The Charles Schwab Corporation Business Information, Profile, and History

Company Perspectives

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History of The Charles Schwab Corporation

The Charles Schwab Corporation ranks among the nation's largest financial services firms. Explosive growth within the stock market during the 1990s has helped operating subsidiary Charles Schwab & Co., Inc. become the largest discount stock broker in the United States and the largest provider of online brokerage services. A pioneer in the area of no-transaction fee mutual funds, the company has also earned standing as one of the three largest managers of mutual funds, alongside Fidelity and Vanguard. Despite its reputation as a major player in the industry, Charles Schwab has been forced in the 2000s to scale back, rethink its strategy, and rethink it again.

Pioneer Discount Broker

Charles Schwab, the company's founder, had received an M.B.A. degree from Stanford University and had been working for a small California investment adviser when, in 1971, he founded his own company, First Commander Corp. He and two partners created a stock mutual fund that soon had $20 million in assets. They ran into trouble with securities regulators, however, when it was learned that they had failed to register the fund. This error temporarily forced Schwab out of business, but he soon reopened a small money-management firm, Charles Schwab & Co., Inc., in San Francisco, which he incorporated in 1974.

On May 1, 1975, the U.S. Congress deregulated the stock brokerage industry by taking away the power of the New York Stock Exchange to determine the commission rates charged by its members. This opened the door to discount brokers, who took orders to buy and sell securities, but did not offer advice or do research the way larger, established brokers such as Merrill Lynch did. This presented an opportunity to win individual investors well enough versed in the stock market not to need the advice offered by established brokers. Schwab quickly took advantage of deregulation, opening a small San Francisco brokerage, financed primarily with borrowed money, and buying a seat on the New York Stock Exchange.

The new discount brokers, whose commissions might be only 30 percent of the rates before deregulation, were scorned by the old-line brokerages. During his first few years as a discount broker, Schwab had to contend with bad publicity generated by the older firms, some of whom threatened to break their leases if landlords allowed Schwab to rent offices in the same building.

Schwab fought back by buying newspaper ads featuring his photograph and asking customers to contact him personally, helping to build the firm's credibility. Possibly the most important early decision made by Schwab was to open branch offices around the United States. He reasoned that even investors not needing advice would prefer doing business through a local office instead of a toll-free telephone number. The move won customers and helped differentiate Schwab from the large number of discount firms appearing after deregulation.

Over the next few years Schwab did several things to pull away from the pack. The company offered innovative new services including the ability to place orders 24 hours a day. It bought advanced computer systems to deal quickly with huge volumes of orders and continued its heavy advertising, seeking to project an upscale image. Top executives were given expensive foreign cars, and an interior design staff was commissioned to help showcase certain new branches. Some industry analysts maintain that with these measures Schwab helped bring discount brokering into the mainstream of financial institutions.

Purchase by BankAmerica: 1983

The firm's rapid expansion was costly, however. Partly as a result of high operating costs and partly because sales were dependent on the sentiments of small investors, profits were erratic. Schwab sometimes turned to employees and larger customers to raise money for further expansion. By 1980 Schwab was by far the largest discounter in the country. That year, to fund further growth, Schwab decided to take the company public. The offering was called off, however, when some problems caused by the attempted conversion to a new computer system proved an embarrassment to the company. Raising sufficient capital in private became more difficult, partly because of the erratic earnings. Finally, in 1983, Schwab arranged for San Francisco's BankAmerica Corporation to acquire the company for $55 million in BankAmerica stock. BankAmerica also agreed to supply Schwab with capital. The bank loaned Schwab $50 million over the next three years, but Schwab remained one of the most highly leveraged brokerages.

The sale to BankAmerica may have provided needed capital, but it also fettered the company with banking regulations. Schwab wanted to offer new, proprietary lines of investments including Charles Schwab mutual funds. However, federal law at the time forbid banks and their subsidiaries from underwriting such securities. Although Schwab initially sought to challenge the law, as its wording contained some ambiguities, BankAmerica did not want to irritate banking regulators. Tensions between Schwab and its parent were further exacerbated when BankAmerica's stock price began falling, making Schwab's stake in the corporation worth less.

