Part I.
Item 1. Business
Introduction
We are a leading credit card issuer and electronic payment services company with
one of the most recognized brands in U.S. financial services. Since our
inception in 1986, we have grown to become one of the largest card issuers in
the United States with $48.2 billion in managed receivables as of November 30,
2007. We are also a leader in payments processing, as we are one of only two
credit card issuers with its own U.S. payments network and the only issuer whose
wholly-owned network operations include both credit and debit functionality. In
2007, we processed 3.8 billion transactions through our signature card network
(the "Discover Network") and PULSE EFT Association (the "PULSE Network" or
"PULSE"), one of the nation's leading ATM/debit networks.
We issue credit cards in the United States under the Discover Card brand to
various segments within the consumer and small business sectors. Most of our
cards offer a Cashback Bonus rewards program. In addition, we offer a range of
banking products to our customers, including personal loans, student loans,
certificates of deposit and money market accounts.
Discover Network cards currently are accepted at millions of merchant and cash
access locations primarily in the United States, Mexico, Canada and the
Caribbean. In October 2004, the U.S. Department of Justice ("DOJ") prevailed in
its antitrust lawsuit (the "DOJ litigation") against Visa U.S.A., Inc. (together
with its predecessors, "Visa") and MasterCard Worldwide (together with its
predecessors, "MasterCard") which challenged their exclusionary rules-rules that
effectively precluded us from offering network services to financial
institutions. Since then, we have accelerated our network growth by entering the
debit market with the acquisition of the PULSE Network, and by signing card
issuing agreements with a number of financial institutions. We also have
significantly expanded our relationships with companies that provide merchants
with credit card processing services, which we believe will further increase the
number of merchants accepting Discover Network cards.
In addition, we issue credit cards on the MasterCard and Visa networks in the
United Kingdom, the world's second-largest credit card market. Our portfolio
includes Goldfish, one of the United Kingdom's leading rewards credit cards, as
well as several Morgan Stanley-branded credit cards and a number of affinity
credit cards. As of November 30, 2007, we had $4.4 billion of managed
receivables in the United Kingdom. On February 7, 2008, we entered into an
agreement to sell our credit card business in the United Kingdom to Barclay's
Bank Plc. The closing is expected to occur by the end of our second quarter of
2008 and is subject to the satisfaction of a number of conditions. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-Sale of International Card Segment; First Quarter 2008 Charge" for
more information relating to the sale of our Goldfish business.
Our revenues (net interest income plus other income) have increased over the
last three years, from $4.3 billion in 2005 to $5.1 billion in 2007, and net
income was $589 million (which included a non-cash impairment charge of $279
million after tax related to our credit card business in the United Kingdom,
also referred to as the Goldfish business), $1.1 billion, and $578 million for
the years ended November 30, 2007, 2006 and 2005, respectively. For additional
financial information relating to our business and our operating segments, see
Note 23: Segment Disclosures to the consolidated and combined financial
statements and for additional financial information concerning our geographic
regions, see Note 25: Geographical Distribution of Loans to the consolidated and
combined financial statements.
On June 30, 2007, we were spun-off from our former parent company, Morgan
Stanley, through the distribution of our shares to its shareholders (the
"Distribution"). We became a subsidiary of Morgan Stanley in May 1997 as a
result of the combination of Dean Witter, Discover & Co. and Morgan Stanley
Group, Inc. The entity currently named Discover Financial Services was a
subsidiary of Sears, Roebuck and Co. ("Sears") from 1960 until 1993, when it was
part of the spin-off of Dean Witter Financial Services Group Inc. from Sears.
The Discover Card business was launched in 1986.
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We were incorporated in Delaware in 1960. Our principal executive offices are
located at 2500 Lake Cook Road, Riverwoods, Illinois 60015. Our main telephone
number is (224) 405-0900.
Available Information
We are required to file current, annual and quarterly reports, proxy statements
and other information required by the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), with the SEC. You may read and copy any document
we file with the SEC at the SEC's Public Reference Room located at 100 F Street,
N.E., Washington, DC 20549. Information on the operation of the Public Reference
Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC
maintains an internet website at http://www.sec.gov, from which interested
persons can electronically access our SEC filings.
We will make available free of charge through our internet site
http://www.discover.com, our annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statements, Forms 3, 4 and 5 filed
by or on behalf of directors, executive officers and certain large stockholders,
and any amendments to those documents filed or furnished pursuant to the
Exchange Act. These filings will become available as soon as reasonably
practicable after such material is electronically filed with or furnished to the
SEC.
We also make available, on the Investor Relations page of our website, our
(i) Corporate Governance Policies, (ii) Code of Ethics and Business Conduct and
(iii) the charter of the Audit, Compensation, and Nominating and Governance
Committees of our Board of Directors. These documents will also be available in
print without charge to any person who requests them by writing or telephoning:
Discover Financial Services, Office of the Corporate Secretary, 2500 Lake Cook
Road, Riverwoods, Illinois 60015, U.S.A., telephone number (224) 405-0900.
Operating Model
We operate in three reportable segments: U.S. Card, Third-Party Payments and
International Card. On February 7, 2008, we announced that we had entered into a
definitive sale and purchase agreement to sell our U.K. credit card business,
which represents substantially all of the International Card segment, to
Barclay's Bank Plc. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Sale of International Card Segment; First
Quarter 2008 Charge" for more information relating to the sale of our Goldfish
business.
U.S. Card
From our inception in 1986 until October 2004, we operated as a "closed loop"
credit card business in which we performed all functions related to our credit
card business by acting as the card issuer, network and merchant acquirer. As a
result of the resolution of the DOJ litigation, we recently began entering into
agreements with a number of third-party merchant acquirers.
We issue Discover Cards through our wholly-owned subsidiary Discover Bank.
Cardmembers are permitted to "revolve" their balances and repay their
obligations over a period of time and at an interest rate set forth in their
cardmember agreements, which may be either fixed or variable. The interest that
we earn on revolving balances is our primary source of revenue from cardmembers.
We finance these balances using a variety of debt instruments, including
securitizations, from which we derive a significant portion of our income. We
also charge cardmembers other fees, including fees for late payment and for
exceeding credit limits. In addition, we receive fees from merchants or merchant
acquirers based on sales volume charged to Discover Network cards. We recognize
rewards cost as a reduction of discount and interchange revenue.
Where we have a direct relationship with the merchant, which is the case with
respect to our large merchants that represent a majority of Discover Card sales
volume, we receive discount and fee revenue from merchants. Discount and fee
revenue is based on pricing that varies due to a number of factors including
industry, special marketing arrangements, competitive pricing levels and size of
merchant.
