% in
2002 and 44.1% in 2001.
17. Employee Incentive and Deferred Compensation Plans
Stock Option Plans
The Company's stock incentive plans provide for granting options to
employees, officers and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within 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 11 million, 26 million and
11 million options in 2002, 2001 and 2000, respectively.
A summary of option activity follows:
- ------------------------------------------------------------------------------------------------------------------------------------
2002 2001 2000
------------------------- --------------------------- ----------------------------
Weighted- Weighted- Weighted-
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Options Price Options Price Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 153 $ 16.20 97 $ 16.46 90 $ 10.31
Granted (1) 26 $ 11.32 68 $ 15.43 29 $ 26.27
Exercised (6) $ 6.59 (6) $ 4.73 (20) $ 2.74
Canceled (2) (17) $ 19.39 (6) $ 24.10 (2) $ 20.15
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
end of year 156 $ 15.38 153 $ 16.20 97 $ 16.46
====================================================================================================================================
Exercisable at
end of year 77 $ 12.93 54 $ 11.31 38 $ 7.02
====================================================================================================================================
Available for
future grant at
end of year 41 50 22
====================================================================================================================================
Weighted-average
fair value of
options granted
during the year (1,3) $ 5.35 $ 7.26 $ 15.44
====================================================================================================================================
(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.
(2) In 2002, 5 million options were voluntarily rescinded by the Co-Chief Executive Officers of the Company. The weighted-average
exercise price of these options is $17.04 and the weighted-average fair value is $8.03.
(3) The fair value of options granted is estimated as of the grant date using the Black-Scholes option pricing model. See
discussion in note "2 - Significant Accounting Policies."
- 39 -
Options outstanding and exercisable are as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2002
- ------------------------------------------------------------------------------------------------------------------------------------
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 19 2.9 $ 3.91 19 $ 3.91
$ 7.01 to $ 10.00 26 6.2 $ 8.74 19 $ 8.38
$ 10.01 to $ 15.00 36 8.5 $ 11.97 11 $ 12.00
$ 15.01 to $ 19.00 29 8.3 $ 15.41 10 $ 15.30
$ 19.01 to $ 26.00 20 7.0 $ 22.06 10 $ 22.27
$ 26.01 to $ 40.00 26 7.2 $ 29.64 8 $ 29.82
-----------------------------------------------------------------------------------------------------------------------------------
$ 1.00 to $ 40.00 156 7.0 $ 15.38 77 $ 12.93
====================================================================================================================================
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.
Restricted stock information is as follows:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Restricted stock awards 2 1
Average market price of awarded shares $ 10.44 $ 18.15 $ 27.73
Restricted shares outstanding (at year end) 4 5 8
Restricted stock expense and amortization $ 22 $ 27 $ 32
- --------------------------------------------------------------------------------
Other Deferred Compensation Plans
The Company sponsors deferred compensation plans for both officers and
non-employee directors. The Company's deferred compensation plan for officers
permits participants to defer the payment of certain cash compensation. The
deferred compensation liability was $184 million and $199 million at December
31, 2002 and 2001, respectively. The Company's deferred compensation plan for
non-employee directors permits participants to defer receipt of all or a portion
of their directors' fees and to receive either a grant of stock options, or upon
ceasing to serve as a director, the number of shares of CSC's common stock that
would have resulted from investing the deferred fee amount into CSC's common
stock.
18. 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 $47 million in
2002, $49 million in 2001 and $78 million in 2000.
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. 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. U.S. Trust matches
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 $9
million in 2002, $7 million in 2001 and $4 million in 2000. At December 31, 2002
and 2001, the U.S. Trust ESOP held a total of 6 million and 7 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
- 40 -
health care benefits (the health care cost trend rate) is 12.0% in 2002,
decreasing gradually to 5.5% in the year 2010. A one percentage point change in
the assumed health care cost trend rates would not have a material effect on the
postretirement benefit obligation.
