Charles Schwab Corporation is an American company based in San Francisco, California. Charles Schwab offers commercial banking, stock brokerage, and wealth management advisory services to both retail and institutional clients. The company's chairman is its founder Charles Schwab.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 Commission file number 1-9700 THE CHARLES SCHWAB CORPORATION (Exact name of Registrant as specified in its charter) Delaware 94-3025021 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 120 Kearny Street, San Francisco, CA 94108 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (415) 627-7000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 1,383,657,459 shares of $.01 par value Common Stock Outstanding on October 31, 2000
THE CHARLES SCHWAB CORPORATION Quarterly Report on Form 10-Q For the Quarter Ended September 30, 2000 Index Page Part I - Financial Information Item 1. Condensed Consolidated Financial Statements: Statement of Income 1 Balance Sheet 2 Statement of Cash Flows 3 Notes 4-8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-21 Item 3. Quantitative and Qualitative Disclosures About Market Risk 21-23 Part II - Other Information Item 1. Legal Proceedings 23 Item 2. Changes in Securities and Use of Proceeds 23 Item 3. Defaults Upon Senior Securities 23 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 5. Other Information 23 Item 6. Exhibits and Reports on Form 8-K 24 Signature 25 ------------------------------------------------ Forward-Looking Statements - This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as "believe," "anticipate," "expect," "intend," "plan," "will," "may" and other similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management's beliefs, objectives and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company's senior management. These statements relate to, among other things, the Company's status under the Bank Holding Company Act, the ability to successfully pursue the Company's strategy to attract and retain client assets, the decline in average revenue per share traded, sources of liquidity, capital expenditures and contingent liabilities. Achievement of the expressed beliefs, objectives and expectations is subject to certain risks and uncertainties that could cause actual results to differ materially from those beliefs, objectives and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. See "Forward-Looking Statements" in Management's Discussion and Analysis of Financial Condition and Results of Operations in this interim report and in the Company's Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 18, 2000 for a discussion of important factors that may cause such differences.
<TABLE> <CAPTION> Part I - FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED STATEMENT OF INCOME (In thousands, except per share amounts) (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, 2000 1999 2000 1999 - -------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Revenues Commissions $ 474,935 $ 386,007 $1,804,539 $1,328,514 Asset management and administration fees 410,488 308,854 1,172,111 884,370 Interest revenue, net of interest expense (1) 315,875 210,882 931,423 586,452 Principal transactions 96,599 92,905 469,588 361,053 Other 24,675 17,074 75,067 52,014 - -------------------------------------------------------------------------------------------------------------------- Total 1,322,572 1,015,722 4,452,728 3,212,403 - -------------------------------------------------------------------------------------------------------------------- Expenses Excluding Interest Compensation and benefits 596,399 434,533 1,851,716 1,357,216 Other compensation - merger retention programs 16,424 23,025 Occupancy and equipment 106,644 78,552 295,401 218,862 Communications 86,314 63,503 263,489 205,490 Advertising and market development 62,554 59,282 243,362 169,516 Professional services 55,136 47,489 190,506 131,014 Depreciation and amortization 67,973 44,304 185,492 124,217 Commissions, clearance and floor brokerage 29,397 22,277 106,759 73,348 Merger-related (2) 328 68,986 Goodwill amortization 13,527 1,593 32,042 4,865 Other 47,405 28,326 186,387 143,718 - -------------------------------------------------------------------------------------------------------------------- Total 1,082,101 779,859 3,447,165 2,428,246 - -------------------------------------------------------------------------------------------------------------------- Income before taxes on income 240,471 235,863 1,005,563 784,157 Taxes on income 98,177 91,756 426,131 308,304 - -------------------------------------------------------------------------------------------------------------------- Net Income $ 142,294 $ 144,107 $ 579,432 $ 475,853 ==================================================================================================================== Weighted-Average Common Shares Outstanding - Diluted 1,414,897 1,375,736 1,401,894 1,372,959 ==================================================================================================================== Earnings Per Share Basic $ .10 $ .11 $ .43 $ .36 Diluted $ .10 $ .11 $ .41 $ .35 ==================================================================================================================== Dividends Declared Per Common Share (3) $ .0110 $ .0093 $ .0297 $ .0279 ==================================================================================================================== All periods have been restated to reflect the merger of The Charles Schwab Corporation (CSC) with U.S. Trust Corporation (USTC). (1) Interest revenue is presented net of interest expense. Interest expense for the three months ended September 30, 2000 and 1999 was $357,560 and $226,998, respectively. Interest expense for the nine months ended September 30, 2000 and 1999 was $994,135 and $636,346, respectively. (2) Merger-related costs include professional fees, change in control related compensation expense and other expenses relating to the merger of CSC with USTC. (3) Dividends declared per common share do not include dividends declared by USTC prior to the completion of the merger. See Notes to Condensed Consolidated Financial Statements. </TABLE>
<TABLE> <CAPTION> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED BALANCE SHEET (In thousands, except per share amounts) (Unaudited) September 30, December 31, 2000 1999 - ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> Assets Cash and cash equivalents $ 2,792,176 $ 2,612,451 Cash and investments required to be segregated under federal or other regulations (including resale agreements of $3,705,165 in 2000 and $6,165,043 in 1999) 4,684,747 8,826,121 Securities owned - at market value 1,495,895 1,333,220 Receivable from brokers, dealers and clearing organizations 382,575 482,657 Receivable from brokerage clients - net 20,815,303 17,060,222 Loans to banking clients - net 3,004,996 2,689,205 Equipment, office facilities and property - net 962,372 678,208 Goodwill - net 501,940 53,723 Other assets 867,637 586,305 - ---------------------------------------------------------------------------------------------------------------------- Total $35,507,641 $34,322,112 ====================================================================================================================== Liabilities and Stockholders' Equity Deposits from banking clients $ 3,790,141 $ 4,204,943 Drafts payable 459,814 467,758 Payable to brokers, dealers and clearing organizations 1,407,826 1,748,765 Payable to brokerage clients 23,414,371 23,422,592 Accrued expenses and other liabilities 1,279,769 1,243,121 Short-term borrowings 320,406 141,157 Long-term debt 793,293 518,000 - ---------------------------------------------------------------------------------------------------------------------- Total liabilities 31,465,620 31,746,336 - ---------------------------------------------------------------------------------------------------------------------- Stockholders' equity: Preferred stock - 9,940 shares authorized; $.01 par value per share; none issued Common stock - 2,000,000 shares authorized; $.01 par value per share; 1,383,228 issued and outstanding in 2000 and 1,336,636 shares issued in 1999 13,835 13,366 Additional paid-in capital 1,530,455 595,282 Retained earnings 2,589,562 2,144,683 Treasury stock - 7,336 shares in 1999, at cost (96,742) Employee stock ownership plans (414) (967) Unamortized restricted stock compensation (75,868) (70,926) Accumulated other comprehensive loss (15,549) (8,920) - ---------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 4,042,021 2,575,776 - ---------------------------------------------------------------------------------------------------------------------- Total $35,507,641 $34,322,112 ====================================================================================================================== All periods have been restated to reflect the merger of The Charles Schwab Corporation with U.S. Trust Corporation. See Notes to Condensed Consolidated Financial Statements. </TABLE>
<TABLE> <CAPTION> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) (Unaudited) Nine Months Ended September 30, 2000 1999 - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> Cash Flows from Operating Activities Net income $ 579,432 $ 475,853 Noncash items included in net income: Depreciation and amortization 185,492 124,217 Goodwill amortization 32,042 4,865 Net amortization of premium on securities available for sale 2,768 3,596 Compensation payable in common stock 59,028 24,631 Deferred income taxes (220) 15,145 Other 6,775 7,795 Net change in: Cash and investments required to be segregated under federal or other regulations 4,088,662 1,732,458 Securities owned (excluding securities available for sale) (32,422) (61,865) Receivable from brokers, dealers and clearing organizations 95,187 (76,671) Receivable from brokerage clients (3,756,978) (3,930,185) Other assets (41,067) (19,130) Drafts payable (10,735) (108,183) Payable to brokers, dealers and clearing organizations (324,998) (161,000) Payable to brokerage clients 35,078 2,247,163 Accrued expenses and other liabilities 148,993 291,239 - ----------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 1,067,037 569,928 - ----------------------------------------------------------------------------------------------------------- Cash Flows from Investing Activities Purchases of securities available for sale (284,622) (333,941) Proceeds from sales of securities available for sale 10,019 Proceeds from maturities, calls and mandatory redemptions of securities available for sale 159,230 323,135 Net change in loans to banking clients (315,798) (397,926) Purchase of equipment, office facilities and property - net (466,737) (252,754) Cash payments for business combinations and investments, net of cash received (48,147) (7,863) - ----------------------------------------------------------------------------------------------------------- Net cash used by investing activities (956,074) (659,330) - ----------------------------------------------------------------------------------------------------------- Cash Flows from Financing Activities Net change in deposits from banking clients (414,802) 231,314 Net change in short-term borrowings 179,249 (59,456) Proceeds from long-term debt 311,000 144,000 Repayment of long-term debt (35,839) (34,841) Dividends paid (47,172) (45,536) Purchase of treasury stock (35,397) Proceeds from stock options exercised and other 75,799 51,385 - ----------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 68,235 251,469 - ----------------------------------------------------------------------------------------------------------- Effect of exchange rate changes on cash and cash equivalents 527 (910) - ----------------------------------------------------------------------------------------------------------- Increase in Cash and Cash Equivalents 179,725 161,157 Cash and Cash Equivalents at Beginning of Period 2,612,451 1,720,908 - ----------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents at End of Period $ 2,792,176 $ 1,882,065 =========================================================================================================== All periods have been restated to reflect the merger of The Charles Schwab Corporation with U.S. Trust Corporation. See Notes to Condensed Consolidated Financial Statements. </TABLE>