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Where we do not have a direct relationship with the merchant, we receive
interchange and assessment fees from the merchant acquirer that settles
transactions with the merchant. The amount of this fee is based on a
standardized schedule and can vary based on the type of merchant or type of card
(e.g., consumer vs. business).
The following chart shows the U.S. Card transaction cycle:
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We also offer various products and services, such as Payment Protection,
Identity Theft Protection, Wallet Protection, Credit ScoreTracker and other
cross-sell and fee-based products to our existing customer base.
Third-Party Payments
Our payments business includes the PULSE Network, as well as financial
institutions that issue credit, debit and prepaid cards on the Discover Network.
When a financial institution joins the PULSE Network, debit cards issued by that
institution can be used at all of the ATMs and PIN point-of-sale debit terminals
that participate in the network, and the PULSE mark can be used on that
institution's debit cards and ATMs. In addition, financial institution
participants may sponsor merchants and independent sales organizations to
participate in the network's PIN POS and ATM debit service. A participating
financial institution assumes liability for transactions initiated through the
use of debit cards issued by that institution, as well as for ensuring
compliance with PULSE's operating rules and policies applicable to that
institution's debit cards, ATMs and, if applicable, sponsored merchants and
independent sales organizations. PULSE derives its revenue from switch fees paid
for PIN POS and ATM transactions routed to the PULSE Network for authorization,
as well as membership and other fees paid by participants in the network. We
earn merchant discount and acquirer interchange revenue, net of issuer
interchange paid, plus assessments and fees for processing transactions for
third-party issuers of credit cards on the Discover Network.
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The following chart shows the third-party payments transaction cycle:
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International Card
Our international card issuing business differs from our U.S. card business in
that we rely on third-party networks, historically the MasterCard Network, and
more recently, as a member of Visa Europe, the Visa Network. As a result, third
parties maintain the relationships with merchants and pass customer charges on
to our U.K. card issuing bank, Goldfish Bank Limited. As in the U.S. card
business, we charge interest fees, late payment and overlimit fees and fees for
various other products and services.
The following table shows our International Card transaction cycle:
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Marketing
The key functions performed in marketing include customer acquisition, product
development, pricing and analytics, customer management, advertising and brand
management, rewards/Cashback Bonus, fee products and website management.
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Customer Acquisition
We seek creditworthy individuals by leveraging an integrated acquisition and
risk management process. To acquire new customers, we use proprietary targeting
and analytical models to identify attractive prospects and match them with our
product offerings. We employ multiple acquisition channels, including direct
mail, internet, print advertising, direct response television and telemarketing.
Direct mail has historically accounted for the greatest proportion of new
accounts, representing approximately 50% of new accounts acquired in 2007. We
focus on our account acquisition costs through product innovation, expanded
creative testing, enhanced targeting/modeling and production efficiencies.
Historically, telemarketing was also a significant channel but we have largely
shifted to other channels such as internet-acquired accounts.
Product Development
We continue to develop card features and benefits to attract and retain
cardmembers and merchants, such as our popular 5% Cashback Bonus program where
cardmembers who sign up for this program earn 5% cash rewards in select retail
categories. The category mix changes each quarter, allowing us to target
different areas of cardmember spending each season, alert cardmembers to new
places they can use their cards and manage our rewards costs.
We have also relaunched several card products, including our 5% Gas Card (now
known as the Discover Open Road Card) and a redesigned Miles by Discover Card.
In June 2006, we announced the launch of a small business credit card that
offers cash rewards, distinctive control features and dedicated service. The
Discover Motiva Card, launched in March 2007, provides cardmembers with a full
month's interest as a reward each time they make six consecutive on-time
payments. In 2007, we launched personal loan and student loan products, as well
as the Discover Insurance Center.
Pricing and Analytics
We use an analytical pricing strategy that provides competitive pricing for
cardmembers and seeks to maximize revenue on a risk-adjusted basis. We assign
specific annual percentage rates (APRs), fees and terms for different products
and cardmembers, including purchases, balance transfers and cash advances. We
periodically assess individual-level behavior practices and use risk models to
determine appropriate pricing terms for our cardmembers, providing lower
promotional rates for some customers while assessing higher rates for others who
have demonstrated high-risk behaviors such as defaulting on their payments.
Customer Management
We actively work to increase sales and build loan balances of new and existing
cardmembers by marketing to them through a variety of channels, including mail,
phone and online. Targeted offers may include balance transfers, fee products
and reinforcement of our Cashback Bonus rewards program.
We also continue to improve our modeling and customer engagement capabilities,
which we believe will help us offer the right products and pricing at the right
time and through the right channels. Recent enhancements include the development
of a large prospect database, trade-line level data and a customer contact
strategy and management system.
Advertising and Brand Management
We maintain a full-service, in-house marketing and communications department
charged with delivering communications to foster customer engagement with our
products and services. This helps us promote our brands, launch new products,
supervise external agencies and provide integrated marketing communications.
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Rewards /Cashback Bonus
Under our Cashback Bonus rewards program, we provide cardmembers with up to 1%
Cashback Bonus, based upon their level and type of purchases. The amount of the
Cashback Bonus generally increases as the cardmember's purchases increase during
the year. Cardmembers earn a full 1.0% once their total annual purchases exceed
$3,000. Annual purchases up to $1,500 earn a 0.25% Cashback Bonus and purchases
between $1,500 and $3,000 earn 0.50%. Purchases made at certain warehouse clubs
or discount stores earn a fixed Cashback Bonus reward of 0.25%. Cardmembers can
earn additional rewards by participating in periodic "5% Get More" promotions
for select categories of merchants.
Cardmembers can choose from several card products that allow them to accelerate
their cash rewards earnings based on how they want to use credit. For example,
the Discover Open Road Card provides 5% Cashback Bonus on the first $100 in gas
and auto maintenance purchases each billing period.
Cardmembers who are not delinquent or otherwise disqualified may redeem Cashback
Bonus rewards at any time in increments of $20, and cardmembers have the option
to choose a statement credit, direct deposit, partner gift card or charitable
donation. When cardmembers choose to redeem their Cashback Bonus with one of our
more than 100 merchant partners, they have the opportunity to increase their
reward, up to double the reward amount.
Fee Products
We market several fee-based products to our cardmembers, including the
following:
Identity Theft Protection. The most comprehensive identity theft
monitoring service we offer includes an initial credit report, credit
bureau file monitoring, prompt alerts that help cardmembers spot possible
identity theft quickly, and access to knowledgeable professionals who can
provide information about identity theft issues or credit reports.
Payment Protection. This service allows cardmembers to suspend their
payments in the event of unemployment, disability or other life events for
up to two years. In most states, any outstanding balance up to $25,000 is
cancelled in the event of death.