- 41 -
2002 2001 2000
---------------------------------- -------------------------------- -----------------------------------
Pension Health & Pension Health & Pension Health &
Plan Life Total Plan Life Total Plan Life Total
- ------------------------------------------------------------------------------------------------------------------------------------
Components of expense
(credit):
Service cost and
expenses $ 13 $ 13 $ 9 $ 9 $ 8 $ 8
Interest cost 18 $ 1 19 17 $ 1 18 16 $ 1 17
Actual (gain) loss on
plan assets 19 19 78 78 (9) (9)
Other net amortizations
and deferrals (50) (50) (116) (116) (25) (25)
- ------------------------------------------------------------------------------------------------------------------------------------
Net expense (credit)(1) $ $ 1 $ 1 $ (12) $ 1 $ (11) $ (10) $ 1 $ (9)
- ------------------------------------------------------------------------------------------------------------------------------------
Change in plan assets:
Fair value of plan
assets at
beginning of year $ 281 $ 369 $ 367
Actual gain (loss) on
plan assets (19) (78) 9
Employer contribution $ 1 $ 1 $ 1
Benefits and expenses
paid (10) (1) (10) (1) (7) (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Fair value of plan
assets at end of year $ 252 $ 281 $ 369
- ------------------------------------------------------------------------------------------------------------------------------------
Change in benefit
obligation:
Benefit obligation at
beginning of year $ 248 $ 20 $ 211 $ 20 $ 200 $ 19
Service cost 13 9 8
Interest cost 18 2 17 1 16 2
Actuarial (gain) loss 13 1 16 (6)
Benefits paid (10) (2) (9) (1) (7) (1)
Amendments (1) 4
- ------------------------------------------------------------------------------------------------------------------------------------
Pension benefit obligation
at end of year (PBO) $ 281 $ 21 $ 248 $ 20 $ 211 $ 20
- ------------------------------------------------------------------------------------------------------------------------------------
Prepaid (accrued) cost:
Excess of plan assets
over benefit
obligation $ (29) $ (21) $ 34 $ (20) $ 158 $ (20)
Unrecognized cumulative
net (gains) losses 74 10 (1) (120) (1)
Unrecognized prior
service cost 4 (1) 5 (1) 1 (1)
Unrecognized net
asset at date
of initial
application (2)
- ------------------------------------------------------------------------------------------------------------------------------------
Prepaid (accrued) cost $ 49 $ (22) $ 49 $ (22) $ 37 $ (22)
- ------------------------------------------------------------------------------------------------------------------------------------
Discount rate used for PBO 6.75% 6.75% 7.50% 7.50% 8.00% 8.00%
Rate of increase in
salary (2) 5.30% 5.30% 6.10% 6.10% 6.10% 6.10%
Health care cost trend rate N/A 12.00% N/A 13.00% N/A 8.00%
Expected rate of return
on plan assets 9.00% N/A 9.00% N/A 9.00% N/A
- ------------------------------------------------------------------------------------------------------------------------------------
(1) The pension credit and postretirement benefit expense are determined using the assumptions as of the beginning of the year. The
benefit obligations and the funded status are determined using the assumptions as of the measurement date.
(2) In 2002, the rate of increase in compensation is based on an age-related table with assumed rates of increase in compensation
ranging from 8.0% to 3.0%. The amount shown is the average assumed rate of increase for the given plan year.
N/A Not applicable.
- 42 -
19. 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:
- --------------------------------------------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Net loss on cash flow
hedging instruments, net of tax:
Beginning balance $ (31)
Cumulative effect of
accounting change for
adoption of SFAS No. 133 $ (12)
Change during the year (6) (19)
- --------------------------------------------------------------------------------
Ending balance $ (37) $ (31)
================================================================================
Foreign currency translation
adjustment:
Beginning balance $ (13) $ (11) $ 5
Change during the year 8 (2) (16)
- --------------------------------------------------------------------------------
Ending balance $ (5) $ (13) $ (11)
================================================================================
Net unrealized gain (loss) on
securities available for sale,
net of tax:
Beginning balance $ 7 $ (3) $ (13)
Net unrealized gain
arising during the year 18 5 10
Reclassification adjustment
for realized (gain) loss
included in net income (1) 5
- --------------------------------------------------------------------------------
Ending balance $ 24 $ 7 $ (3)
================================================================================
Total accumulated other
comprehensive income (loss),
net of tax:
Beginning balance $ (37) $ (14) $ (8)
Change during the year 19 (23) (6)
- --------------------------------------------------------------------------------
Ending balance $ (18) $ (37) $ (14)
================================================================================
20. 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.