The Charles Schwab Corporation Notes to Condensed Consolidated Financial Statements (Tabular Amounts in Thousands, Except Per Share Amounts and Ratios) (Unaudited) 1. Basis of Presentation The Company The accompanying unaudited condensed consolidated financial statements include The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company). 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 368 domestic branch offices in 48 states, as well as branches in the Commonwealth of Puerto Rico and the U.S. Virgin Islands. U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to as U.S. Trust) is an investment management firm that through its subsidiaries also provides fiduciary services and private banking services with 31 offices in 11 states. Other subsidiaries include Charles Schwab Europe (CSE), a retail securities brokerage firm located in the United Kingdom, Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in Nasdaq and other securities providing trade execution services to broker-dealers and institutional clients, and CyBerCorp Holdings, Inc. (formerly known as CyBerCorp, Inc.), an electronic trading technology and brokerage firm providing Internet-based services to highly active, online investors. These financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and, in the opinion of management, reflect all adjustments necessary to present fairly the financial position, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the U.S. All adjustments were of a normal recurring nature. All material intercompany balances and transactions have been eliminated. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto and the condensed consolidated financial statements and notes thereto which are filed as Exhibit 99.1 and Exhibit 99.2, respectively, to the Company's Current Report on Form 8-K, as filed with the SEC on July 18, 2000 and the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2000. The Company's results for any interim period are not necessarily indicative of results for a full year. Certain items in prior periods' financial statements have been reclassified to conform to the 2000 presentation. Merger with U.S. Trust Corporation On May 31, 2000, CSC completed its merger (the Merger) with USTC. The condensed consolidated financial statements included in this Quarterly Report on Form 10-Q give retroactive effect to the Merger, which was accounted for as a pooling of interests. The pooling of interests method of accounting requires the restatement of all periods presented as if CSC and USTC had been operating as a combined entity during such periods. Stockholders' equity and other per share information as of September 30, 2000 and December 31, 1999 reflects the accounts of the Company as if the common stock issued in the Merger had been outstanding during all of the periods presented. Dividends declared per common share do not include dividends declared by USTC prior to the completion of the Merger. The separate results of operations for U.S. Trust and the Company (excluding U.S. Trust) during the periods preceding the Merger that are included in the Company's condensed consolidated statement of income are as follows: - -------------------------------------------------------------------------------- Three Months Three Months Nine Months Ended Ended Ended March 31, 2000 Sep. 30, 1999 Sep. 30, 1999 - -------------------------------------------------------------------------------- Revenues: Company (excluding U.S. Trust) $1,571,876 $ 883,687 $2,817,374 U.S. Trust 153,752 132,035 395,029 - -------------------------------------------------------------------------------- Combined $1,725,628 $1,015,722 $3,212,403 ================================================================================ Net Income: Company (excluding U.S. Trust) $ 284,247 $ 124,579 $ 418,437 U.S. Trust 15,711 19,528 57,416 - -------------------------------------------------------------------------------- Combined $ 299,958 $ 144,107 $ 475,853 ================================================================================ 2. New Accounting Standards Statement of Financial Accounting Standards (SFAS) No. 137, which amended the effective date of SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities, was issued in June 1999. SFAS No. 138, which also amended SFAS No. 133, was issued in June 2000. The Company is required to adopt SFAS No. 133 by January 1, 2001. This statement establishes accounting and reporting standards requiring that all derivative instruments are recorded on the balance sheet as either an asset or a liability, measured at its fair value. The statement requires that changes in the derivative's fair value are recognized currently in earnings unless specific hedge accounting criteria are met and such hedge accounting treatment is elected. The adoption of this statement is not expected to have a material impact on the Company's financial position, results of operations, earnings per share or cash flows. SFAS No. 140 - Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which replaces SFAS No. 125, was issued in September 2000. This statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The Company is required to adopt SFAS No. 140 by the second quarter of 2001 for transfers and servicing of financial assets and extinguishments of liabilities and by the fourth quarter of 2000 for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral. The adoption of this statement is not expected to have a material impact on the Company's financial position, results of operations, earnings per share or cash flows. In December 1999, the SEC issued Staff Accounting Bulletin 101 (SAB 101) - Revenue Recognition in Financial Statements, as amended, which summarizes certain of the SEC staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. This bulletin specifies that revenue should not be recognized until it is realized or realizable and earned. The Company is required to adopt SAB 101 in the fourth quarter of 2000, and its adoption is not expected to have a material impact on the Company's financial position, results of operations, earnings per share or cash flows. In July 2000, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board issued a consensus in EITF No. 00-16 - Recognition and Measurement of Employer Payroll Taxes on Employee Stock-Based Compensation, that requires an employer to recognize a liability and corresponding expense for employer payroll taxes on employee stock options on the date of exercise of the stock option. The Company adopted this consensus in the third quarter of 2000 on a prospective basis. Prior to adoption, the Company recorded an estimated liability for employer payroll taxes on employee stock options based on the number of vested stock options outstanding at the end of each period. The adoption of this consensus did not have, and is not expected to have in the future, a material impact on the Company's financial position, results of operations, earnings per share or cash flows. 3. Business Combination Upon completion of the merger with USTC, the Company incurred merger-related costs of $50 million pre-tax, or $44 million after-tax, for change in control related compensation payable to U.S. Trust employees and professional fees. During the first nine months of 2000, merger-related costs totaled $69 million pre-tax, or $63 million after-tax. Merger-related costs are recorded separately on the condensed consolidated statement of income. In addition, under the terms of the merger agreement, the Company established a retention program for all U.S. Trust employees, whereby the employees will receive cash compensation, contingent upon continued employment, at the end of the two-year period following the completion of the Merger. The Company is recognizing the $125 million cost of the cash component of the U.S. Trust retention program over this two-year period. Accordingly, the Company is recognizing up to $16 million pre-tax, or $9 million after-tax, per quarter for this other compensation expense - merger retention programs, which is recorded separately on the condensed consolidated statement of income. In addition, under the terms of the merger agreement, U.S. Trust employees received an aggregate of 2,718,000 stock options, of which 50% vest at the end of the three-year period following the completion of the Merger and 50% vest at the end of the four-year period following the completion of the Merger. 4. Allowance for Credit Losses on Banking Loans and Nonperforming Assets An analysis of allowance for credit losses is as follows: - -------------------------------------------------------------------------------- Three Nine Months Ended Months Ended September 30, September 30, 2000 1999 2000 1999 - -------------------------------------------------------------------------------- Balance at beginning of period $20,200 $19,711 $20,169 $19,414 Recoveries 94 311 125 858 Charge-offs (28) (8) (28) (258) - -------------------------------------------------------------------------------- Net recoveries 66 303 97 600 - -------------------------------------------------------------------------------- Balance at end of period $20,266 $20,014 $20,266 $20,014 ================================================================================ Nonperforming assets, which consist of non-accrual, or impaired, loans are as follows: - -------------------------------------------------------------------------------- Sep. 30, Jun. 30, Mar. 31, Dec. 31, Sep. 30, 2000 2000 2000 1999 1999 - -------------------------------------------------------------------------------- Non-accrual loans $493 $428 $428 $1,673 $435 ================================================================================ 5. Comprehensive Income Comprehensive income includes net income and changes in equity except those resulting from investments by, or distributions to, stockholders. Comprehensive income is as follows: - -------------------------------------------------------------------------------- Three Nine Months Ended Months Ended September 30, September 30, 2000 1999 2000 1999 - -------------------------------------------------------------------------------- Net income $142,294 $144,107 $579,432 $475,853 Foreign currency translation adjustment (5,108) 2,119 (14,208) (233) Change in net unrealized gain (loss) on securities available for sale, net of tax 7,442 (1,025) 7,579 (11,375) - -------------------------------------------------------------------------------- Total comprehensive income, net of tax $144,628 $145,201 $572,803 $464,245 ================================================================================ 6. Earnings Per Share Basic EPS excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential reduction in EPS that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Earnings per share under the basic and diluted computations are as follows: - -------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30, September 30, 2000 1999 2000 1999 - -------------------------------------------------------------------------------- Net income $ 142,294 $ 144,107 $ 579,432 $ 475,853 ================================================================================ Weighted-average common shares outstanding - basic 1,372,542 1,313,263 1,353,933 1,308,059 Common stock equivalent shares related to stock incentive plans 42,355 62,473 47,961 64,900 - -------------------------------------------------------------------------------- Weighted-average common shares outstanding - diluted 1,414,897 1,375,736 1,401,894 1,372,959 ================================================================================ Basic earnings per share $ .10 $ .11 $ .43 $ .36 ================================================================================ Diluted earnings per share $ .10 $ .11 $ .41 $ .35 ================================================================================ The computation of diluted EPS for the nine months ended September 30, 2000 and 1999, respectively, excludes stock options to purchase 511,000 and 7,625,000 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. 7. Regulatory Requirements Upon completion of the merger with USTC, CSC became a financial holding company and 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), which became effective in March 2000, permits qualifying bank holding companies to become financial holding companies and thereby affiliate with a far broader range of financial companies than has previously been permitted for a bank holding company. The GLB Act identifies several activities as financial in nature, including securities brokerage, underwriting, dealing in or making a market in securities, investment management services and insurance activities. The Federal Reserve Board may prohibit a financial holding company from engaging in new activities or acquiring additional companies if the Federal Reserve Board concludes that the financial holding company's capital or managerial resources are not adequate. Federal Reserve Board regulations under the Act may also limit CSC's business or impose additional costs or requirements. 