Wallet Protection. This service offers one-call convenience if the
cardmember's wallet is lost or stolen, including requesting cancellation
and replacement of the cardmember's credit and debit cards, monitoring the
cardmember's credit files for 90 days, providing up to $100 to replace the
cardmember's wallet, and if needed, lending the cardmember up to $1,000 in
emergency cash.
Credit ScoreTracker. A comprehensive credit score tracking product
offering Discover cardmembers resources that help them understand and
monitor their credit score. Credit ScoreTracker is specifically designed
for score monitoring, alerting cardmembers when their score changes,
allowing cardmembers to set a target score and providing resources to help
them understand the factors that may be influencing their score.
Cardmember Website
Cardmembers can register their accounts online at Discover.com, which offers a
range of benefits and control features that allow cardmembers to customize their
accounts to meet their own preferences and needs. Key offerings include:
Online account services that allow cardmembers to customize their
accounts, choose how and when they pay their bills, and create annual
account summaries that assist with budgeting and taxes;
Email reminders to help cardmembers avoid fees and track big purchases or
returns;
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Secure online account numbers that let cardmembers shop online without
ever revealing their actual account numbers; and
ShopDiscover, an online portal where cardmembers automatically earn 5-20%
Cashback Bonus when they shop at well-known online merchants.
Credit Risk
Risk management is a critical and fully integrated component of our management
and growth strategy. We have developed a risk management structure to manage
credit and other risks facing our business.
Credit risk refers to the risk of loss arising from borrower default when a
borrower is unable or unwilling to meet their financial obligations to Discover.
Our credit risk is generally highly diversified across millions of accounts
without significant individual exposures; accordingly, we manage risk on a
portfolio basis. We have a risk committee that is composed of our senior
management and is responsible for the establishment of criteria relating to risk
management.
New Cardmembers
We subject all credit applications to an underwriting process that assesses the
creditworthiness of each applicant. In terms of identifying potential
cardmembers, we give consideration to the prospective cardmember's financial
stability, as well as ability and willingness to pay.
Prospective cardmembers' applications are evaluated using credit information
provided by the credit bureaus and other sources. Credit scoring systems, both
externally developed and proprietary, are used to evaluate cardmember and credit
bureau data. We assign credit lines to our cardmembers on the basis of risk
level, income and expected card usage.
We use experienced credit underwriters to supplement our automated
decision-making processes. Approximately 25% of all applications are subject to
manual review that covers the areas of key cardmember data verification, fraud
prevention and approval of higher credit lines. We periodically review policies,
procedures and processes to ensure accurate implementation.
Portfolio Management
Proactive management of a cardmember's account is a critical part of credit
management, and all accounts are subject to ongoing credit assessment. This
assessment reflects information relating to the performance of the individual's
Discover account as well as information from a credit bureau relating to the
cardmember's broader credit performance. This information is used as an integral
part of credit decision-making as well as for management reporting purposes.
The measurement and management of credit risk is supported by scoring models
(statistical evaluation models). At the individual cardmember level, we use
custom risk models together with generic industry models as an integral part of
the credit decision-making process.
Depending on the duration of the cardmember's account, risk profile and other
performance metrics, the account may be subject to a range of account management
treatments, for example, eligibility for marketing initiatives, authorization,
increases or decreases in retail and cash credit limits, pricing adjustments and
delinquency strategies.
Cardmember Assistance
Authorizations. Each transaction is subject to screening and approval through a
proprietary point-of-sale decision system. This system utilizes rules-based
decision-making logic, statistical models and data integrity
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checks to manage fraud and credit risks. Strategies are subject to regular
review and enhancement to enable us to respond quickly to changing credit
conditions as well as to protect our cardmembers and the business from emerging
fraud activity.
Proactive Account Management. We use a variety of collection and recovery
strategies, with overdue delinquent accounts scored and segmented to tailor the
collection approach. We employ predictive call campaigns, as well as offering
payment programs for certain cardmembers to find customized solutions that fit
their financial situation. We offer tools such as payment email reminders,
flexible payment plans and a collections website designed to educate and assist
cardmembers with their payment needs. Our payment plans are designed to help
bring accounts out of delinquency or overlimit exposure.
Collections. All monthly billing statements of accounts with past due amounts
include a request for payment of such amounts. These accounts also receive a
written notice of late fee charges, as well as an additional request for
payment, after the first monthly statement that reflects a past due amount.
Collection personnel generally initiate contact with cardmembers within 30 days
after any portion of their balance becomes past due. The nature and the timing
of the initial contact, typically a personal call or letter, are determined by a
review of the cardmember's prior account activity and payment habits. For higher
risk accounts, as determined by statistically derived predictive models,
telephone contacts may begin as soon as the account becomes past due. Lower risk
cardmembers are typically contacted by letter and further collection efforts are
determined by behavioral scoring, financial exposure and the lateness of the
payment.
We reevaluate our collection efforts and consider the implementation of other
techniques as a cardmember becomes more days delinquent. We limit our exposure
to delinquencies through controls within the authorizations system and criteria
based account suspension and revocation. In situations involving a cardmember
with financial difficulties, we may enter into arrangements to extend or
otherwise change payment schedules.
Recovery. Credit card loans are charged-off at the end of the month during which
an account becomes 180 days contractually past due. The only exceptions are
bankrupt accounts, deceased customers, accounts on payment hardship or
settlement programs and fraudulent transactions, which are charged off earlier.
We use various recovery techniques and channels that include internal collection
activities, use of collections agencies, legal action and sales of charged-off
accounts and the related receivables. The timing and choice of channel utilized
are subject to a recovery optimization strategy that encompasses factors such as
cost and duration against expected recovery effectiveness.
Fraud Prevention
We actively monitor cardmember accounts to prevent, detect, investigate and
resolve fraud. Our fraud prevention processes are designed to protect the
security of cards, applications and accounts in a manner consistent with our
cardmembers' needs to easily acquire and use our products. Prevention systems
handle the authorization of application information, verification of cardmember
identity, sales, processing of convenience and balance transfer checks and
electronic transactions.
Our fraud detection program utilizes a variety of proven systems techniques to
identify and halt fraudulent transactions, including neural and pattern
recognition technology, rules-based decision-making logic, report analysis and
manual account reviews. Accounts identified by the fraud detection system are
managed by proprietary software that integrates effective fraud prevention with
customer centric service.
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Customer Service and Processing Services
Customer Service
We currently manage over 70 million annual inbound service calls placed to
1-800-Discover. We are committed to answering calls within 60 seconds or less
and to providing "one-call resolution."