EPS under the basic and diluted computations are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Net income $ 109 $ 199 $ 718
================================================================================
Weighted-average common
shares outstanding - basic 1,358 1,373 1,360
Common stock equivalent shares
related to stock incentive plans 17 26 44
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,375 1,399 1,404
================================================================================
Basic EPS:
Income before
extraordinary gain $ .07 $ .06 $ .53
Extraordinary gain, net of tax $ .01 $ .08
Net income $ .08 $ .14 $ .53
================================================================================
Diluted EPS:
Income before
extraordinary gain $ .07 $ .06 $ .51
Extraordinary gain, net of tax $ .01 $ .08
Net income $ .08 $ .14 $ .51
================================================================================
The computation of diluted EPS for the years ended December 31, 2002, 2001
and 2000, respectively, excludes outstanding stock options to purchase 111
million, 83 million and 13 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.
21. 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
- 43 -
an activity, make an acquisition, or retain ownership of a company. The Federal
Reserve Board may also take actions as appropriate to enforce applicable federal
law.
Federal Reserve Board policy provides that a bank holding company generally
should not pay cash dividends unless its net income is sufficient to fully fund
the dividends and the company's prospective retained earnings appear to be
sufficient to meet the capital needs, asset quality and overall financial
condition of the holding company and its depository institution subsidiaries.
CSC's primary depository institution 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.
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:
- --------------------------------------------------------------------------------
2002 2001
----------------- -----------------
December 31, Amount Ratio (1) Amount Ratio (1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,477 22.5% $ 3,606 19.8%
U.S. Trust $ 600 16.5% $ 564 16.0%
U.S. Trust NY $ 360 12.1% $ 354 12.3%
Total Capital:
Company $ 3,505 22.7% $ 3,632 19.9%
U.S. Trust $ 624 17.1% $ 585 16.6%
U.S. Trust NY $ 380 12.8% $ 372 12.9%
Leverage:
Company $ 3,477 9.2% $ 3,606 9.7%
U.S. Trust $ 600 9.2% $ 564 8.9%
U.S. Trust NY $ 360 6.8% $ 354 6.8%
- --------------------------------------------------------------------------------
(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, 2002
and 2001, 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, or 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 $49 million in 2002 and $62 million in 2001.
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 was any evidence of misappropriation
or misuse of client funds on the part of any USTC/USTNY employee. In addition,
the order required USTC/USTNY to
- 44 -
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.
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
requirement, which is based on the type of business conducted by the
broker-dealer. The minimum dollar requirement for both Schwab and SCM is $1
million. Under the alternative method, a broker-dealer may not repay
subordinated borrowings, pay cash dividends, or make any unsecured advances or
loans to its parent or employees if such payment would result in net capital of
less than 5% of aggregate debit balances or less than 120% of its minimum dollar
requirement. At December 31, 2002, Schwab's net capital was $1.2 billion (18% of
aggregate debit balances), which was $1.1 billion in excess of its minimum
required net capital and $869 million in excess of 5% of aggregate debit
balances. At December 31, 2002, SCM's net capital was $99 million, which was $98
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, 2002, in accordance with
applicable regulations.
22. Commitments and Contingent Liabilities
Operating leases and other commitments: The Company has noncancelable
operating leases for office space and equipment. Future minimum rental
commitments, including guaranteed residual values (discussed below under
Guarantees) and which are net of sublease commitments, under these leases at
December 31, 2002 are as follows:
- --------------------------------------------------------------------------------
2003 $ 257
2004 244
2005 393
2006 161
2007 169
Thereafter 786
- --------------------------------------------------------------------------------
Total $ 2,010
================================================================================
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 $338 million in 2002, $365 million in 2001 and $298 million in
2000. At December 31, 2002, the Company had other commitments totaling $6
million, which include committed capital contributions to venture capital funds.
Guarantees: During 2001, the Company began occupying and making lease
payments on a newly renovated office building in San Francisco, California. 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 (defined in the Trust Agreement as 1.75% above the
one-month LIBOR rate). 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. Faced with
continued declines in the San Francisco, California commercial real estate
market, the Company obtained appraisals in the first and fourth quarters of 2002
in order to estimate its obligations under the residual value guarantee. On the
basis of these appraisals, the Company determined that it was probable that the
fair value of the property at the end of the lease term would be less than the
residual value
- 45 -
guarantee by approximately $98 million. This shortfall is being amortized as
additional rent expense on a straight-line basis over the initial lease term
which ends in June 2005. Effective in the first quarter of 2003, the Company
plans to cease amortizing the shortfall upon adoption of FIN No. 46 -
Consolidation of Variable Interest Entities. See note "2 - Significant
Accounting Policies" regarding FIN No. 46.