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 bank subsidiaries. CSC's primary bank subsidiary is United States Trust Company of New York (U.S. Trust NY). The operations and financial condition of CSC's bank 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 nonbank 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. The Company, U.S. Trust and their U.S.-based insured depository institution subsidiaries must meet regulatory capital guidelines adopted by the federal banking agencies. The Federal Reserve Board has not indicated whether the guidelines will be modified with respect to a bank holding company, such as CSC, that also qualifies as a financial holding company. Under the Federal Deposit Insurance Act, the banking regulatory agencies are permitted or, in certain cases, required to take certain substantial restrictive actions with respect to institutions falling within one of the lowest three of five capital categories. The Company's, U.S. Trust's and U.S. Trust NY's regulatory capital and ratios are as follows: 2000 1999 ------------------ ------------------ September 30, Amount Ratio(1) Amount Ratio(1) - -------------------------------------------------------------------------------- Tier 1 Capital: Company $3,499,586 13.1% $2,274,609 12.2% U.S. Trust $ 453,915 17.2% $ 264,912 12.1% U.S. Trust NY $ 286,948 13.3% $ 174,394 9.6% Total Capital: Company $3,533,390 13.2% $2,307,682 12.4% U.S. Trust $ 474,181 18.0% $ 284,926 13.0% U.S. Trust NY $ 304,741 14.2% $ 192,186 10.6% Leverage: Company $3,499,586 10.0% $2,274,609 7.8% U.S. Trust $ 453,915 9.2% $ 264,912 6.6% U.S. Trust NY $ 286,948 7.4% $ 174,394 5.5% - -------------------------------------------------------------------------------- (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. Each of CSC's other bank subsidiaries exceed the well-capitalized standards set forth by the banking regulatory authorities. Based on their respective regulatory capital ratios at September 30, 2000 and 1999, the Company, U.S. Trust and U.S. Trust NY are well capitalized (the highest category). There are no conditions or events that management believes have changed the Company's, U.S. Trust's and U.S. Trust NY's well-capitalized status. The capital of the Company, U.S. Trust and U.S. Trust NY exceeded minimum requirements at September 30, 2000. To remain a financial holding company, each of CSC's bank subsidiaries must be well capitalized, well managed and meet requirements relating to the provision of public services to the communities in which CSC's bank subsidiaries operate. If CSC ceases to qualify as a financial holding company it will be subject to substantial additional restrictions on its activities. 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, which requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from client transactions or a minimum dollar amount, which is based on the type of business conducted by the broker-dealer. The minimum dollar amount for both Schwab and SCM is $1 million. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement. At September 30, 2000, Schwab's net capital was $2.1 billion (10% of aggregate debit balances), which was $1.7 billion in excess of its minimum required net capital and $1.1 billion in excess of 5% of aggregate debit balances. At September 30, 2000, SCM's net capital was $30 million, which was $29 million in excess of its minimum required net capital. Certain other subsidiaries of CSC are subject to regulatory and other requirements of the jurisdictions in which they operate. At September 30, 2000, these subsidiaries were in compliance with their applicable requirements. Schwab, SCM and CSE had portions of their cash and investments segregated for the exclusive benefit of clients at September 30, 2000, in accordance with applicable regulations. 8. Commitments and Contingent Liabilities For discussion of legal proceedings, see Part II - Other Information, Item 1 - Legal Proceedings. 9. Segment Information 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. Financial information for the Company's reportable segments is presented in the table below. Intersegment revenues are immaterial and are therefore not disclosed. Total revenues and income before taxes on income are equal to the Company's consolidated amounts as reported in the condensed consolidated statement of income. - -------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30, September 30, 2000 1999 2000 1999 - -------------------------------------------------------------------------------- Revenues Individual Investor $ 847,775 $ 627,072 $2,832,904 $1,963,618 Institutional Investor 210,035 151,529 642,376 451,595 Capital Markets 104,579 105,086 501,961 402,161 U.S. Trust 160,183 132,035 475,487 395,029 - -------------------------------------------------------------------------------- Total $1,322,572 $1,015,722 $4,452,728 $3,212,403 ================================================================================ Income (Loss) Before Taxes (Benefit) on Income (Loss) Individual Investor $ 161,667 $ 153,001 $ 685,764 $ 496,376 Institutional Investor 73,024 39,121 229,902 119,444 Capital Markets (20,114) 11,726 35,346 73,699 U.S. Trust (1) 25,894 32,015 54,551 94,638 - -------------------------------------------------------------------------------- Total $ 240,471 $ 235,863 $1,005,563 $ 784,157 ================================================================================ (1) Includes merger-related costs and merger retention program costs recorded by U.S. Trust of $15 million pre-tax in the third quarter of 2000 and $68 million pre-tax in the first nine months of 2000. Excluding these costs, income before taxes on income for this segment would have been $41 million in the third quarter of 2000 and $123 million in the first nine months of 2000. 10. Supplemental Cash Flow Information Certain information affecting the cash flows of the Company follows: - -------------------------------------------------------------------------------- Nine Months Ended September 30, 2000 1999 - -------------------------------------------------------------------------------- Income taxes paid $ 236,179 $ 134,117 ================================================================================ Interest paid: Brokerage clients cash balances $ 799,359 $ 494,069 Deposits from banking clients 113,819 83,074 Stock-lending activities 34,649 23,646 Long-term debt 46,487 29,502 Short-term borrowings 14,327 6,570 Other 3,235 3,576 - -------------------------------------------------------------------------------- Total interest paid $1,011,876 $ 640,437 ================================================================================ Non-cash investing and financing activities: Common stock and options issued for purchases of businesses $ 508,815 $ 44,745 ================================================================================ 11. Subsequent Event On October 27, 2000, CSC filed a Registration Statement under the Securities Act of 1933 on Form S-4 relating to the registration of an aggregate of 15 million shares of CSC's common stock, par value of $.01 per share. CSC may offer and issue these shares in connection with future acquisitions of other businesses, properties or securities. On November 8, 2000, this Registration Statement was declared effective by the SEC. As of the filing date of this Quarterly Report on Form 10-Q, none of the shares under this Registration Statement have been issued.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Description of Business The Company: The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) provide securities brokerage and related financial services for 7.4 million active client accounts(a). Client assets in these accounts totaled $961.0 billion at September 30, 2000. Charles Schwab & Co., Inc. (Schwab), is a securities broker-dealer with 368 domestic branch offices in 48 states, as well as branches in the Commonwealth of Puerto Rico and the U.S. Virgin Islands. U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to as U.S. Trust) is an investment management firm that through its subsidiaries also provides fiduciary services and private banking services with 31 offices in 11 states. Other subsidiaries include Charles Schwab Europe (CSE), a retail securities brokerage firm located in the United Kingdom, Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in Nasdaq and other securities providing trade execution services to broker-dealers and institutional clients, and CyBerCorp Holdings, Inc. (CyBerCorp) (formerly known as CyBerCorp, Inc.), an electronic trading technology and brokerage firm providing Internet-based services to highly active, online investors. - ------------------------------ (a) Accounts with balances or activity within the preceding eight months. The Company provides financial services to individuals, institutional clients and broker-dealers through four segments - Individual Investor, Institutional Investor, Capital Markets and U.S. Trust. The Individual Investor segment includes the Company's domestic and international retail operations. The Institutional Investor segment provides custodial, trading and support services to independent investment managers, and serves company 401(k) plan sponsors and third-party administrators. The Capital Markets segment provides trade execution services in Nasdaq, exchange-listed and other securities primarily to broker-dealers and institutional clients. The U.S. Trust segment provides investment management, fiduciary services and private banking services to individual and institutional clients. The Company's strategy is to attract and retain client assets by focusing on a number of areas within the financial services industry - retail brokerage, mutual funds, support services for independent investment managers, 401(k) defined contribution plans, equity securities market-making, investment management, fiduciary services and private banking services. To pursue its strategy and its objective of long-term profitable growth, the Company plans to continue to leverage its competitive advantages. These advantages include nationally recognized brands, a broad range of products and services, multi-channel delivery systems and an ongoing investment in technology. While the Company's business continues to be predominantly conducted in the U.S., the Company continues to selectively expand its international presence. Brands: The Company's nationwide advertising and marketing programs support its strategy by continually reinforcing the strengths and key attributes of Schwab's full-service offering and U.S. Trust's wealth management services. By maintaining a consistent level of visibility in the market place, the Company seeks to establish Schwab and U.S. Trust as leading and lasting financial service brands in a focused and cost-effective manner. The Company uses a combination of network, cable and local television, print media, athletic event sponsorship, and online channels in its advertising to investors. Products and Services: The Company offers a broad range of value-oriented products and services to meet clients' varying investment and financial needs, including help and advice and access to extensive investment research, news and information. The Company's approach to advice is based on long-term investment strategies and guidance on portfolio diversification and asset allocation. The Company strives to demystify investing by educating and assisting clients in the development of investment plans. This approach is designed to be offered consistently across all of Schwab's delivery channels and provides clients with a wide selection of choices for their investment needs. Schwab's registered representatives can assist investors in developing asset allocation strategies and evaluating their investment choices, and refer investors who desire additional guidance to independent investment managers through the Schwab AdvisorSource(TM) service. Schwab clients and potential clients in need of personalized wealth-management services can receive referrals to U.S. Trust's investment management, trust and private banking capabilities as part of the AdvisorSource referral services program. Schwab's Mutual Fund Marketplace(R) provides clients with the ability to invest in 2,020 mutual funds from 337 fund families, including 1,207 Mutual Fund OneSource(R) funds. Schwab also provides custodial, trading and support services to independent investment managers. As of September 30, 2000, these managers were guiding the investments of 977,000 Schwab client