We perform the functions required to service and operate cardmember credit
accounts, including new account solicitation, application processing, new
account fulfillment, transaction authorization and processing, cardmember
billing, payment processing, cardmember service and collection of delinquent
accounts. We believe that direct management of these functions reduces our
customer attrition and is cost-effective.
Designed around customer and account manager needs, our technology and systems
enable our account managers to quickly access information in a manner that
supports accurate and timely resolution of inquiries. We develop and maintain
our infrastructure solutions with the flexibility to change and adapt quickly to
meet customer expectations and needs. In addition to our systems, we invest in
our people, providing them with the training and work environment that
facilitates their ability to build strong customer relationships.
Processing Services
Processing Services is composed of four functional areas: card
personalization/embossing, print/mail, remittance processing and check/document
processing. Card personalization/embossing is responsible for the embossing and
mailing of plastic credit cards for new accounts, replacements and reissues, as
well as gift cards. Print/mail specializes in statement and letter printing and
mailing for merchants and cardmembers. Remittance processing handles account
payments, check processing and product enrollments.
Technology
We provide technology systems processing through a combination of owned and
hosted data centers. These data centers support our Discover and PULSE Networks,
provide cardmembers with access to their accounts at all times and manage
transaction authorizations, among other functions.
Our approach to technology development and management involves both third-party
and in-house resources. We use third-party vendors for basic technology services
(e.g., telecommunications, hardware and operating systems). Each vendor
participates in a formal selection process to ensure that we have partners who
can provide us with a cost-effective and reliable technology platform. This
approach enables us to focus our in-house resources on building proprietary
systems (e.g., for cardmember and merchant settlement, authorizations and
customer relationship management) that we believe enhance our operations,
improve cost efficiencies and help distinguish us in the marketplace.
Discover Card Terms and Conditions
The terms and conditions governing our products vary by product and change over
time. Each cardmember enters into an agreement governing the terms and
conditions of the cardmember's account. Discover Card's terms and conditions are
generally uniform from state to state. The cardmember agreement permits us to
change the credit terms, including the annual percentage rates and the fees
imposed on accounts, with notice to the cardmember. The cardmember has the right
to opt out of the change of terms and pay their balance off under the old terms.
Each cardmember agreement provides that the account can be used for purchases,
cash advances and balance transfers. Each Discover Card account is assigned a
credit limit when the account is initially opened. Thereafter, individual credit
limits may be increased or decreased from time to time, at our discretion, based
primarily on our evaluation of the cardmember's creditworthiness.
Discover Bank offers various features and services with the Discover Card
accounts, including the Cashback Bonus reward described under
"-Marketing-Rewards/Cashback Bonus." A cardmember's earned Cashback
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Bonus rewards are recorded in a "Cashback Bonus Account"; eligible cardmembers
may redeem their rewards in increments of $20.
Discover Card accounts generally have the same billing and payment structure,
though there are some differences between the consumer and business credit
cards, as described below. Unless we waive the right to do so, we send a monthly
billing statement to each cardmember who has an outstanding debit or credit
balance. Cardmembers also can waive their right to receive a physical copy of
their bill, in which case they will receive email notifications of the
availability of their billing statement online at the Discover Card Account
Center. Discover Card accounts are grouped into multiple billing cycles for
operational purposes. Each billing cycle has a separate billing date, on which
we process and bill to cardmembers all activity that occurred in the related
accounts during the period of approximately 28 to 34 days that ends on that
date.
We offer fixed and variable rates of periodic finance charges on accounts.
Neither cash advances nor balance transfers are subject to a grace period.
Periodic finance charges on purchases are calculated on a daily basis, subject
to a grace period that essentially provides that periodic finance changes are
not imposed if the cardmember pays his or her entire balance each month. Certain
account balances, such as balance transfers, may accrue periodic finance charges
at lower fixed rates for a specified period of time. Variable rates are indexed
to the highest prime rate published in The Wall Street Journal on the last
business day of the month.
Additional Consumer Card Terms. Each cardmember with an outstanding debit
balance in his or her consumer Discover Card account must generally make a
minimum payment each month. If a cardmember exceeds his or her credit limit as
of the last day of the billing period, we may include all or a portion of this
excess amount in the cardmember's minimum monthly payment. From time to time, we
have offered and may continue to offer eligible cardmembers the opportunity to
not make the minimum monthly payment, while continuing to accrue periodic
finance charges, without being considered past due. A cardmember may pay the
total amount due at any time. We also may enter into arrangements with
delinquent cardmembers to extend or otherwise change payment schedules, and to
waive finance charges, fees and/or principal due, including re-aging accounts in
accordance with regulatory guidance. Income may be reduced during any period in
which we offer cardmembers the opportunity to not make the minimum monthly
payment or to extend or change payment schedules.
In addition to periodic finance charges, we may impose other charges and fees on
Discover Card accounts, including cash advance transaction fees, late fees where
a cardmember has not made a minimum payment by the required due date, overlimit
fees for balances that exceed a cardmember's credit limit as of the close of the
cardmember's monthly billing cycle, balance transfer fees, returned check fees,
pay-by-phone fees and fees for balance transfers or other promotional checks
that are returned by us due to insufficient credit availability.
For most consumer cards we use the two-cycle billing method for determining
periodic finance charges. This means if a cardmember begins a billing cycle with
no outstanding balance, makes purchases or other transactions and then does not
pay the outstanding balance in full by the payment due date, we impose finance
charges beginning on the date transactions were posted to the account.
Terms and conditions may vary for other products, such as the Discover Business
Card, Discover Motiva Card and our U.K. cards.
Payments and Merchant Relationships
Merchant Relationships
We support our growing base of merchants through a merchant acquiring model that
includes direct relationships with the largest merchants in the United States
and outsourced arrangements with our merchant acquiring partners for small and
mid-size merchants.
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We have chosen to retain direct relationships with most of our largest merchant
accounts because many prefer dealing with us directly, we are able to retain the
entire discount revenue from the merchant and we are able to capitalize on joint
marketing programs and opportunities. Competitor networks and credit card
companies typically do not enjoy direct relationships with merchants.
Since mid-2006, Discover Network has worked with merchant acquirers to allow
them to begin offering a comprehensive payments processing package for small and
mid-size merchants that includes consolidated servicing for Discover, Visa and
MasterCard transactions. Integrated payments solutions provide these merchants
with streamlined statementing and customer service. In some cases, Discover has
sold and will continue to sell small and mid-size merchant acquiring portfolios
to third-party acquirers to facilitate integrated servicing and reduced costs.
As we outsource merchant acquiring, we expect to reduce our fee income and
expenses.