The Company has also provided residual value guarantees in connection with
the operating leases it used to finance two corporate aircraft and a fractional
interest in a third airplane. At December 31, 2002, the maximum amounts of
residual value guarantees under these leases totaled $14 million expiring in
2004 and $20 million expiring in 2007. The Company believes that proceeds from
the sale of these airplanes would be sufficient to cover the residual value
guarantees and therefore no liability for these guarantees has been recognized.
The Company provides certain indemnifications (i.e., protection against
damage or loss) to counterparties in connection with the disposition of certain
of its assets. Such indemnifications typically relate to title to the assets
transferred, ownership of intellectual property rights (e.g., patents), accuracy
of financial statements, compliance with laws and regulations, failure to pay,
satisfy or discharge any liability, or to defend claims, as well as errors,
omissions, and misrepresentations. These indemnification agreements have various
expiration dates and the Company's liability under these agreements is generally
limited to certain maximum amounts. The Company, however, remains subject to
certain uncapped potential liabilities, for example regarding the transfer of
trust assets and related obligations in connection with the sale of its
Corporate Trust business to Bank of NY. Other than the possible uncapped
obligations, at December 31, 2002, the Company's maximum potential liability
under these indemnification agreements is limited to approximately $215 million.
The Company does not believe that any material loss related to such
indemnifications, including the uncapped indemnification obligations, is likely
and therefore no liability for these indemnifications has been recognized.
Standby letters of credit (LOCs) are conditional commitments issued by U.S.
Trust to guarantee the performance of a client to a third party. For example,
LOCs can be used to guarantee performance under lease and other agreements by
professional business corporations and for other purposes. The credit risk
involved in issuing LOCs is essentially the same as that involved in extending
loans. LOCs are generally partially or fully collateralized by cash, marketable
equity securities, marketable debt securities (including corporate and U.S.
Treasury debt securities), and other assets. At December 31, 2002, U.S. Trust
had LOCs outstanding totaling $71 million which are short-term in nature and
generally expire within one year. At December 31, 2002, no liability for these
LOCs has been recognized.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging LOCs, in favor of the clearing houses, that are
guaranteed by multiple banks. At December 31, 2002, the outstanding value of
these LOCs totaled $639 million. No funds were drawn under these LOCs at
December 31, 2002.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: 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 was presented to
the court for its approval in December 2002.
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
- 46 -
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 breached those duties in various ways.
The plaintiffs in these cases seek unspecified compensatory damages, punitive
damages and other relief. U.S. Trust NY and USTC, N.A. have reached a tentative
settlement with the plaintiffs. Under the terms of this settlement, plaintiffs
would release U.S. Trust NY and 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.
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 matters 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 matters cannot be
predicted with certainty. There can be no assurance that these matters 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, results of operations, and cash flows. However, it is the
opinion of management, after consultation with legal counsel, that the ultimate
outcome of these existing claims and proceedings will not have a material
adverse impact on the financial condition, results of operations, or cash flows
of the Company.
23. Financial Instruments Subject to Off-Balance-Sheet Risk, Credit Risk or
Market Risk
Securities lending: 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, and therefore the potential for Schwab to make payments under these
client transactions is remote. Accordingly, no liability has been recognized for
these transactions.
Margin lending: Schwab provides margin loans to its clients which are
collateralized by securities in their brokerage accounts. These clients have
agreed to allow Schwab to pledge those securities in accordance with federal
regulations. Schwab was allowed, under such regulations, to
- 47 -
pledge securities with a market value of $9.4 billion and $13.1 billion at
December 31, 2002 and 2001, respectively. The market value of Schwab's client
securities pledged to fulfill the short sales of its clients was $824 million
and $894 million at December 31, 2002 and 2001, respectively, and the market
value of Schwab's client securities pledged in securities lending transactions
to other broker-dealers was $1.3 billion and $554 million at December 31, 2002
and 2001, respectively. The market value of Schwab's client securities pledged
to fulfill Schwab's and SCM's proprietary short sales was $12 million and $15
million at December 31, 2002 and 2001, respectively. Additionally, Schwab
borrows securities from other broker-dealers to fulfill short sales of its
clients. The market value of these borrowed securities was $57 million and $247
million at December 31, 2002 and 2001, respectively. Schwab has also pledged a
portion of its securities owned in order to fulfill the short sales of clients
and in connection with securities lending transactions to other broker-dealers.
The market value of these pledged securities was $3 million and $1 million at
December 31, 2002 and 2001, 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.