accounts containing $242.7 billion in assets. The Company responds to evolving client needs with continued product, technology and service innovations. During the third quarter of 2000, Schwab broadened its service offerings by: expanding its PocketBroker(TM) wireless investing service to provide clients access to Schwab via PalmPilot(TM), RIM Wireless Handheld(TM) pager and Internet-ready cellular phones; announcing alliances with Sprint PCS and AT&T Wireless Group to enable clients to access PocketBroker(TM) through their wireless Web menus; and introducing an electronic signature capability which allows existing clients to open additional accounts entirely online. During the same period, Schwab expanded its Web site to include Smart Investor(TM), an interactive online resource for investor education and information, as well as SchwabWelcome, which guides prospective clients through the process of getting started as an investor at Schwab. Additionally, as part of its participation in the REDIBook ECN LLC, an electronic communication network, Schwab launched a pre-market trading session, as well as introduced a series of enhancements to its existing after-hours trading session. These enhancements include a longer after-hours session, the addition of odd and mixed lots, the ability to place limit orders for most exchange-listed securities, and access to after-hours trading via its Velocity(TM) desktop trading software. U.S. Trust provides an array of financial services for affluent individuals and their families. These services include investment management, investment consulting, trust, financial and estate planning and private banking, including mortgage, personal lending and deposit products. U.S. Trust also provides investment management, corporate trust and special fiduciary services for corporations, endowments, foundations, pension plans and other institutional clients. Delivery Systems: The Company's multi-channel delivery systems allow clients to choose how they prefer to do business with the Company. To enable clients to obtain services in person with a Company representative, the Company maintains a network of offices. Schwab's branch offices also provide investors with access to the Internet. Telephonic access to Schwab is provided primarily through five regional client telephone service centers and two online client support centers that operate both during and after normal market hours. The Company's fifth regional client telephone service center, which is located in Austin, Texas, began handling calls in September 2000. Additionally, clients are able to obtain financial information on an automated basis through Schwab's automated telephonic and online channels. Automated telephonic channels include TeleBroker(R), Schwab's touch-tone telephone quote and trading service, and VoiceBroker(TM), Schwab's voice recognition quote and trading service. Online channels include the Charles Schwab Web Site(TM), an information and trading service on the Internet at www.schwab.com, the CyBerCorp Web site, an Internet service for professional traders, and PC-based services such as SchwabLink(R), a service for investment managers. While the online channel is the Company's fastest-growing channel, the Company continues to stress the importance of Clicks and Mortar(TM) access - blending the power of the Internet with personal service to create a full-service client experience. Schwab provides every retail client access to all delivery channels. Technology: The Company's ongoing investment in technology is a key element in expanding its product and service offerings, enhancing its delivery systems, providing fast and consistent client service, reducing processing costs, and facilitating the Company's ability to handle significant increases in client activity without a corresponding rise in staffing levels. The Company uses technology to empower its clients to manage their financial affairs and is a leader in driving technological advancements in the financial services industry. International Expansion: During the third quarter of 2000, Schwab launched a Spanish-language Web site that serves Hispanic clients in the U.S., the Caribbean, and Central and South America. During the same period, Charles Schwab do Brasil, a subsidiary of CSC, opened the Company's first representative office in Latin America. Merger with U.S. Trust Corporation: On May 31, 2000, CSC completed its merger (the Merger) with USTC. The condensed consolidated financial statements and financial information in this Quarterly Report on Form 10-Q give retroactive effect to the Merger, which was accounted for as a pooling of interests. The pooling of interests method of accounting requires the restatement of all periods presented as if CSC and USTC had been operating as a combined entity during such periods. Share and per share information presented throughout this report has been restated to reflect the common shares issued to USTC shareholders pursuant to the exchange ratio under the terms of the merger agreement. Certain reclassifications have been made to prior year amounts to conform to the current presentation. Risk Management For discussion on the Company's principal risks and some of the policies and procedures for risk identification, assessment and mitigation, see "Management's Discussion and Analysis of Results of Operations and Financial Condition - Risk Management" which is filed as Exhibit 99.1 to the Company's Current Report on Form 8-K as filed with the Securities and Exchange Commission (SEC) on July 18, 2000. See Liquidity and Capital Resources of this report for a discussion on liquidity risk; and see Item 3 - Quantitative and Qualitative Disclosures About Market Risk for additional information relating to market risk. Given the nature of the Company's revenues, expenses and risk profile, the Company's earnings and CSC's common stock price may be subject to significant volatility from period to period. The Company's results for any interim period are not necessarily indicative of results for a full year. 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. Forward-Looking Statements This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as "believe," "anticipate," "expect," "intend," "plan," "will," "may" and other similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management's beliefs, objectives and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company's senior management. These statements relate to, among other things, the Company's status under the Bank Holding Company Act (see note "7 - Regulatory Requirements" in the Notes to Condensed Consolidated Financial Statements), the ability to successfully pursue the Company's strategy to attract and retain client assets (see Description of Business: The Company), sources of liquidity (see Liquidity and Capital Resources - Liquidity), capital expenditures (see Liquidity and Capital Resources - Cash Flows and Capital Resources), and contingent liabilities (see Part II - Other Information, Item 1 - Legal Proceedings). Achievement of the expressed expectations is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed expectations described in these statements. Important factors that may cause such differences are noted in this interim report and the Company's Current Report on Form 8-K as filed with the SEC on July 18, 2000, and include, but are not limited to: the effect of client trading patterns on Company revenues and earnings; the inability to assimilate acquired companies and to achieve the anticipated benefits; the Company's inability to attract and retain key personnel; changes in the Company's level of personnel hiring, investment in new or existing technology, or utilization of public media for advertising; changes in technology; computer system failures and security breaches; the effects of competitors' pricing, product and service decisions and intensified competition; evolving regulation and changing industry practices adversely affecting the Company; adverse results of litigation; the inability to obtain external financing; changes in revenues and profit margin due to cyclical securities markets and interest rates; the level and volatility of equity prices; a significant downturn in the securities markets over a short period of time or a sustained decline in securities prices and trading volumes; a significant decline in the real estate market; and risks associated with international expansion and operations. Three Months Ended September 30, 2000 Compared To Three Months Ended September 30, 1999 Financial Overview The Company's revenues increased in the third quarter of 2000 mainly due to higher levels of average balances and rates earned on margin loans to clients, an increase in client assets, and higher trading volumes. Revenues of $1.3 billion in the third quarter of 2000 grew $307 million, or 30%, from the third quarter of 1999 due to increases in revenues of $221 million, or 35%, in the Individual Investor segment, $59 million, or 39%, in the Institutional Investor segment, and $28 million, or 21%, in the U.S. Trust segment, partially offset by a decrease in revenues of $1 million in the Capital Markets segment. See note "9 - - Segment Information" in the Notes to Condensed Consolidated Financial Statements for financial information by segment. Total expenses excluding interest during the third quarter of 2000 were $1.1 billion, up 39% from $780 million for the third quarter of 1999. This increase was primarily due to a 31% increase in the Company's full-time equivalent employees to 25,400 at September 30, 2000 and related costs, higher occupancy and equipment, communications and depreciation and amortization expenses. Net income for the third quarter of 2000 was $142 million, down 1% from third quarter 1999 net income of $144 million. Income before taxes on income for the third quarter of 2000 was $240 million, up $5 million, or 2%, from the third quarter of 1999 due to increases of $9 million, or 6%, in the Individual Investor segment and $34 million, or 87%, in the Institutional Investor segment, partially offset by decreases of $32 million in the Capital Markets segment and $6 million, or 19%, in the U.S. Trust segment. The decrease to a loss in the Capital Markets segment was primarily due to a substantial increase in expenses as a result of continued growth in employees and higher trading volume-related expenses, while revenues remained unchanged. The decrease in income in the U.S. Trust segment was primarily due to $16 million of other compensation - merger retention program expense recorded in the third quarter of 2000. Diluted earnings per share for the third quarters of 2000 and 1999 were $.10 and $.11 per share, respectively. All references to earnings per share information in this report reflect diluted earnings per share unless otherwise noted. The after-tax profit margin for the third quarter of 2000 was 10.8%, down from 14.2% for the third quarter of 1999. The annualized return on stockholders' equity for the third quarter of 2000 was 15%, down from 25% for the third quarter of 1999 primarily due to a 73% increase in average stockholders' equity from the third quarter of 1999 to the third quarter of 2000, as well as the decline in net income as discussed above. The Company's third quarter 2000 results include charges for goodwill and intangible asset amortization related to the acquisition of CyBerCorp and other compensation - merger retention programs expense related to the merger with USTC and the acquisition of CyBerCorp. These charges totaled $23 million after-tax. Excluding these charges, the Company's third quarter 2000 after-tax profit margin would have been 12.5% and earnings would have been $166 million, up 15% from the third quarter of 1999. The Company's client trading activity is shown in the following table (in thousands): - -------------------------------------------------------------------------------- Three Months Ended September 30, Percent Daily Average Trades 2000 1999 Change - -------------------------------------------------------------------------------- Revenue Trades Online 174.8 97.7 79% TeleBroker(R) and VoiceBroker(TM) 5.0 6.5 (23) Regional client telephone service centers, branch offices and other 23.7 30.9 (23) - -------------------------------------------------------------------------------- Total 203.5 135.1 51% ================================================================================ Mutual Fund OneSource(R) Trades Online 32.7 20.1 63% TeleBroker and VoiceBroker .7 .9 (22) Regional client telephone service centers, branch offices and other 17.6 19.3 (9) - -------------------------------------------------------------------------------- Total 