Schwab introduced the Mutual Fund Marketplace in 1984 with an initial investment of $5 million. The Marketplace allowed customers to invest in 250 separate mutual funds and switch between them using Schwab as the bookkeeper. All of a customer's mutual fund accounts were put on a single monthly statement. The company's profile was further raised in 1984 when Schwab's book How to Be Your Own Stockbroker was published. In it Schwab presented himself as a populist fighting against Wall Street stockbrokers in the name of the average investor. He contended that there is an inherent conflict of interest when a firm owns stock in inventory, writes favorable research recommendations on those stocks, and has commissioned salespeople sell those stocks to the public. At the same time, Schwab's company was moving into elegant new headquarters in downtown San Francisco.

In 1985 Schwab had 90 branches and 1.2 million customers, generating $202 million in revenue. Though it was far larger than its leading discount competitors, it was small compared with the largest retail brokerages, which had over 300 branches. The firm was growing in other ways, however. It offered personal computer software, called the Equalizer, that allowed investors to place orders via computer as well as to call up stock information and obtain research reports.

Buyback and Public Offering in 1987

In 1987 Charles Schwab and a group of investors bought the company back from BankAmerica for $280 million. Seven weeks later, he announced plans to take the company public. The buyback had resulted in a debt of $200 million, and the initial public offering (IPO) was partly designed to eliminate some of this debt. It was also intended to raise money for further expansion. Schwab wanted to increase the number of branches to 120, including offices in Europe. The September 1987 IPO created a new holding company, The Charles Schwab Corporation, with Charles Schwab & Co., Inc. as its principal operating subsidiary.

The discount brokerage business had grown intensely competitive. Discounters handled a significant amount of retail equity trades by 1987, but hundreds of firms had entered the field, including banks, savings and loans, and mutual fund companies. Since Schwab was clearly the player to beat in discounting, competitors' advertisements specifically offered rates lower than Schwab's. Nevertheless, at this time Schwab had 1.6 million customers, about five times as many as its nearest competitor, Quick & Reilly Group. In 1987 the firm had sales of $465 million and profits of $26 million, twice the industry's average profit margin. To achieve this success, Schwab was spending about $15 million a year on advertising.

Schwab was already doing well with its expanded product line. Mutual Fund Marketplace had attracted $1.07 billion in client assets by year-end 1986. The company was also offering Individual Retirement Accounts, certificates of deposit, money-market accounts, and Schwab One cash-management accounts. Despite these successes, Schwab was badly hurt by the stock market crash of October 1987. By mid-1988, trading volume had fallen to about 10,400 trades a day, a 40 percent drop from the months before the crash. Schwab cut costs to maintain profitability, reducing managerial salaries anywhere from 5 to 20 percent and laying off employees. Charles Schwab cut his own pay by 20 percent for six months and put branch expansion plans on hold. The firm also raised its trading commission by 10 percent, so that it needed only 8,000 trades a day to break even, down from 12,000 trades. Even with the cost-cutting, the firm's 1988 earnings plummeted 70 percent to $7.4 million on sales of $392 million.

Rapid Expansion

By 1989 Schwab was expanding again. The company bought Chicago-based Rose & Co. for $34 million from Chase Manhattan; as the fifth largest discount broker in the United States, Rose & Co. brought Schwab 200,000 new customers at a cost of about $70 each. With the purchase, Schwab controlled about 40 percent of the discount market, though discounters made only 8 percent of all retail commissions. Over the long run, Schwab realized its best strategy was to win customers from the full-service brokers. To help create more independent stock investors, it pioneered a service called TeleBroker that let customers place stock orders and get price quotes from any touchtone telephone 24 hours a day. It also released a new version of the Equalizer. The software had already sold 30,000 copies at $169 each since its introduction.

Individual investors returned to the stock market in 1989, and the firm's income surged to $553 million, with profits of $18.9 million. Income was further helped by an increase in client assets, from $16.8 billion in 1987 to $25 billion in early 1990. Commissions accounted for 70 percent of revenue, down from 85 percent in 1987.