Financial instruments held for trading purposes: 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
enter into exchange-traded futures and options contracts to mitigate market risk
on these inventories. The notional amounts and fair values of these futures and
options contracts are shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2002 2001
- --------------------------------------------------------------------------------
Exchange-traded Contracts:
Net Short Futures (1):
Notional Amount $ 61 $ 125
Fair Value $ 63 $ 125
Long Put Options:
Notional Amount $ 4 $ 23
Fair Value (2)
- --------------------------------------------------------------------------------
(1) Notional amount represents original contract price of the futures. Fair
value represents the index price. The difference between the notional and
fair value amounts are settled daily in accordance with futures market
requirements.
(2) Amount was less than $1 million at both December 31, 2002 and 2001.
Securities financing: 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,
2002 and 2001, the market value of collateral received in connection with resale
agreements that is available to be repledged or sold was $16.5 billion and $15.3
billion, respectively.
At December 31, 2002 and 2001, financial instruments in the amount of $674
million and $809 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, 2002 and 2001, the
fair value of collateral pledged under repurchase agreements that is available
to be repledged or sold by the counterparties is $334 million and $184 million,
respectively.
Concentration risk: The Company's most significant concentration of risk is
its exposure to securities issued by the U.S. Government and its agencies (U.S.
Government). The Company's direct market risk exposure, primarily from
investments in securities available for sale, amounted to $1.2 billion at
December 31, 2002. The Company maintains indirect exposure to U.S. Government
securities held as collateral to secure its resale agreements. The Company's
primary credit exposure on these resale transactions is with its counterparty.
The Company would have exposure to the U.S. Government securities only in the
event of the counterparty's default on the resale agreements. Securities issued
by the U.S. Government held as collateral for resale agreements at December 31,
2002 totaled $16.5 billion.
- 48 -
Commitments to extend credit and LOCs: 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 LOCs. 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 $622 million and $586 million at December 31, 2002 and
2001, respectively. LOCs outstanding at December 31, 2002 and 2001 amounted to
$71 million and $77 million, respectively.
Interest rate swaps: As part of its consolidated asset and liability
management process, the Company utilizes Swaps to manage interest rate risk. The
market values of Swaps can vary depending on movements in interest rates. The
amounts at risk upon default are generally limited to the unrealized market
value gains of the Swaps, if any. The risk of default depends on the
creditworthiness of the counterparty. The Company evaluates the creditworthiness
of its counterparties as part of its normal credit review procedures.
U.S. Trust uses Swaps to hedge the interest rate risk associated with its
variable rate deposits from banking clients. The Swaps are structured for U.S.
Trust to receive a variable rate of interest and pay a fixed rate of interest.
At December 31, 2002, these Swaps had a weighted-average variable interest rate
of 1.57%, a weighted-average fixed interest rate of 6.38%, a weighted-average
maturity of 1.8 years, and an aggregate notional principal amount of $790
million. At December 31, 2001, the notional principal amount of such Swaps
totaled $905 million, and they carried a weighted-average variable interest rate
of 2.15%, a weighted-average fixed interest rate of 6.37%, and a
weighted-average maturity of 2.6 years. These Swaps have been designated as cash
flow hedges under SFAS No. 133 and are recorded on the consolidated balance
sheet, with changes in their fair values primarily recorded in other
comprehensive income (loss), a component of stockholders' equity. At December
31, 2002 and 2001, U.S. Trust recorded a derivative liability of $64 million and
$54 million, respectively, for these Swaps. Based on current interest rate
assumptions and assuming no additional Swap agreements are entered into, U.S.
Trust expects to reclassify approximately $35 million, or $21 million after tax,
from other comprehensive loss to interest expense over the next twelve months.
During 2002, CSC entered into Swaps with an aggregate notional principal
amount of $293 million that effectively convert the interest rate
characteristics of a like amount of its Medium-Term Notes from fixed to
variable. These Swaps are structured for CSC to receive a fixed rate of interest
and pay a variable rate of interest based on the three-month LIBOR rate. At
December 31, 2002, the net effect of the Swaps converted the Medium-Term Notes
from a weighted-average fixed interest rate of 7.57% to a weighted-average
variable interest rate of 3.87%. The variable interest rates reset every three
months. At December 31, 2002, these Swaps had a weighted-average maturity of 6.3
years. These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the consolidated balance sheet. Changes in fair value of the
Swaps are completely offset by changes in fair value of the hedged Medium-Term
Notes. Therefore, there is no effect on net income. At December 31, 2002, CSC
recorded a derivative asset of $26 million for these Swaps. Concurrently, the
carrying value of the Medium-Term Notes was increased by $26 million.