In addition to our U.S.-based merchant acceptance locations, Discover Network
cards also are accepted (through relationships with in-country banks and
processors) at many locations in Canada, Mexico and the Caribbean. Also, over
the past two years we have signed reciprocal network agreements with China
UnionPay and JCB that enable our cardmembers to use their Discover Network cards
in China and, eventually, in Japan.
Networks and Merchant Operations
Account Governance, Regulations and Specifications. The terms of our direct
merchant relationships are governed by a Merchant Services Agreement ("MSA").
These MSAs also are accompanied by additional program documents that further
define our network functionality and requirements, including operating
regulations, technical specifications and dispute rules. To enable ongoing
improvements in our network's functionality and in accordance with industry
convention, we publish updates to our program documents on a semi-annual basis.
In a growing number of cases, particularly with small and mid-size merchants,
the merchants enter into agreements directly with a merchant acquirer, and not
with Discover.
New Accounts. Merchants can now apply to accept all Discover Network Cards
utilizing the same process used to accept all other card brands. To facilitate
this process, Discover Network has partnered with all of the top acquirers in
the industry. These acquirer partners perform credit evaluations and screen
applications against unacceptable business types and the Office of Foreign Asset
Control Specifically Designated Nationals list. Once approved, the acquirer
transmits an electronic file to Discover Network registering the new merchants
enabling transaction acceptance.
Transaction Processing. Discover Network partners with a number of vendors to
maintain our secure and highly redundant connectivity that enables continuous
support of POS authorizations. This connectivity also enables merchants to
receive timely payment for their Discover Network card transactions.
Risk Management, Fraud Prevention and Compliance. Discover Network operates
systems and processes that seek to prevent fraud and ensure compliance with our
operating regulations. Our systems evaluate incoming merchant sales activity to
identify abnormalities that require investigation prior to the initiation of
settlement. Risk Management personnel are responsible for validating compliance
with our operating regulations and law, including enforcing our data security
standards and our prohibitions against internet gambling and other illegal or
otherwise unacceptable activities. Discover Network is a founding and current
member of the PCI Security Standards Council, LLC, and requires merchants and
service providers to comply with the Payment Card Industry Data Security
Standard.
Third-Party Payments and PULSE Network
Third-Party Payments Business
In October 2004, the U.S. Supreme Court declined to consider the appeal by Visa
and MasterCard of a court ruling that would end years of anticompetitive
practices that had effectively prevented us from offering our
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electronic payment products and services to other financial institutions. As a
result of this ruling, third-party financial institutions are now able to issue
debit and credit cards and other card products on the Discover or PULSE
Networks.
Following this ruling, we have signed third-party issuing/distribution
agreements for credit, debit and prepaid cards, including agreements with GE
Money (to issue Wal-Mart and SAM'S CLUB Discover Network cards), HSBC and a
number of other financial institutions for issuance of card products on the
Discover Network.
PULSE Network
In January 2005, we strengthened our payment processing capabilities through the
acquisition of the PULSE Network, one of the nation's leading ATM/debit
networks. PULSE links cardholders of more than 4,500 financial institutions with
over 265,000 ATMs as well as POS terminals located throughout the United States.
PULSE's primary source of revenue is transaction fees charged for switching and
settling ATM, PIN POS and signature debit transactions initiated through the use
of debit cards issued by participating financial institutions. In addition,
PULSE offers a variety of optional products and services that produce income for
the network, including signature debit processing, prepaid card processing and
connections to other regional and national electronic funds transfer networks.
International Card Business
In 1999, we launched our international card issuing business in the United
Kingdom, the world's second largest credit card market. Our U.K. business is
focused primarily on rewards-based offerings. Our model has been to establish
local resources and capabilities in all functions, but leverage our capabilities
and scale in the United States by actively transferring skills, applications and
best practices to the U.K. market. For example, our business has an operations
center in Scotland that performs all key customer service and collections
functions with its own technology platform tailored for international markets,
but processing is conducted in the United States. The recent migration of
technology and risk systems in-house to the United States and away from an
outsourced local provider has substantially reduced the cost per account. We
expect to continue to have a higher cost structure than some of our competitors
due to their larger scale. Given the widespread acceptance of MasterCard and
Visa in Europe, we currently issue our U.K. cards on the MasterCard and Visa
networks.
In 2006, Discover made two acquisitions: the Goldfish credit card business from
Lloyds TSB Bank Plc and several card portfolios from Liverpool Victoria. The
Goldfish business now forms part of our international business, providing us
with a strong brand, and the Liverpool Victoria portfolios supplement our
existing affinity programs. Goldfish customers earn points based on spend that
can be redeemed for vouchers at many of the leading retailers in the United
Kingdom.
Our Morgan Stanley Platinum Card has a Cashback Bonus program similar to the
program offered in the United States. We also offer the buy and fly! MasterCard
that has a travel rewards program. A newer product is i24, our fee-based card
targeted to a more affluent customer base and providing services such as
concierge and travel insurance in addition to cash rewards.
Our financial performance in the United Kingdom has been adversely affected by
market conditions such as high delinquencies and rising bankruptcy levels,
compounded by changing regulations. In order to improve profitability, we have
taken steps to change our credit and collections strategies and pricing,
operations, and rewards optimization. On February 7, 2008, we entered into an
agreement to sell our credit card business in the United Kingdom to Barclays
Bank Plc. The closing is expected to occur by the end of our second quarter of
2008 and is subject to the satisfaction of a number of conditions. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-Sale of International Card Segment; First Quarter 2008 Charge" for
more information relating to the sale of our Goldfish business.
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Competition
We compete with other card issuers and networks on the basis of a number of
factors, including: merchant acceptance, products and services, incentives and
reward programs, brand, network, reputation and pricing. Many of our competitors
are well established and financially strong, have greater financial resources
than we do, are larger than us and/or have lower capital costs and operating
costs than we have and expect to have.
As a credit card issuer, we compete for accounts and utilization with cards
issued by other financial institutions (including American Express, Bank of
America, Chase and Citigroup, as well as third-party issuers on the Discover
Network) and, to a lesser extent, businesses that issue their own private label
cards or otherwise extend credit to their customers. There has been a trend
toward consolidation among credit card issuers, leading to greater concentration
of resources. Credit card industry participants have increasingly used
advertising, targeted marketing, account acquisitions and pricing competition in
interest rates, annual fees, reward programs and low-priced balance transfer
programs to attract and retain cardholders and increase card usage. In addition,
because most domestically issued credit cards, other than those issued on the
American Express network, are issued on the Visa and MasterCard networks, most
other card issuers benefit from the dominant position and marketing and pricing
power of Visa and MasterCard. See "Risk Factors-We face competition from other
credit card issuers, and we may not be able to compete effectively, which could
result in fewer customers and lower account balances and could materially
adversely affect our financial condition, cash flows and results of operations"
and "Risk Factors-We incur considerable expenses in competing with other credit
card issuers, and many of our competitors have greater scale, which may place us
at a competitive disadvantage."