Throughout the 1980s, Schwab updated its Mutual Fund Marketplace to allow customers to switch their investments from fund to fund by telephone. Customers paid a commission ranging from .6 percent to .08 percent, with a minimum fee of $29. Analysts were generally positive, pointing out that the amount of interest lost from having a check in the mail would pay for most of the service's commission fees. In 1991 Schwab entered a new and lucrative market with the acquisition of Mayer & Schweitzer, an over-the-counter stock market maker.

Meanwhile, Schwab was opening branch offices at a furious pace--17 in 1992 alone--and doubling the amount of money it spent on advertising. Schwab's aggressive stance helped raise its share of the discount market to 46 percent as the company attracted more than 40,000 new accounts a month. In 1992 Schwab acquired its first corporate jet, spending $12 million on a model with enough fuel capacity to reach London, where it was opening its first European branch. These additional costs helped drag down third-quarter earnings in 1992 when stock trading temporarily tapered off. The dip was a reminder that the company was still highly dependent on commissions and caused its stock to drop 20 percent.

Schwab cut advertising by 20 percent and took other steps to slow cost increases. The company converted a greater share of new branch offices into bare-bones operations with only one broker. Schwab already paid its 2,500 brokers less than other discounters, an average of $31,000 a year, compared with $50,000 at Fidelity Brokerage Services and $36,000 at Quick & Reilly.

Introduction of OneSource Leading to Explosive Growth

The firm also continued searching for ways to become less dependent on commissions. The introduction in July 1992 of the Mutual Fund OneSource, a program allowing investors to trade mutual funds (more than 200 in all) from eight outside fund companies, without paying any transaction fees, attracted more than $500 million in assets within two months and over $4 billion by July 1993; it was thus the most successful first-year pilot of any new service in Schwab's history. The fund companies paid Schwab a small percentage fee, typically 0.25 to 0.35 percent, of the fund assets held in Schwab accounts.

During 1992 Schwab customers opened 560,000 new accounts at its 175 branch offices, while assets in customer accounts grew 38 percent to $65.6 billion. Revenue soared to $909 million, with record profits of $81 million. As a result of these successes, Schwab opened 20 more branch offices in 1993, opened an office in London (its first in Europe), and introduced several proprietary mutual funds, including Schwab International Index Fund and Schwab Small-Cap Index Fund.

As the 1990s continued, the OneSource program became wildly successful. By 1997 investors could choose among more than 1,400 mutual funds and had poured $80 billion into the funds through the program. OneSource, aided by the long bull market, helped Schwab grow at an amazing rate in the 1990s. From 1992 through 1997, revenues increased at a 25 percent compounded annual rate, while customer assets increased 40 percent per year, from $65.6 billion to $353.7 billion. Also fueling this growth was the emergence of Internet trading as Schwab rapidly gained the number one position among online brokerage services. By May 1997 the firm claimed 700,000 of the 1.5 million active, online brokerage accounts in the United States. It also moved into the top five among all U.S. brokerages.

Schwab's explosive growth, which saw customer accounts increase from two million in 1992 to 4.8 million in 1997, was accompanied by several technological snafus, prompting some company clients to conclude that Schwab was growing too fast. For instance, in the summer of 1997 two computer-related outages temporarily left thousands of Schwab clients without access to their accounts. In addition, some clients were mistakenly sent the statements of other clients. Schwab officials contended that these were isolated incidents and not indicative of out-of-control growth.

The company also had to contend with the aging of the baby boom generation, the members of which were somewhat belatedly planning for retirement. Schwab set up a retirement plan services unit offering 401(k) and other retirement plans. Aging investors also tended to want more advice before deciding where to put their money. In response, Schwab bolstered its ability to deliver investment advice to clients, developing written investment kits; providing access to a wide range of research reports, earnings forecasts, and news stories on its web site; and offering the opportunity to meet in person with representatives at company branches. Another new and highly sought-after service added by Schwab in 1997 was access to initial public offerings at the offering price. The firm entered into alliances with Credit Suisse First Boston Corporation, J.P. Morgan & Co., and Hambrecht & Quist Group to gain access to IPOs led by these companies.