- 49 -
24. Fair Value of Financial Instruments
Substantially all of the Company's financial instruments are recorded at
estimated fair value or amounts that approximate fair value. The carrying
amounts (as recorded on the consolidated balance sheet) and estimated fair
values of the Company's financial instruments are as follows:
- --------------------------------------------------------------------------------
2002 2001
------------------ ------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
- --------------------------------------------------------------------------------
Financial Assets:
Cash and cash equivalents $ 3,114 $ 3,114 $ 4,407 $ 4,407
Cash and investments
segregated 21,005 21,005 17,741 17,741
Securities owned 1,716 1,716 1,700 1,700
Receivables from
brokers, dealers and
clearing organizations 222 222 446 446
Receivables from
brokerage clients - net 6,845 6,845 9,620 9,620
Loans to banking
clients - net 4,555 4,651 4,046 4,048
Swaps 26 26
- --------------------------------------------------------------------------------
Total $37,483 $37,579 $37,960 $37,962
================================================================================
Financial Liabilities:
Deposits from
banking clients $ 5,231 $ 5,231 $ 5,448 $ 5,448
Drafts payable 134 134 396 396
Payables to brokers, dealers
and clearing organizations 1,476 1,476 833 833
Payables to
brokerage clients 26,401 26,401 26,989 26,989
Accrued expenses
and other liabilities, excluding
interest rate swap agreements 1,238 1,238 1,273 1,273
Swaps 64 64 54 54
Short-term borrowings 508 508 578 578
Long-term debt 642 674 730 765
- --------------------------------------------------------------------------------
Total $35,694 $35,726 $36,301 $36,336
================================================================================
Cash and cash equivalents, cash and investments segregated, receivables,
deposits from banking clients, payables, accrued expenses and other liabilities,
and short-term borrowings are short-term in nature and accordingly are recorded
at fair value or amounts that approximate fair value.
Securities owned are recorded at estimated fair value. Such fair values are
estimated using quoted market prices, where available, or third-party pricing
services.
Loans to banking clients: The fair value of the Company's loans are estimated
using discounted contractual cash flows adjusted for current prepayment
estimates. The discount rates used are based on the interest rates charged to
current clients for comparable loans.
Swaps: The fair value of the Company's Swaps are estimated by obtaining quotes
from dealers and third-party pricing services.
Long-term debt: A portion of the Company's long-term debt has been adjusted for
changes in the fair value of Swaps. See note "23 - Financial Instruments Subject
to Off-Balance-Sheet Risk, Credit Risk or Market Risk." The fair value of the
Company's long-term debt is estimated using third-party pricing services and
discounted cash flow analyses utilizing discount rates currently available for
similar instruments.
Off-balance sheet financial instruments: In the normal course of business, the
Company is a party to certain off-balance-sheet financial instruments, primarily
consisting of firm commitments and LOCs, which represent obligations of the
Company. As of December 31, 2002, the majority of these commitments mature
within one year. The fair value of firm commitments and LOCs are estimated based
on fees charged to enter into similar agreements, considering the
creditworthiness of the counterparties. The Company has reviewed the unfunded
portion of its firm commitments as well as its LOCs and determined that the fair
values of these instruments were immaterial at December 31, 2002 and 2001.
25. 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
advisors, serves company 401(k) plan sponsors and third-party administrators,
and supports company stock option plans. (The Company's mutual fund services are
considered a product and not a segment. Mutual fund service fees are included in
the Individual Investor, Institutional Investor, and U.S. Trust 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,
wealth management, custody, fiduciary, and private banking services to
individual and institutional
- 50 -
clients.
The accounting policies of the segments are the same as those described in
note "2 - Significant Accounting Policies." Financial information for the
Company's reportable segments is presented in the following table. The Company
periodically reallocates certain revenues and expenses among the segments to
align them with the changes in the Company's organizational structure.
Previously-reported segment information has been revised to reflect changes
during the year in the Company's internal organization. The Company evaluates
the performance of its segments based on adjusted operating income before taxes,
which excludes non-operating revenues, restructuring and other charges, goodwill
and other impairment 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. Total revenues, net interest revenue (i.e., interest revenue, net of
interest expense), 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.