In the United Kingdom, we issue credit cards on the MasterCard and Visa
networks. We compete for accounts and utilization with cards issued by other
financial institutions (including American Express, Bank of America, Barclays,
Capital One, Halifax Bank of Scotland and Royal Bank of Scotland). As in the
United States, credit card issuers in the United Kingdom have used advertising,
targeted marketing, pricing competition in interest rates, reward programs and
low-priced balance transfer programs to attract and retain cardholders and
increase card usage.
In our third-party payments business, we compete with other networks to attract
third-party issuers to issue credit, debit and prepaid cards on the Discover and
PULSE Networks. Discover Network's primary competitors are Visa, MasterCard and
American Express, and PULSE Network's competitors include Visa's Interlink,
STAR, NYCE and Maestro. The former exclusionary rules of Visa and MasterCard
limited our ability to attract merchants and credit and debit card issuers, and
the impact of those rules continues to harm us. In addition, Visa and MasterCard
have entered into long-term arrangements with many financial institutions that
may have the effect of preventing them from issuing credit or debit cards on the
Discover or PULSE Networks. See "Risk Factors-We face competition from other
operators of payment networks, and we may not be able to compete effectively,
which could result in reduced transaction volume, limited merchant acceptance of
our cards, limited issuance of cards on our network by third parties and
materially reduced earnings."
Intellectual Property
We use a variety of methods, such as trademarks, patents, copyrights and trade
secrets, to protect our intellectual property. We also place appropriate
restrictions on our proprietary information to control access and prevent
unauthorized disclosures. Our Discover, PULSE and Goldfish brands are important
assets, and we take steps to protect the value of these assets. However, we may
not be able to always successfully protect our intellectual property or
proprietary information from misappropriation, infringement or unauthorized
disclosure. In addition, our competitors may obtain intellectual property rights
on innovations in our industry. As a result of these actions, our business could
be adversely affected.
Employees
As of November 30, 2007, we employed approximately 12,800 individuals. We
believe our employee relations are good.
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Regulatory Matters
Discover's operations are subject to regulation by U.S. federal, state and
foreign laws and regulations.
Bank Regulation
Banking Subsidiaries. Discover operates two banking subsidiaries in the United
States and a banking subsidiary in the United Kingdom. In the United States,
Discover Bank offers a wide variety of products, but does not offer commercial
loans other than business credit cards. Discover Bank offers credit card loans,
home loans, student loans and personal loans, as well as checking accounts,
certificates of deposit and money market accounts. Discover Bank is chartered
and regulated by the Office of the Delaware State Bank Commissioner (the
"Delaware Commissioner") and the Federal Deposit Insurance Corporation ("FDIC"),
which insures its deposits and serves as the bank's federal banking regulator.
Discover Bank is considered to be a "bank" for purposes of the Bank Holding
Company Act of 1956, as amended ("BHCA"), a federal statute that requires
companies controlling banks to register with the Board of Governors of the
Federal Reserve System (the "Federal Reserve"). However, Discover is not
regulated by the Federal Reserve as a bank holding company pursuant to a
grandfather provision that limits Federal Reserve oversight of certain companies
that meet specific statutory criteria. Discover's grandfathered status would be
forfeited and Discover would be required to register as a bank holding company
if, among other things, Discover Bank engages in commercial lending at the same
time that it accepts demand deposits, or is subject to a change in control under
federal banking law or if Discover acquires more than five percent of the shares
or assets of another bank or savings association, other than in certain limited
circumstances. We have no current intention of engaging in activities that would
require us to register as a bank holding company.
Bank of New Castle is a limited purpose credit card bank, chartered and
regulated by the Delaware Commissioner and the FDIC, which also insures its
deposits. Ownership of Bank of New Castle does not subject Discover to ongoing
holding company regulation by the Delaware Commissioner or the FDIC, and
Discover is not regulated by the Federal Reserve as a bank holding company, as
long as the activities of Bank of New Castle are limited to credit card
operations.
After our recent spin-off, we believe that we will continue to be able to rely
upon this exemption. However, business initiatives or strategic decisions we
take could result in our becoming a bank holding company subject to regulation
by the Federal Reserve. Additionally, risk of Congressional activity to regulate
holding companies such as Discover that own depository institutions but are not
regulated at the holding company level could have a negative impact on our
business, resulting in additional complexity and expense.
Acquisition of Control. Because Discover Bank and Bank of New Castle are each
insured depository institutions, certain acquisitions of the voting stock of
Discover may be subject to regulatory approval or notice under U.S. federal or
Delaware law. Investors are responsible for ensuring that they do not, directly
or indirectly, acquire shares of stock of Discover in excess of the amount which
can be acquired without regulatory approval under the Change in Bank Control
Act, the BHCA and the Delaware Change in Bank Control provisions, which prohibit
any person or company from acquiring control of Discover without, in most cases,
the prior written approval of each of the FDIC, the Federal Reserve and the
Delaware Commissioner.
FDIC Requirements Applicable to Discover's U.S. Banking Subsidiaries. The
Federal Deposit Insurance Act (the "FDIA") imposes various requirements on
insured depository institutions. For example, the FDIA requires, among other
things, the federal banking agencies to take "prompt corrective action" in
respect of depository institutions that do not meet minimum capital
requirements. The FDIA sets forth the following five capital tiers:
"well-capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" and "critically undercapitalized." A depository institution's
capital tier will depend upon how its capital levels compare with various
relevant capital measures and certain other factors that are established by
regulation. At November 30, 2007, Discover Bank and Bank of New Castle met all
applicable requirements to be deemed "well-capitalized."
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Recent regulations proposed by the U.S. bank regulators referred to as the
Basel II proposal could alter the capital adequacy framework for participating
banking organizations. Discover will continue to closely monitor developments on
these matters and assess their impact on Discover and its banking subsidiaries.
The FDIA also prohibits any depository institution from making any capital
distributions (including payment of a dividend) or paying any management fee to
its parent holding company if the depository institution would thereafter be
"undercapitalized." "Undercapitalized" institutions are subject to growth
limitations and are required to submit a capital restoration plan. For a capital
restoration plan to be acceptable, among other things, the depository
institution's parent holding company must guarantee that the institution will
comply with such capital restoration plan.
If a depository institution fails to submit an acceptable plan, it is treated as
if it is "significantly undercapitalized." "Significantly undercapitalized"
depository institutions may be subject to a number of requirements and
restrictions, including orders to sell sufficient voting stock to become
"adequately capitalized," requirements to reduce total assets and cessation of
receipt of deposits from correspondent banks. "Critically undercapitalized"
institutions are subject to the appointment of a receiver or conservator.