51.0 40.3 27% ================================================================================ Total Daily Average Trades Online 207.5 117.8 76% TeleBroker and VoiceBroker 5.7 7.4 (23) Regional client telephone service centers, branch offices and other 41.3 50.2 (18) - -------------------------------------------------------------------------------- Total 254.5 175.4 45% ================================================================================ Assets in client accounts were $961.0 billion at September 30, 2000, an increase of $262.2 billion, or 38%, from a year ago as shown in the table below. This increase from a year ago included net new client assets of $163.8 billion and net market gains of $98.4 billion related to client accounts. - -------------------------------------------------------------------------------- Growth in Client Assets and Accounts (In billions, at quarter end, September 30, Percent except as noted) 2000 1999 Change - -------------------------------------------------------------------------------- Assets in client accounts Schwab One(R), other cash equivalents and deposits from banking clients $ 26.4 $ 23.6 12% Proprietary funds (SchwabFunds(R) and Excelsior(R)): Money market funds 103.1 86.1 20 Equity and bond funds 31.1 23.5 32 - -------------------------------------------------------------------------------- Total proprietary funds 134.2 109.6 22 - -------------------------------------------------------------------------------- Mutual Fund Marketplace(R)(1): Mutual Fund OneSource Retail 63.6 41.0 55 Schwab Institutional(TM)(2) 52.7 36.6 44 - -------------------------------------------------------------------------------- Total Mutual Fund OneSource 116.3 77.6 50 Mutual fund clearing services 22.8 2.2 n/m All other 76.5 64.6 18 - -------------------------------------------------------------------------------- Total Mutual Fund Marketplace 215.6 144.4 49 - -------------------------------------------------------------------------------- Total mutual fund assets 349.8 254.0 38 - -------------------------------------------------------------------------------- Equity and other securities (1) 518.7 364.8 42 Fixed income securities 86.6 69.9 24 Margin loans outstanding (20.5) (13.5) 52 - -------------------------------------------------------------------------------- Total client assets $961.0 $698.8 38% ================================================================================ Net growth in assets in client accounts (3) (for the quarter ended) Net new client assets $ 40.6 $ 24.6 Net market gains (losses) (10.8) (20.5) - ------------------------------------------------------------------------ Net growth $ 29.8 $ 4.1 ======================================================================== New client accounts (in thousands, for the quarter ended) 281.0 283.6 (1%) Active client accounts (in millions) 7.4 6.4 16% ================================================================================ Active online Schwab client accounts (in millions) (4) 4.2 3.0 40% Online Schwab client assets $419.7 $263.6 59% ================================================================================ (1) Excludes money market funds and all proprietary money market, equity and bond funds. (2) Represents assets invested in Mutual Fund OneSource by independent investment managers and retirement plans. (3) Net new client assets in 2000 include U.S. Trust. For 1999, U.S. Trust net new client assets are included in net market gains. (4) Active online accounts are defined as all accounts within a household that has had at least one online session within the past twelve months. n/m Not meaningful. REVENUES Revenues grew $307 million, or 30%, in the third quarter of 2000 compared to the third quarter of 1999, due to a $105 million, or 50%, increase in interest revenue, net of interest expense (referred to as net interest revenue), a $102 million, or 33%, increase in asset management and administration fees, and an $89 million, or 23%, increase in commission revenues. As the Company's non-trading revenues grew at a rate that exceeded the growth rate of total revenues, non-trading revenues represented 57% of total revenues for the third quarter of 2000, up from 53% for the third quarter of 1999 as shown in the table below. - -------------------------------------------------------------------------------- Three Months Ended September 30, Composition of Revenues 2000 1999 - -------------------------------------------------------------------------------- Commissions 36% 38% Principal transactions 7 9 - -------------------------------------------------------------------------------- Total trading revenues 43 47 - -------------------------------------------------------------------------------- Asset management and administration fees 31 30 Net interest revenue 24 21 Other 2 2 - -------------------------------------------------------------------------------- Total non-trading revenues 57 53 - -------------------------------------------------------------------------------- Total 100% 100% ================================================================================ Commissions The Company earns commission revenues by executing client trades primarily through the Individual Investor and Institutional Investor segments. These revenues are affected by the number of client accounts that trade, the average number of commission-generating trades per account, and the average commission per trade. Commission revenues for the Company were $475 million for the third quarter of 2000, up $89 million, or 23%, from the third quarter of 1999. As shown in the table below, the total number of revenue trades executed by the Company has increased 48% as the Company's client base, as well as client trading activity per account, has grown. Average commission per revenue trade decreased 19%. This decline was mainly due to an increase in the proportion of trades placed through the Company's online channels, which have lower commission rates than the Company's other channels, and reduced pricing for certain clients who trade frequently. - -------------------------------------------------------------------------------- Three Months Ended Commissions Earned on September 30, Percent Client Revenue Trades 2000 1999 Change - -------------------------------------------------------------------------------- Client accounts that traded during the quarter (in thousands) 1,702 1,510 13% Average client revenue trades per account 7.54 5.73 32 Total revenue trades (in thousands) 12,825 8,648 48 Average commission per revenue trade $ 36.29 $44.72 (19) Commissions earned on client revenue trades (in millions) (1) $ 465 $ 387 20 ================================================================================ (1) Includes certain non-commission revenues relating to the execution of client trades. Excludes commissions on trades relating to specialist operations and U.S. Trust commissions on trades. 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 Schwab's proprietary funds. Mutual fund service fees are earned primarily through the Individual Investor and Institutional Investor segments. The Company also earns asset management and administration fees for financial services, including investment management and consulting, trust and fiduciary services, financial and estate planning, and private banking services, provided to individual and institutional clients. These fees are primarily based on the value and composition of assets under management and are earned primarily through the U.S. Trust segment, as well as the Individual Investor and Institutional Investor segments. Asset management and administration fees were $410 million for the third quarter of 2000, up $102 million, or 33%, from the third quarter of 1999, as shown in the following table (in millions): - -------------------------------------------------------------------------------- Three Months Ended Asset Management September 30, Percent and Administration Fees 2000 1999 Change - -------------------------------------------------------------------------------- Mutual fund service fees: SchwabFunds(R) $159 $131 21% Mutual Fund OneSource(R) 90 58 55 Excelsior(R) Funds 14 9 56 Other 2 3 (33) Asset management and related services 145 107 36 - -------------------------------------------------------------------------------- Total $410 $308 33% ================================================================================ The increase in asset management and administration fees was primarily due to an increase in client assets in funds purchased through Schwab's Mutual Fund OneSource service, an increase in client assets in Schwab's proprietary funds, collectively referred to as the SchwabFunds, and an increase in U.S. Trust's client assets. Net Interest Revenue Net interest revenue is the difference between interest earned on assets (mainly margin loans to clients, investments required to be segregated for clients, securities available for sale, and private banking loans) and interest paid on liabilities (mainly brokerage client cash balances and banking deposits). Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and hedging strategies. Most of the Company's net interest revenue is earned by Schwab through the Individual Investor and Institutional Investor segments, as well as by U.S. Trust through the U.S. Trust segment. Net interest revenue was $315 million for the third quarter of 2000, up $105 million, or 50%, from the third quarter of 1999 as shown in the following table (in millions): - -------------------------------------------------------------------------------- Three Months Ended September 30, Percent 2000 1999 Change - -------------------------------------------------------------------------------- Interest Revenue Margin loans to clients $469 $254 85% Investments, client-related 80 99 (19) Private banking loans 56 45 24 Securities available for sale 18 14 29 Other 50 26 92 - -------------------------------------------------------------------------------- Total 673 438 54 - -------------------------------------------------------------------------------- Interest Expense Brokerage client cash balances 284 177 60 Deposits from banking clients 40 30 33 Long-term debt 15 9 67 Stock-lending activities 10 7 43 Short-term borrowings 8 2 300 Other 1 3 (67) - -------------------------------------------------------------------------------- Total 358 228 57 - -------------------------------------------------------------------------------- Net interest revenue $315 $210 50% ================================================================================ Client-related and other daily average balances, interest rates and average net interest spread for the third quarters of 2000 and 1999 are summarized in the following table (dollars in millions): - -------------------------------------------------------------------------------- Three Months Ended September 30, 2000 1999 - -------------------------------------------------------------------------------- Interest-Earning Assets (client-related and other): Margin loans to clients: Average balance outstanding $19,996 $13,405 Average interest rate 9.32% 7.50% Investments (client-related): Average balance outstanding $ 5,616 $ 8,262 Average interest rate 5.70% 4.72% Private banking loans: Average balance outstanding $ 2,922 $ 2,487 Average interest rate 7.71% 7.23% Securities available for sale: Average balance outstanding $ 1,152 $ 962 Average interest rate 6.18% 5.69% Average yield on interest-earning assets 8.36% 6.49% Funding Sources (client-related and other): Interest-bearing brokerage client cash balances: Average balance outstanding $20,970 $17,596 Average interest rate 5.38% 4.00% Interest-bearing banking deposits: Average balance outstanding $ 3,021 $ 2,778 Average interest rate 5.23% 4.30% Other interest-bearing sources: Average balance outstanding $ 1,714 $ 1,339 Average interest rate 4.74% 4.23% Average noninterest-bearing portion $ 3,981 $ 3,403 Average interest rate on funding sources 4.61% 3.51% Summary: Average yield on interest-earning assets 8.36% 6.49% Average interest rate on funding sources 4.61% 3.51% - -------------------------------------------------------------------------------- Average net interest spread 3.75% 2.98% ================================================================================ The increase in net interest revenue from the third quarter of 1999 was primarily due to higher levels of margin loans to clients, partially offset by higher average brokerage client cash balances. Principal Transactions Principal transaction revenues are primarily comprised of net gains from market-making activities in Nasdaq and other securities transactions effected through the Capital Markets segment. Factors that influence principal transaction revenues include the volume of client trades, market price volatility, average revenue per share traded and changes in regulations and industry practices. Principal transaction revenues were $97 million for the third quarter of 2000, up $4 million, or 4%, from the third quarter of 1999. This increase was primarily due to greater share volume handled by SCM, substantially offset by lower average revenue per share traded. Expenses Excluding Interest Compensation and benefits expense was $596 million for the third quarter of 2000, up $162 million, or 37%, from the third quarter of 1999 primarily due to a greater number of employees and higher incentive and variable compensation expense resulting from the Company's financial performance. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - -------------------------------------------------------------------------------- Three Months Ended September 30, 2000 1999 - -------------------------------------------------------------------------------- Compensation and benefits expense as a % of total revenues 45% 43% Incentive and variable compensation as a % of compensation and benefits expense 24% 23% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 9% 13% Full-time equivalent employees(1) (at end of quarter) 25.4 19.4 Revenues per average full-time equivalent employee $52.2 $53.5 ================================================================================ (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Occupancy and equipment expense was $107 million for the third quarter of 2000, up $28 million, or 36%, from the third quarter of 1999. This increase was primarily due to facilities expansion to support the Company's growth in employees and enhancements in systems capacity. Communications expense was $86 million for the third quarter of 2000, up $23 million, or 36%, from the third quarter of 1999. This increase was primarily due to higher client trading volumes, increased client use of online news, quotes and information services, and increased telecommunications expenses related to the Company's growth in employees. Depreciation and amortization expense was $68 million for the third quarter of 2000, up $24 million, or 53%, from the third quarter of 1999. The increase was primarily due to the purchase of information technology equipment and software to increase the Company's client service capacity. The increase was also due to amortization of additional leasehold improvements for new branches and office space, as well as internally-developed software. The Company's effective income tax rate was 40.8% for the third quarter of 2000, up from 38.9% for the third quarter of 1999. The increase was primarily due to goodwill amortization, related to the acquisition of CyBerCorp, which is non-deductible for tax purposes. Nine Months Ended September 30, 2000 Compared To Nine Months Ended September 30, 1999 Financial Overview The Company's revenues increased in the first nine months of 2000 mainly due to higher levels of average balances and rates earned on margin loans to clients, higher client trading volume, and an increase in client assets. Revenues of $4.5 billion in the first nine months of 2000 grew $1.2 billion, or 39%, from the first nine months of 1999 due to increases in revenues of $869 million, or 44%, in the Individual Investor segment, $191 million, or 42%, in the Institutional Investor segment, $100 million, or 25%, in the Capital Markets segment, and $80 million, or 20%, in the U.S. Trust segment. See note "9 - Segment Information" in the Notes to Condensed Consolidated Financial Statements for financial information by segment. Total expenses excluding interest during the first nine months of 2000 were $3.4 billion, up 42% from $2.4 billion for the first nine months of 1999, primarily resulting from additional staff and related costs, higher occupancy and equipment, advertising and market development spending, and professional fees and compensation related to the merger with USTC. Net income for the first nine months of 2000 was $579 million, up 22% from the first nine months of 1999 net income of $476 million. Income before taxes on income for the first nine months of 2000 was $1.0 billion, up $221 million, or 28%, from the first nine months of 1999 due to increases of $189 million, or 38%, in the Individual Investor segment and $110 million, or 92%, in the Institutional Investor segment, partially offset by decreases of $40 million, or 42%, in the U.S. Trust segment and $38 million, or 52%, in the Capital Markets segment. The decrease in income in the U.S. Trust segment was primarily due to $68 million of merger-related and other compensation - merger retention program expenses recorded in the first nine months of 2000. The decrease in income in the Capital Markets segment was primarily due to a higher growth rate in expenses as compared to revenues as a result of continued growth in employees and higher trading volume-related expenses. Diluted earnings per share for the first nine months of 2000 and 1999 were $.41 and $.35 per share, respectively. The after-tax profit margin for the first nine months of 2000 was 13.0%, down from 14.8% for the first nine months of 1999. The annualized return on stockholders' equity for the first nine months of 2000 was 23%, down from 31% for the first nine months of 1999 primarily due to a 64% increase in average stockholders' equity from the first nine months of 1999 to the first nine months of 2000, partially offset by the increase in net income as discussed above. The Company's results for the first nine months of 2000 include charges for professional fees, change in control related and retention program compensation and other expenses related to the merger with USTC, and goodwill and intangible asset amortization and retention program compensation related to the acquisition of CyBerCorp. These charges totaled $108 million after-tax. Excluding these charges, the Company's after-tax profit margin for the first nine months of 2000 would have been 15.4% and earnings would have been $688 million, up 44% from the first nine months of 1999. The Company's trading activity is shown in the following table (in thousands): - -------------------------------------------------------------------------------- Nine Months Ended September 30, Percent Daily Average Trades 2000 1999 Change - -------------------------------------------------------------------------------- Revenue Trades Online 210.1 108.1 94% TeleBroker(R) and VoiceBroker(TM) 7.9 8.5 (7) Regional client telephone service centers, branch offices and other 31.4 35.9 (13) - -------------------------------------------------------------------------------- Total 249.4 152.5 64% ================================================================================ Mutual Fund OneSource(R) Trades Online 37.8 22.4 69% TeleBroker and VoiceBroker 1.2 1.0 20 Regional client telephone service centers, branch offices and other 21.3 21.1 1 - -------------------------------------------------------------------------------- Total 60.3 44.5 36% ================================================================================ Total Daily Average Trades Online 247.9 130.5 90% TeleBroker and VoiceBroker 9.1 9.5 (4) Regional client telephone service centers, branch offices and other 52.7 57.0 (8) - -------------------------------------------------------------------------------- Total 309.7 197.0 57% ================================================================================ Assets in client accounts were $961.0 billion at September 30, 2000, an increase of $262.2 billion, or 38%, from a year ago. During the first nine months of 2000, net new client assets and new accounts increased from the first nine months of 1999 as shown in the table below. - -------------------------------------------------------------------------------- Nine Growth in Client Months Ended Assets and Accounts September 30, Percent (In billions, except as noted) 2000 1999 Change - -------------------------------------------------------------------------------- Net growth in assets in client accounts(1) Net new client assets $130.5 $ 73.6 Net market gains (losses) (15.5) 30.9 - ----------------------------------------------------------------- Net growth $115.0 $104.5 ================================================================= New client accounts (in thousands) 1,178.2 1,098.6 7% ================================================================================ (1) Net new client assets in 2000 include U.S. Trust. For 1999, U.S. Trust net new client assets are included in net market gains. REVENUES Revenues grew $1.2 billion, or 39%, in the first nine months of 2000, due to a $476 million, or 36%, increase in commission revenues, a $345 million, or 59%, increase in net interest revenue and a $288 million, or 33%, increase in asset management and administration fees, as well as a $109 million, or 30%, increase in principal transaction revenues. As the Company's non-trading revenues grew at a rate that exceeded the growth rate of total revenues, non-trading revenues represented 49% of total revenues for the first nine months of 2000, up from 47% for the first nine months of 1999 as shown in the table below. - -------------------------------------------------------------------------------- Nine Months Ended September 30, Composition of Revenues 2000 1999 - -------------------------------------------------------------------------------- Commissions 41% 41% Principal transactions 10 12 - -------------------------------------------------------------------------------- Total trading revenues 51 53 - -------------------------------------------------------------------------------- Asset management and administration fees 26 28 Net interest revenue 21 18 Other 2 1 - -------------------------------------------------------------------------------- Total non-trading revenues 49 47 - -------------------------------------------------------------------------------- Total 100% 100% ================================================================================ Commissions Commission revenues for the Company were $1.8 billion for the first nine months of 2000, up $476 million, or 36%, from the first nine months of 1999. As shown in the table below, the total number of revenue trades executed by the Company has increased 64% as the Company's client base, as well as client trading activity per account, has grown. Average commission per revenue trade decreased 18%. This decline was attributable to the factors described in the comparison between the three-month periods. - -------------------------------------------------------------------------------- Nine Months Ended Commissions Earned on September 30, Percent Client Revenue Trades 2000 1999 Change - -------------------------------------------------------------------------------- Client accounts that traded during the period (in thousands) 3,417 2,822 21% Average client revenue trades per account 13.80 10.16 36 Total revenue trades (in thousands) 47,140 28,668 64 Average commission per revenue trade $ 37.99 $ 46.36 (18) Commissions earned on client revenue trades (in millions) (1) $ 1,791 $ 1,329 35 ================================================================================ (1) Includes certain non-commission revenues relating to the execution of client trades. Excludes commissions on trades relating to specialist operations and U.S. Trust commissions on trades. Asset Management and Administration Fees Asset management and administration fees were $1.2 billion for the first nine months of 2000, up $288 million, or 33%, from the first nine months of 1999 as shown in the following table (in millions). This increase was attributable to the factors described in the comparison between the three-month periods. - -------------------------------------------------------------------------------- Nine Months Ended Asset Management September 30, Percent and Administration Fees 2000 1999 Change - -------------------------------------------------------------------------------- Mutual fund service fees: SchwabFunds(R) $ 459 $367 25% Mutual Fund OneSource(R) 254 165 54 Excelsior(R) Funds 38 25 52 Other 14 10 40 Asset management and related services 407 317 28 - -------------------------------------------------------------------------------- Total $1,172 $884 33% ================================================================================ Net Interest Revenue Net interest revenue was $931 million for the first nine months of 2000, up $345 million, or 59%, from the first nine months of 1999 as shown in the following table (in millions): - -------------------------------------------------------------------------------- Nine Months Ended September 30, Percent 2000 1999 Change - -------------------------------------------------------------------------------- Interest Revenue Margin loans to clients $1,334 $ 687 94% Investments, client-related 249 298 (16) Private banking loans 160 126 27 Securities available for sale 53 44 20 Other 129 68 90 - -------------------------------------------------------------------------------- Total 1,925 1,223 57 - -------------------------------------------------------------------------------- Interest Expense Brokerage client cash balances 788 494 60 Deposits from banking clients 113 84 35 Long-term debt 40 24 67 Stock-lending activities 34 23 48 Short-term borrowings 15 6 150 Other 4 6 (33) - -------------------------------------------------------------------------------- Total 994 637 56 - -------------------------------------------------------------------------------- Net interest revenue $ 931 $ 586 59% ================================================================================ Client-related and other daily average balances, interest rates and average net interest spread for the first nine months of 2000 and 1999 are summarized in the following table (dollars in millions): - -------------------------------------------------------------------------------- Nine Months Ended September 30, 2000 1999 - -------------------------------------------------------------------------------- Interest-Earning Assets (client-related and other): Margin loans to clients: Average balance outstanding $20,139 $12,563 Average interest rate 8.85% 7.31% Investments (client-related): Average balance outstanding $ 6,202 $ 8,602 Average interest rate 5.37% 4.63% Private banking loans: Average balance outstanding $ 2,816 $ 2,331 Average interest rate 7.60% 7.24% Securities available for sale: Average balance outstanding $ 1,154 $ 996 Average interest rate 6.08% 5.79% Average yield on interest-earning assets 7.91% 6.30% Funding Sources (client-related and other): Interest-bearing brokerage client cash balances: Average balance outstanding $20,884 $16,886 Average interest rate 5.04% 3.91% Interest-bearing banking deposits: Average balance outstanding $ 3,036 $ 2,701 Average interest rate 4.96% 4.15% Other interest-bearing sources: Average balance outstanding $ 1,973 $ 1,516 Average interest rate 4.50% 3.71% Average noninterest-bearing portion $ 4,418 $ 3,389 Average interest rate on funding sources 4.26% 3.39% Summary: Average yield on interest-earning assets 7.91% 6.30% Average interest rate on funding sources 4.26% 3.39% - -------------------------------------------------------------------------------- Average net interest spread 3.65% 2.91% ================================================================================ The increase in net interest revenue from the first nine months of 1999 was primarily due to higher levels of margin loans to clients, partially offset by higher average brokerage client cash balances. Principal Transactions Principal transaction revenues were $470 million for the first nine months of 2000, up $109 million, or 30%, from the first nine months of 1999. This increase was primarily due to greater share volume handled by SCM, partially offset by lower average revenue per share traded. Expenses Excluding Interest Compensation and benefits expense was $1.9 billion for the first nine months of 2000, up $495 million, or 36%, from the first nine months of 1999 primarily due to a greater number of employees, as well as higher variable compensation expense resulting from the Company's financial performance. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - -------------------------------------------------------------------------------- Nine Months Ended September 30, 2000 1999 - -------------------------------------------------------------------------------- Compensation and benefits expense as a % of revenues 42% 42% Incentive and variable compensation as a % of compensation and benefits expense 30% 30% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 10% 12% Full-time equivalent employees(1) (at end of period) 25.4 19.4 Revenues per average full-time equivalent employee $190.0 $184.3 ================================================================================ (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Occupancy and equipment expense was $295 million for the first nine months of 2000, up $77 million, or 35%, from the first nine months of 1999. This increase was attributable to the factors described in the comparison between the three-month periods. Advertising and market development expense was $243 million for the first nine months of 2000, up $74 million, or 44%, from the first nine months of 1999. This increase was primarily a result of increased Schwab brand-focused television and print media spending. Merger-related expense was $69 million for the first nine months of 2000, up $69 million from the first nine months of 1999. Merger-related expense consists of professional fees and change in control related compensation from the merger with USTC. The Company's effective income tax rate was 42.4% for the first nine months of 2000, up from 39.3% for the first nine months of 1999. The increase was primarily due to charges, which are non-deductible for tax purposes, for certain professional fees relating to the merger with USTC and goodwill amortization relating to the acquisition of CyBerCorp. Liquidity and Capital Resources Upon completion of the merger with USTC, CSC became a financial holding company and bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (Federal Reserve Board) under the Bank Holding Company Act of 1956, as amended. CSC conducts virtually all business through its wholly owned subsidiaries. The capital structure among CSC and its subsidiaries is designed to provide each entity with capital and liquidity consistent with its operations. See note "7 - Regulatory Requirements" in the Notes to Condensed Consolidated Financial Statements. A description of significant aspects of this structure for CSC and four of its subsidiaries, Schwab, U.S. Trust, SCM and CSE follows. 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 bank subsidiaries, SCM and CSE 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, maintaining CSC's bank subsidiaries' capital guidelines and maintaining Schwab's and SCM's net capital. Based on their respective regulatory capital ratios at September 30, 2000 and 1999, the Company and its bank subsidiaries are well capitalized. CSC has liquidity needs that arise from its issued and outstanding $741 million Senior Medium-Term Notes, Series A (Medium-Term Notes), as well as from the funding of cash dividends, acquisitions and other investments. The Medium-Term Notes have maturities ranging from 2000 to 2010 and fixed interest rates ranging from 5.96% to 8.05% with interest payable semiannually. The Medium-Term Notes are rated A2 by Moody's Investors Service and A by Standard & Poor's Ratings Group. CSC has a prospectus supplement on file with the Securities and Exchange Commission enabling CSC to issue up to $750 million in Senior or Senior Subordinated Medium-Term Notes, Series A. At September 30, 2000, all of these notes remained unissued. CSC maintains a $1.2 billion committed, unsecured credit facility with a group of banks which is scheduled to expire in June 2001. 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 minimum levels of stockholders' equity, and Schwab and SCM to maintain specified levels of net capital, as defined. The Company believes that these restrictions will not have a material effect on its ability to meet foreseeable dividend or funding requirements. This facility was unused during the first nine months of 2000. CSC also has direct access to $675 million of the $765 million uncommitted, unsecured bank credit lines, provided by eight banks, that are primarily utilized by Schwab to manage short-term liquidity. The amount available to CSC under these lines is lower than the amount available to Schwab because the credit line provided by one of these banks is only available to Schwab, while the credit line provided by another one of these banks includes a sub-limit on credit available to CSC. These lines were not used by CSC during the first nine months of 2000. Schwab Liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $22.9 billion and $23.0 billion at September 30, 2000 and December 31, 1999, respectively. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future. Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash dividends, or making unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement of $1 million. At September 30, 2000, Schwab's net capital was $2.1 billion (10% of aggregate debit balances), which was $1.7 billion in excess of its minimum required net capital and $1.1 billion in excess of 5% of aggregate debit balances. Schwab has historically targeted net capital to be 10% of its aggregate debit balances, which primarily consist of client margin loans. To achieve this target, as client margin loans have grown, an increasing amount of cash flows have been retained to support aggregate debit balances. To manage Schwab's regulatory capital position, CSC provides Schwab with a $1.4 billion subordinated revolving credit facility maturing in September 2002, of which $705 million was outstanding at September 30, 2000. At quarter end, Schwab also had outstanding $25 million in fixed-rate subordinated term loans from CSC maturing in 2002. Borrowings under these subordinated lending arrangements qualify as regulatory capital for Schwab. To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines totaling $765 million at September 30, 2000 ($675 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 24 days during the first nine months of 2000, with the daily amounts borrowed averaging $82 million. These lines were unused at September 30, 2000. To satisfy the margin requirement of client option transactions with the Options Clearing Corporation (OCC), Schwab had unsecured letter of credit agreements with twelve banks in favor of the OCC aggregating $1.0 billion at September 30, 2000. Schwab pays a fee to maintain these letters of credit. No funds were drawn under these letters of credit at September 30, 2000. U.S. Trust U.S. Trust's liquidity needs are generally met through earnings generated by its operations. U.S. Trust's liquidity is affected by the Federal Reserve Board's risk-based and leverage capital guidelines. In addition, CSC's bank subsidiaries are subject to limitations on the amount of dividends they can pay to U.S. Trust without prior approval of the bank regulatory authorities. In addition to traditional funding sources such as deposits, federal funds purchased and repurchase agreements, CSC's bank subsidiaries have established their own external funding sources. At September 30, 2000, U.S. Trust had $50 million Trust Preferred Capital Securities outstanding with a fixed interest rate of 8.41%. Certain of CSC's bank subsidiaries have established credit facilities with the Federal Home Loan Bank System (FHLB) totaling approximately $499 million. At September 30, 2000, $150 million in short-term borrowings and $2 million in long-term debt were outstanding under these facilities. SCM SCM's liquidity needs are generally met through earnings generated by its operations. Most of SCM's assets are liquid, consisting primarily of marketable securities, cash and cash equivalents, and receivable from brokers, dealers and clearing organizations. SCM's liquidity is affected by the same net capital regulatory requirements as Schwab (see discussion above). At September 30, 2000, SCM's net capital was $30 million, which was $29 million in excess of its minimum required net capital. SCM may borrow up to $70 million under a subordinated lending arrangement with CSC maturing in 2002. Borrowings under this arrangement qualify as regulatory capital for SCM. In addition, CSC provides SCM with a $25 million short-term credit facility. Borrowings under this arrangement do not qualify as regulatory capital for SCM. No funds were drawn under these facilities at September 30, 2000. CSE CSE's liquidity needs are generally met through earnings generated by its operations. Most of CSE's assets are liquid, consisting primarily of cash and investments required to be segregated, receivable from brokers, dealers and clearing organizations, and receivable from brokerage clients and others. CSE may borrow up to (pound)70 