- --------------------------------------------------------------------------------
Year Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Total Revenues
Individual Investor $ 2,392 $ 2,510 $ 3,617
Institutional Investor 833 821 841
Capital Markets 259 342 687
U.S. Trust 651 654 643
- --------------------------------------------------------------------------------
Operating revenues 4,135 4,327 5,788
Non-operating revenues (1) 26
- --------------------------------------------------------------------------------
Total $ 4,135 $ 4,353 $ 5,788
================================================================================
Net Interest Revenue
Individual Investor $ 524 $ 591 $ 894
Institutional Investor 107 134 165
Capital Markets 14 27 52
U.S. Trust 196 177 126
- --------------------------------------------------------------------------------
Total $ 841 $ 929 $ 1,237
================================================================================
Adjusted Operating Income
Before Taxes
Individual Investor $ 256 $ 225 $ 779
Institutional Investor 240 274 311
Capital Markets 16 36 140
U.S. Trust (2) 117 112 158
- --------------------------------------------------------------------------------
Adjusted Operating Income
Before Taxes 629 647 1,388
Excluded items (3) (461) (512) (157)
- --------------------------------------------------------------------------------
Income before taxes on income
and extraordinary gain 168 135 1,231
Tax expense on income (71) (57) (513)
Extraordinary gain on sale of
corporate trust business,
net of tax 12 121
- --------------------------------------------------------------------------------
Net Income $ 109 $ 199 $ 718
================================================================================
Capital Expenditures
Individual Investor $ 104 $ 203 $ 483
Institutional Investor 30 51 95
Capital Markets 12 25 83
U.S. Trust 17 36 44
- --------------------------------------------------------------------------------
Total $ 163 $ 315 $ 705
================================================================================
Depreciation and Amortization (4)
Individual Investor $ 222 $ 295 $ 228
Institutional Investor 55 49 32
Capital Markets 21 27 23
U.S. Trust 23 33 25
- --------------------------------------------------------------------------------
Total $ 321 $ 404 $ 308
================================================================================
(1) Primarily consists of a gain on the sale of an investment.
(2) Excludes an extraordinary pre-tax gain of $22 million in 2002 and $221
million in 2001 relating to the sale of USTC's Corporate Trust business.
(3) In 2002, includes restructuring and other charges of $373 million (see note
"3 - Restructuring and Other Charges") and goodwill and other impairment
charges of $61 million (see note "4 - Goodwill and Other Impairment
Charges"). In 2001, includes restructuring and other charges of $419
million (see note "3 - Restructuring and Other Charges") and a gain on the
sale of an investment. In 2002, 2001 and 2000, also include merger- and
acquisition-related charges of $27 million, $119 million and $157 million,
respectively.
(4) For 2001 and 2000, include goodwill amortization, which ceased on January
1, 2002 upon the adoption of SFAS No. 142.
- 51 -
Fees received from Schwab's proprietary mutual funds represented
approximately 20% of the Company's consolidated revenues in 2002, 18% in 2001,
and 11% in 2000. 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 2002, 2001
and 2000. 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 December 31, 2002, 2001 and 2000.
26. Supplemental Cash Flow Information
- --------------------------------------------------------------------------------
Year Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Income taxes paid $ 91 $ 218 $ 240
================================================================================
Interest paid:
Brokerage client cash balances $ 176 $ 706 $1,068
Deposits from banking clients 88 128 155
Long-term debt 55 56 47
Short-term borrowings 24 25 19
Other 5 25 45
- --------------------------------------------------------------------------------
Total interest paid $ 348 $ 940 $1,334
================================================================================
Non-cash investing and financing
activities:
Common stock and options issued
for purchases of businesses $ 4 $ 71 $ 529
================================================================================
27. Subsequent Event
On January 31, 2003, the Company sold CSE to Barclays PLC (Barclays) in a
transaction approved by the Board of Directors on January 30, 2003. Pursuant to
the sale agreement, Barclays acquired CSE's British pound sterling product
offering and its client base. As part of the sale, assets of approximately $760
million (consisting primarily of cash and cash equivalents and receivables from
brokers, dealers and clearing organizations) and liabilities of approximately
$735 million (consisting primarily of payables to brokerage clients) were
transferred by the Company to Barclays. The impact of this sale on the Company's
results of operations is not expected to be material. The Company will continue
to maintain its U.S. dollar-based business in the United Kingdom, which provides
trading on U.S. exchanges and access to U.S. investment products.