Each of Discover's U.S. banking subsidiaries may also be held liable by the FDIC
for any loss incurred, or reasonably expected to be incurred, due to the default
of the other U.S. banking subsidiary and for any assistance provided by the FDIC
to the other U.S. banking subsidiary that is in danger of default.
The FDIA prohibits a bank from accepting brokered deposits or offering interest
rates on any deposits significantly higher than the prevailing rate in its
normal market area or nationally (depending upon where the deposits are
solicited), unless (1) it is well-capitalized or (2) it is adequately
capitalized and receives a waiver from the FDIC. A bank that is adequately
capitalized and that accepts brokered deposits under a waiver from the FDIC may
not pay an interest rate on any deposit in excess of 75 basis points over
certain prevailing market rates. There are no such restrictions on a bank that
is well-capitalized. As of November 30, 2007, Discover Bank and Bank of New
Castle each met the FDIC's definition of a well-capitalized institution for
purposes of accepting brokered deposits. An inability to accept brokered
deposits in the future could materially adversely impact funding costs and
liquidity. Under the regulatory definition of brokered deposits, as of
November 30, 2007, Discover Bank had brokered deposits of $18.7 billion and Bank
of New Castle had no brokered deposits.
The FDIA also affords FDIC-insured depository institutions, such as Discover
Bank and Bank of New Castle, the ability to "export" favorable interest rates
permitted under the laws of the state where the bank is located. Discover Bank
and Bank of New Castle are both located in Delaware and, therefore, charge
interest on loans to out of state borrowers at rates permitted under Delaware
law, regardless of the usury limitations imposed by the state laws of the
borrower's residence. Delaware law does not limit the amount of interest that
may be charged on loans of the type offered by Discover Bank or Bank of New
Castle. This flexibility facilitates the current nationwide lending activities
of Discover Bank and Bank of New Castle.
U.S. Credit Card Regulation
The relationship between Discover and its U.S. customers is regulated
extensively under federal and state consumer protection laws. Federal laws
include the Truth in Lending Act, the Equal Credit Opportunity Act, the Fair
Credit Reporting Act and the Gramm-Leach-Bliley Act. Moreover, our U.S. banking
subsidiaries are subject to the Servicemembers Civil Relief Act, which protects
persons called to active military service and their dependents from undue
hardship resulting from their military service. The Servicemembers Civil Relief
Act applies to all debts incurred prior to the commencement of active duty
(including credit card and other open-end debt) and limits the amount of
interest, including service and renewal charges and any other fees or charges
(other than bona fide insurance) that is related to the obligation or liability.
These and other federal laws, among other things, require disclosures of the
cost of credit, provide substantive consumer rights, prohibit discrimination in
credit transactions, regulate the use of credit report information, provide
financial privacy protections, require
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safe and sound banking operations and prohibit unfair and deceptive trade
practices. State, and in some cases local, laws also may regulate in these areas
as well as provide additional consumer protections.
Violations of applicable consumer protection laws can result in significant
potential liability in litigation by customers, including civil money penalties,
actual damages, restitution and attorneys' fees. Federal banking regulators, as
well as state attorneys general and other state and local consumer protection
agencies, also may seek to enforce consumer protection requirements and obtain
these and other remedies.
Members of Congress are currently holding hearings on certain practices in the
credit card industry, including those relating to grace periods, the two-cycle
billing method (which we currently utilize on most of our products), interest
rates and fees. It is not clear at this time whether new limitations on credit
card practices or new required disclosures will be adopted by Congress or at the
state level and, if adopted, what impact any new limitations would have on
Discover. The Federal Reserve is also revising disclosure and other rules for
credit cards that could impact our business. See "Risk Factors-Changes in
regulations, or the application thereof, may adversely affect our business,
financial condition and results of operations."
Anti-Money Laundering
Our Anti-Money Laundering (AML) Program is coordinated and implemented on an
enterprise-wide basis. In the United States, for example, the USA PATRIOT Act of
2001 imposes significant obligations to deter money laundering and terrorist
financing activity, identify customers, report suspicious activity to
appropriate authorities, adopt an AML program that includes policies, procedures
and internal controls, provide employees with AML training, designate an AML
compliance officer and undergo an annual, independent audit to assess the
effectiveness of its AML program. Outside the United States, designated types of
financial institutions are subject to similar AML requirements. Discover has
established appropriate policies, procedures and internal controls that are
designed to comply with these AML requirements.
Activities in the United Kingdom
We conduct our U.K. credit card business through Goldfish Bank Limited, which is
subject to the Financial Services Authority ("FSA") in relation to, among other
matters, capital adequacy, non-investment insurance mediation activities,
anti-money laundering and deposit taking. The bank's deposit taking and
insurance mediation activities are supervised by the FSA and its consumer credit
activities are regulated by the Office of Fair Trading.
The relationship between Goldfish Bank Limited and its U.K. customers is
regulated extensively under consumer protection laws. These include the Consumer
Credit Act, the Data Protection Act and the Unfair Terms in Consumer Contracts
Regulations. The bank is also governed by two key self-regulatory codes of
practice-the Banking Code and the British Code of Advertising, Sales Promotion
and Direct Marketing. These and other laws and regulations, among other things,
regulate the content of credit advertisements and credit agreements, provide
substantive consumer rights, regulate the use of customer data, and provide
enforcement powers to regulatory authorities in relation to unfair and deceptive
trade practices.
Violations of applicable consumer protection laws may result in the bank not
being able to enforce credit agreements against cardmembers, potential civil
liability in litigation by customers, and enforcement action by the regulatory
authorities.
During the last three years there have been increasing regulatory initiatives
with respect to late and overlimit fees, interchange fees and the sale of retail
insurance products, a relaxation of bankruptcy laws and an increase in
industry-wide consumer protection measures. For instance, in May 2006, Office of
Fair Trading actions resulted in an industry-wide reduction of late, overlimit
and insufficient funds fees. As a result, we reduced these fees in our U.K.
business from £20 to £12. Future regulatory measures would likely continue to
increase our compliance
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costs and the risk of consumer complaints, litigation and regulatory inquiries,
as well as materially impact the economics of our business.
Electronic Funds Networks
Discover operates the Discover and PULSE Networks, which deliver switching and
settlement services to financial institutions and other program participants for
a variety of ATM, POS and other electronic banking transactions. These
operations are regulated by certain state and federal banking, privacy and data
security laws. Moreover, the Discover and PULSE Networks are subject to
examination under the oversight of the Federal Financial Institutions
Examination Council, an interagency body composed of the federal bank and thrift
regulators and the National Credit Union Association. Changes in existing
federal or state regulation could increase the cost or risk of providing network
services, change the competitive environment, or otherwise materially adversely
affect our operations. The legal environment regarding privacy and data security
is particularly dynamic, and any disclosure of confidential customer information
could have a material adverse impact on our business, including loss of consumer
confidence.