On January 1, 1998, David S. Pottruck became president and co-CEO of Charles Schwab Corporation, with Charles Schwab remaining chairman and sharing the co-CEO title. This unusual arrangement seemed to indicate that Pottruck, age 49 at the time, was in line to succeed the 60-year-old Schwab, though the company founder had made no retirement plans. Just a month or so earlier, Timothy F. McCarthy was named president and chief operating officer of Charles Schwab & Co., giving him day-to-day responsibility for the management of the brokerage unit, with Pottruck controlling overall administration, finance, technology, and corporate strategy.

It was this new management team that would have to contend with what would likely be an increasingly volatile stock market in the early 21st century. Also, the shift to more trading on the Internet, where fees were lower, was cutting into Schwab's bread-and-butter commissions. It was reported in September 1998 that the company, which already offered services in Hong Kong and the United Kingdom, was considering entering the Japanese market, among other international expansion possibilities.

A Volatile New Millennium

The new century started out with a bang. Schwab put down $3 billion for the 149-year-old U.S. Trust Corp. The wealth advisory company, looking toward the retirement of insiders, had been positioning itself for change. Schwab, meanwhile, wanted to expand its services to investors with very high net worth. When the Gramm-Leach-Bliley Act which allowed financial institutions crossover businesses passed in 1999, the way was eased for a merger between the pair.

A bust followed the bang, however. Schwab soon was reeling from a dramatic drop-off in online trading precipitated by the tech stock collapse and deepened by the September 11, 2001 terrorist attacks and the Enron bankruptcy in December.

To avoid layoffs, Schwab eliminated bonuses, cut executive pay, promoted unpaid sabbaticals and days off, and encouraged part-time or job-share positions, Fortune recounted. Yet those and other efforts failed to stem the tide of pink slips to come. During 2001, daily average trades dropped by roughly a third. Yearly revenue fell 25 percent to $4.35 billion and net income was off by 72 percent to $199 million.

Seeking to regain some ground, in May 2002, the firm established Schwab Private Client to serve individuals with more than $500,000 to invest. Concurrently, they began promoting a new in-house computer-based stock grading system. "It's a systematic approach with nothing but objectivity, not influenced by corporate relationships, investment banking, or any of the above," Pottruck told Business Week. Meanwhile, households with less than $50,000 to invest were being asked to pay more for Schwab services.

While Schwab had a strong track record bringing new ventures into the financial market, some of its endeavors had of late been less successful. In 1999, Schwab led a consortium to establish Epoch Partners Inc. to underwrite tech IPOs, but it stalled with the tech stock meltdown and Schwab sold its stake in the venture in 2001 to Goldman Sachs. Two other endeavors, wireless-trading service PocketBroker and online-service CyberTrader, had yet to find their stride.

The merger with U.S. Trust (UST) had not yet lived up to expectations, due, in part, to the market downturn. Private banking assets had generally declined, with UST average assets falling more precipitously than its competitors, according to Institutional Investor. Another fly in UST's ointment was a $10 million fine for violation of money laundering rules, a judgment handed down after the merger with Schwab. Moreover, a melding of clients between Schwab and UST had yet to manifest itself, as Schwab investment advisers balked at the idea. Late in 2002, Schwab instituted a change of leadership and direction at UST.

Schwab relinquished his position as co-CEO in 2003, leaving Pottruck in charge. Schwab, who controlled 25 percent of the company and continued as chairman, attributed the decision to step down to a current wave of concern regarding corporate governance.

Changes were taking place abroad as well. Charles Schwab Europe, the firm's pound-denominated brokerage in the United Kingdom, was sold to Barclays PLC, American Banker reported. The dollar-denominated business continued to offer trades on U.S. exchanges and in U.S. investment products. The company's Canadian brokerage operation had been sold in 2002 and joint ventures in Japan and Australia exited in the final quarter of 2001. The rise, then fall, of the markets prompted Schwab to enter, then exit, online international markets.