million, equivalent to $103 million at September 30, 2000, under subordinated lending arrangements with CSC. At September 30, 2000, CSE had outstanding (pound)18 million under these arrangements, equivalent to $29 million, with (pound)5 million maturing in 2001 and (pound)13 million maturing in 2003. Cash Flows and Capital Resources Net income plus depreciation and amortization, including goodwill amortization, was $797 million for the first nine months of 2000, up 32% from $605 million for the first nine months of 1999, allowing the Company to finance its operations primarily with internally generated funds. Depreciation and amortization expense related to equipment, office facilities and property was $173 million for the first nine months of 2000, as compared to $117 million for the first nine months of 1999, or 4% of revenues for each period. Amortization expense related to intangible assets was $12 million for the first nine months of 2000, as compared to $7 million for the first nine months of 1999. Goodwill amortization expense was $32 million for the first nine months of 2000, as compared to $5 million for the first nine months of 1999. This increase was primarily due to goodwill amortization related to the acquisition of CyBerCorp. The Company's capital expenditures net of proceeds from the sale of fixed assets were $467 million in the first nine months of 2000 and $253 million in the first nine months of 1999, or 10% and 8% of revenues for each period, respectively. Capital expenditures in the first nine months of 2000 were for facilities expansion, equipment relating to the Company's information technology systems and software. Capital expenditures as described above include the capitalized costs for developing internal-use software of $75 million in the first nine months of 2000 and $46 million in the first nine months of 1999. Schwab opened 28 new domestic branch offices during the first nine months of 2000 and 1999. Capital expenditures may vary from period to period as business conditions change. The Company issued $311 million and repaid $36 million of long-term debt during the first nine months of 2000. During the first nine months of 2000, 18,454,300 of the Company's stock options, with a weighted-average exercise price of $2.55, were exercised with cash proceeds received by the Company of $47 million and a related tax benefit of $165 million. (These stock options were granted prior to the merger with USTC, and therefore did not include U.S. Trust employees). During the first five months of 2000, 4,800,200 of U.S. Trust's stock options, with a weighted-average exercise price of $7.06, were exercised with cash proceeds received by the Company of $27 million and a related tax benefit of $12 million. The cash proceeds are recorded as an increase in cash and a corresponding increase in stockholders' equity. The tax benefit is recorded as a reduction in income taxes payable and a corresponding increase in stockholders' equity. During the first nine months of 2000, the Company did not repurchase any common stock. During the first nine months of 1999, the Company repurchased 2,143,500 shares of its common stock for $35 million. There is no current authorization for share repurchases. During the first nine months of 2000 and 1999, the Company paid common stock cash dividends of $47 million and $46 million, respectively. 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 September 30, 2000 was $4.8 billion, up $1.7 billion, or 56% from December 31, 1999. At September 30, 2000, the Company had long-term debt of $793 million, or 16% of total financial capital, that bear interest at a weighted-average rate of 7.22%. At September 30, 2000, the Company's stockholders' equity was $4.0 billion, or 84% of total financial capital. Item 3. Quantitative and Qualitative Disclosures About Market Risk Financial Instruments Held For Trading Purposes The Company held municipal, other fixed income and government securities and certificates of deposit with a fair value of approximately $38 million and $26 million at September 30, 2000 and 1999, respectively. These securities, and the associated interest rate risk, are not material to the Company's financial position, results of operations or cash flows. Through Schwab and SCM, the Company maintains inventories in exchange-listed, Nasdaq and other equity securities on both a long and short basis. The fair value of these securities at September 30, 2000 was $84 million in long positions and $53 million in short positions. The fair value of these securities at September 30, 1999 was $61 million in long positions and $39 million in short positions. Using a hypothetical 10% increase or decrease in prices, the potential loss or gain in fair value is estimated to be approximately $3,100,000 and $2,200,000 at September 30, 2000 and 1999, respectively, due to the offset of change in fair value in long and short positions. In addition, the Company generally enters into exchange-traded option contracts to hedge against potential losses in equity inventory positions, thus reducing this potential loss exposure. This hypothetical 10% change in fair value of these securities at September 30, 2000 and 1999 would not be material to the Company's financial position, results of operations or cash flows. The notional amount and fair value of option contracts were not material to the Company's consolidated balance sheets at September 30, 2000 and 1999. Financial Instruments Held For Purposes Other Than Trading The Company maintains investments primarily in mutual funds to fund obligations under its deferred compensation plan, which is available to certain employees. These investments were approximately $65 million and $55 million at September 30, 2000 and 1999, respectively. Any decrease in the fair value of these investments would result in a comparable decrease in the deferred compensation plan obligation and would not affect the Company's financial position, results of operations or cash flows. Debt Issuances At September 30, 2000, CSC had $741 million aggregate principal amount of Medium-Term Notes, with fixed interest rates ranging from 5.96% to 8.05%. At September 30, 1999, CSC had $465 million aggregate principal amount of Medium-Term Notes, with fixed interest rates ranging from 5.90% to 7.50%. At September 30, 2000 and 1999, U.S. Trust had $50 million Trust Preferred Capital Securities outstanding, with a fixed interest rate of 8.41%. In addition at September 30, 2000 and 1999, U.S. Trust had $2 million and $13 million FHLB long-term debt outstanding, respectively. The FHLB long-term debt had fixed interest rates ranging from 6.69% to 6.76% at September 30, 2000 and 6.59% to 6.76% at September 30, 1999. 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 September 30, 2000 and 1999, based on estimates of market rates for debt with similar terms and remaining maturities, approximated their carrying amount. 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 and Swaps utilized by U.S. Trust to hedge its interest rate risk. Key variables in the model include assumed margin loan and brokerage client cash balance growth, changes to the level and term structure of interest rates, the repricing of financial instruments, prepayment and reinvestment assumptions, loan, banking deposit, and brokerage client cash balance pricing and volume assumptions. The simulations involve assumptions that are inherently uncertain and as a result, the simulations cannot precisely estimate net interest revenue or precisely predict the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due to the timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies, including changes in asset and liability mix. The simulations in the table below 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 200 basis point increase or decrease in interest rates and the effect on simulated net interest revenue over the next twelve months at September 30, 2000 and 1999 (dollars in millions). The change in simulated net interest revenue sensitivity from 1999 to 2000 was primarily due to increases in the overall size of the balance sheet, driven by the growth in brokerage client cash balances. - -------------------------------------------------------------------------------- Impact on Net Interest Revenue Increase (Decrease) 2000 1999 ------------- ------------- September 30, Amount % Amount % - -------------------------------------------------------------------------------- Increase of 200 basis points $118 8.3% $88 9.5% Decrease of 200 basis points ($118) (8.3%) ($90) (9.7%) ================================================================================ As demonstrated by the simulations presented, the Company manages the consolidated balance sheet to produce increases in net interest revenue when interest rates rise. This position partially offsets the potential for decreases in trading activity, and therefore commission revenue, that may result during periods of rising interest rates. The impact of the Company's hedging activities upon net interest revenue for the quarters ended September 30, 2000 and 1999 was immaterial to the Company's results of operations. PART II - OTHER INFORMATION Item 1. Legal Proceedings The nature of the Company's business subjects it to numerous regulatory investigations, claims, lawsuits and other proceedings in the ordinary course of its business. The results of these legal proceedings 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. However, it is the opinion of management, after consultation with outside legal counsel, that the ultimate outcome of the current matters will not have a material adverse impact on the financial condition or operating results of the Company. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) The following exhibits are filed as part of this quarterly report on Form 10-Q. - -------------------------------------------------------------------------------- Exhibit Number Exhibit - -------------------------------------------------------------------------------- 10.87 Trust Agreement under the Charles Schwab Profit Sharing and Employee Stock Ownership Plan, effective November 1, 1990, dated October 25, 1990, amended by: the First Amendment, effective January 1, 1992, dated December 20, 1991 filed as Exhibit 10.101 to the Registrant's Form 10-K for the year ended December 31, 1996; the Second Amendment, effective July 1, 1992, dated June 30, 1992 filed as Exhibit 10.116 to the Registrant's Form 10-Q for the quarter ended June 30, 1997; the Third Amendment, effective January 1, 1996, dated May 8, 1996 filed as Exhibit 10.169 to the Registrant's Form 10-Q for the quarter ended June 30, 1997; the Fourth Amendment, effective January 1, 1998, filed as Exhibit 10.202 to the Registrant's Form 10-K for the year ended December 31, 1998; all amendments are incorporated herein by reference. 12.1 Computation of Ratio of Earnings to Fixed Charges. 27.1 Financial Data Schedule (electronic only). - -------------------------------------------------------------------------------- (b) Reports on Form 8-K On July 18, 2000, the Registrant filed a Current Report on Form 8-K which included a press release announcing its consolidated results of operations for the three-month and six-month periods ended June 30, 2000. This Current Report on Form 8-K was filed to present 30 days of combined results of operations of The Charles Schwab Corporation (CSC) and U.S. Trust Corporation. On July 18, 2000, the Registrant filed a Current Report on Form 8-K which included the audited consolidated balance sheets of CSC and its subsidiaries (collectively referred to as the Company) as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years ended December 31, 1999, 1998 and 1997, together with the Independent Auditors' Reports thereon, as well as the Company's management's discussion and analysis of results of operations and financial condition, and supplementary financial information. Also included in this Current Report on Form 8-K are the unaudited condensed consolidated balance sheets of the Company as of March 31, 2000 and December 31, 1999, and the related condensed consolidated statements of income and cash flows for each of the three months ended March 31, 2000 and 1999, together with the Company's management's discussion and analysis of results of operations and financial condition, and supplementary financial information.
SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE CHARLES SCHWAB CORPORATION (Registrant) Date: November 9, 2000 /s/ Christopher V. Dodds --------------------- ---------------------------------- Christopher V. Dodds Executive Vice President and Chief Financial Officer