- 52 -
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.
Management of the Company is also responsible for establishing and
maintaining disclosure controls and procedures for the Company. Disclosure
controls and procedures are designed to help ensure that information we disclose
to the public is recorded, processed, summarized and reported within required
time specifications and to enable management to make timely decisions regarding
required disclosures. To meet these responsibilities, management of the Company
has designed such disclosure controls and procedures to help ensure that
material information relating to the Company is evaluated and, where
appropriate, communicated to management, particularly during the period in which
a public report is being prepared. Additionally, management of the Company has
evaluated, on a quarterly basis, the effectiveness of the Company's disclosure
controls and procedures. Although no cost-effective disclosure controls and
procedures system will preclude all errors and irregularities, we believe the
Company's system of disclosure controls and procedures 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
February 24, 2003
/s/ David S. Pottruck
- -------------------------
President and Co-Chief Executive Officer
February 24, 2003
/s/ Christopher V. Dodds
- -------------------------
Executive Vice President and Chief Financial Officer
February 24, 2003
- 53 -
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, 2002 and
2001, and the related consolidated statements of income, stockholders' equity,
and cash flows for each of the three years in the period ended December 31,
2002. 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, 2002 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2002 in conformity with accounting principles generally accepted in
the United States of America.
As discussed in Note 2 to the consolidated financial statements, the
Company adopted Statement of Financial Accounting Standards No. 142 - Goodwill
and Other Intangible Assets effective January 1, 2002.
/s/ Deloitte & Touche LLP
- -------------------------
San Francisco, California
February 24, 2003
- 54 -
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) Diluted Share(1) Share(1) Share(2) Per Share Ratio(3)
- ------------------------------------------------------------------------------------------------------------------------------------
2002 by Quarter (4)
Fourth $ 996 $1,109 $ (79) 1,340 $(.06) $(.06) $.0110 $12.00 - 7.22 150 - 90
Third 1,031 1,036 (4) 1,358 .00 .00 .0110 11.89 - 7.51 91 - 58
Second 1,049 893 98 1,385 .07 .07 .0110 13.19 - 9.60 94 - 69
First 1,059 929 94 1,389 .07 .07 .0110 19.00 - 12.25 136 - 88
- ------------------------------------------------------------------------------------------------------------------------------------
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
- ------------------------------------------------------------------------------------------------------------------------------------
(1) Both basic and diluted earnings per share include an extraordinary gain of $.01 per share in 2002 and $.08 per share in 2001.
(2) Dividends declared per common share do not include dividends declared by U.S. Trust Corporation prior to the completion of the
merger in 2000.
(3) Price/earnings ratio is computed by dividing the high and low market prices by diluted earnings per share for the 12-month
period ended on the last day of the quarter presented.
(4) 2002 includes an extraordinary gain, restructuring charges, goodwill and other impairment charges, and merger- and
acquisition-related costs totaling $287 million after-tax. Excluding this amount, net income would have been $396 million and
the after-tax profit margin would have been 9.6%.
(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%.
- 55 -
THE CHARLES SCHWAB CORPORATION
Chart Appendix List
In this appendix, the following descriptions of certain charts in portions
of the Company's 2002 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 2002 Annual Report to Stockholders.
EDGAR
Version
Page Number Chart Description
- ----------- -----------------
9 Stacked bar chart titled "Revenues" representing the composition
of revenues by category for the years ended December 31, 2002,
2001, and 2000 (years shown on the bottom axis) as follows
(billions of dollars): Asset management & administration fees
$1.8, $1.7 and $1.6, respectively; Net interest revenue $.8, $.9
and $1.2, respectively; Other $.1, $.1 and $.1, respectively;
Commissions $1.2, $1.4 and $2.3, respectively; Principal
transactions $.2, $.3 and $.6, respectively; Revenues (bar
labeled) $4.1, $4.4 and $5.8, respectively.
9 Stacked bar chart titled "Revenues by Segment" representing the
composition of revenues by segment for the years ended December
31, 2002, 2001, and 2000 (years shown on the bottom axis) as
follows (billions of dollars): Individual Investor $2.4, $2.6 and
$3.6, respectively; Institutional Investor $.8, $.8 and $.8,
respectively; Capital Markets $.2, $.3 and $.7, respectively;
U.S. Trust $.7, $.7 and $.7, respectively; Revenues by Segment
(bar labeled) $4.1, $4.4 and $5.8, respectively.
- 56 -