In a move to bring in new revenue, the Charles Schwab Bank opened in 2003. The bank planned to focus on mortgages, tapping into the red-hot market. Long-term interest rates were at their lowest levels in more than four decades. Operating primarily online, by phone, and mail, the bank also would offer checking, savings, and certificates of deposit accounts, according to Long Island Business News.

During the later half of 2003, Schwab joined the growing list of financial companies targeted for investigation by Eliot Spitzer, New York's attorney general, and the Securities and Exchange Commission (SEC). Schwab faced allegations regarding market timing by a fund family operated by UST and illegal late trading in the Schwab Mutual Fund Marketplace. The tarnishing of its trustworthiness, a trait crucial to the brand, hit Schwab stock harder than other financial operations under investigation. Brokerage stock overall had been climbing as the market recovered.

For much of its history, Schwab had been aided by bull market conditions that drew a broader range of investors into the arena. When the bear market took hold, both revenue and stock price suffered. Revenue of $5.8 billion in 2000 fell to $4.1 billion in 2002. Stock as high as $50.16 per share in April 1999, traded in the $11 per share range in 2003. A quarter of its employees had been axed. Survivors of the cuts lost bonuses, which made up a good deal of compensation, and their 401(k) matches.

In July 2004, the board asked Pottruck to resign. Schwab returned as CEO. The firm's new mission was to win back retail customers and reestablish its discount brokerage status. Some industry watchers expected Schwab to divest noncore, unprofitable businesses such as Schwab Capital Markets, according to American Banker. Sale of the upscale U.S. Trust Corp. also was the subject of speculation. Efforts to add multimillionaire clients and sell advisory services to less well-heeled investors produced lackluster results. In addition, while Schwab was moving into new areas, E*Trade Financial Corp. and Ameritrade, offering cheaper trades, eroded Schwab's core market share.

Schwab did sell Schwab Capital Markets in 2004, to USB AG. The firm also settled the SEC's mutual fund late trade investigation by agreeing to pay a $350,000 fine.

In an effort to retain clients and entice new ones Schwab had been cutting fees: seven price cuts in the past 16 months, according to a September 2004 American Banker article. The latest cuts included elimination of the annual service fee on accounts of less than $25,000 and the order-handling fee on equity trades.

Cuts in fees, an aggressive nationwide ad campaign, and severance costs at UST ate into 4th quarter earnings in 2005. Another sour note was hit when the New York Stock Exchange fined Schwab $1 million in regard to violations involving disbursement of customer assets. Schwab began trading concurrently on the NYSE and NASDAQ in 2004 and moved solely to the NASDAQ in 2005. On the flip side, trading activity improved at Schwab and UST made gains in new assets. Since May, UST had been headed up by the former CEO of Citigroup's global private bank.

Schwab succeeded in posting record income for the year, at $725 million up from $286 million in 2004. Total client assets reached a new peak, $1.2 trillion. Both net income and earnings per share surpassed previous records set in 2000.

Former Citigroup Global Consumer Group Chair and CEO Marjorie Magner joined the Schwab board of directors in 2006. The addition of Magner, who led one of Citigroup's most profitable business divisions, fueled speculation as to her future role with the company, perhaps that of a successor to the founder.

Principal Subsidiaries

Charles Schwab & Co., Inc.; U.S. Trust Corporation; Charles Schwab Bank, N.A.; CyberTrader, Inc.

Principal Competitors

E*Trade Financial Corporation; FMR Corp.; Merrill Lynch & Co., Inc.; Scottrade, Inc.; TD Ameritrade Holding Corporation.

Chronology

• Key Dates
• 1971 Charles Schwab and partners form short-lived stock mutual fund.
• 1975 End of fixed rate commissions opens door for discount brokers.
• 1980 Public offering is sidetracked by technology problems.
• 1983 Bank of America buys firm.
• 1987 Management buyback, followed by public offering, creates new holding company.
• 1992 Company finds instant success with Mutual Fund OneSource.
• 1997 Company ranks as top online broker in the United States.
• 2000 Merger with U.S. Trust is completed.
• 2002 Company begins building affluent client base.
• 2004 Company works to regain traditional customers.
• 2005 Charles Schwab Corporation posts record numbers.