Executive Officers
Set forth below is information concerning our executive officers, each of whom
is a member of our executive committee.
Name Age Position
David W. Nelms 47 Chief Executive Officer and Director
Roger C. Hochschild 43 President and Chief Operating Officer
Roy A. Guthrie 54 Executive Vice President, Chief Financial
Officer
Kathryn McNamara Corley 48 Executive Vice President, General Counsel
and Secretary
Mary Margaret Hastings Georgiadis 44 Executive Vice President, Chief Marketing
Officer
Charlotte M. Hogg 37 Senior Vice President, International
Carlos Minetti 45 Executive Vice President, Cardmember
Services and Consumer Banking
Diane E. Offereins 50 Executive Vice President, Chief Technology
Officer and PULSE Network
James V. Panzarino 55 Senior Vice President, Chief Credit Risk
Officer
Harit Talwar 47 Executive Vice President, Discover Network
|
David W. Nelms has served as our Chief Executive Officer since 2004, and was
President and Chief Operating Officer from 1998 to 2004. Mr. Nelms was also our
Chairman from 2004 until our spin-off. Prior to joining Discover, Mr. Nelms
worked at MBNA America Bank from 1990 to 1998, most recently as a Vice Chairman.
Mr. Nelms holds a Bachelor's of Science degree in Mechanical Engineering from
the University of Florida and an M.B.A. from Harvard Business School.
Roger C. Hochschild has served as President and Chief Operating Officer since
2004, and was Executive Vice President, Chief Marketing Officer from 1998 to
2001. From 2001 to 2004, Mr. Hochschild was Executive Vice President, Chief
Administrative and Chief Strategic Officer of our former parent Morgan Stanley.
Mr. Hochschild holds a Bachelor's degree in Economics from Georgetown University
and an M.B.A. from the Amos Tuck School at Dartmouth College.
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Roy A. Guthrie has served as Executive Vice President, Chief Financial Officer
since 2005. Prior to joining Discover, Mr. Guthrie was President, Chief
Executive Officer of CitiFinancial International, LTD, a Consumer Finance
Business of Citigroup, from 2000 to 2004. In addition Mr. Guthrie served on
Citigroup's Management Committee during this period of time. Mr. Guthrie served
as Chief Financial Officer of Associates First Capital Corporation from 1996 to
2000, while it was a public company and served as a member of its board from
1998 to 2000. Mr. Guthrie holds a Bachelor's degree in Economics from Hanover
College and an M.B.A. from Drake University.
Kathryn McNamara Corley has served as Executive Vice President, General Counsel
and Secretary since February 2008. Prior thereto, she had served as Senior Vice
President, General Counsel and Secretary since 1999. Prior to becoming General
Counsel, Ms. Corley was Managing Director for our former parent Morgan Stanley's
global government and regulatory relations. Ms. Corley holds a Bachelor's degree
in Political Science from the University of Southern California and a J.D. from
George Mason University School of Law.
Mary Margaret Hastings Georgiadis has served as Executive Vice President, Chief
Marketing Officer since 2004. Ms. Georgiadis was at McKinsey & Company from 1986
to 1988 and 1990 to 2004, most recently as Partner. At McKinsey & Company,
Ms. Georgiadis headed the marketing and retail practices and also cofounded and
led the customer acquisition and management and retail practices. Ms. Georgiadis
holds a Bachelor's degree in Economics from Harvard-Radcliffe Colleges and an
M.B.A. from Harvard Business School.
Charlotte M. Hogg has served as Senior Vice President and Managing Director of
our international business since 2004. Ms. Hogg was a Managing Director and Head
of our former parent Morgan Stanley's Strategic Planning Group from 2001 to
2004. Ms. Hogg holds a Bachelor's degree in Economics and History from Oxford
University and was a Kennedy Memorial Trust Scholar at the John F. Kennedy
School of Government at Harvard University.
Carlos Minetti has served as Executive Vice President, Cardmember Services and
Consumer Banking since September 2006. Prior thereto, he had been Executive Vice
President, Cardmember Services since January 2001 and Executive Vice President,
Cardmember Services and Risk Management since January 2003. Prior to joining
Discover, Mr. Minetti worked in card operations and risk management for American
Express from 1987 to 2000, most recently as Senior Vice President. Mr. Minetti
holds a Bachelor's of Science degree in Industrial Engineering from Texas A & M
University and an M.B.A. from the University of Chicago.
Diane E. Offereins has served as Executive Vice President, Chief Technology
Officer since 1998. In addition, she was appointed to oversee the PULSE Network
in 2006. From 1993 to 1998, Ms. Offereins was at MBNA America Bank, most
recently as Senior Executive Vice President. Ms. Offereins holds a Bachelor of
Business Administration degree in Accounting from Loyola University.
James V. Panzarino has served as Senior Vice President, Chief Credit Risk
Officer since 2006, and was Senior Vice President, Cardmember Assistance from
2003 to 2006. Prior to joining Discover, Mr. Panzarino was Vice President of
External Collections and Recovery at American Express from 1998 to 2002.
Mr. Panzarino holds a Bachelor's degree in Business Management and Communication
from Adelphi University.
Harit Talwar has served as Executive Vice President, Discover Network since
December 2003. From 2000 to 2003, Mr. Talwar was Managing Director for
Discover's international business. Mr. Talwar held a number of positions at
Citigroup from 1985 to 2000, most recently Country Head, Consumer Banking
Division, Poland. Mr. Talwar holds a B.A. Hons degree in Economics from Delhi
University in India and received his M.B.A. from the Indian Institute of
Management, Ahmedabad.
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Item 1A. Risk Factors
You should carefully consider each of the following risks described below and
all of the other information in this annual report on Form 10-K in evaluating
us. Our business, financial condition, cash flows and/or results of operations
could be materially adversely affected by any of these risks. The trading price
of our common stock could decline due to any of these risks.
This annual report on Form 10-K also contains forward-looking statements that
involve risks and uncertainties. Our actual results could differ materially from
those anticipated in these forward-looking statements as a result of certain
factors, including the risks faced by us described below and elsewhere in this
annual report on Form 10-K. See "Special Note Regarding Forward-Looking
Statements."
Risks Related to Our Business
We face competition from other credit card issuers, and we may not be able to
compete effectively, which could result in fewer customers and lower account
balances and could materially adversely affect our financial condition, cash
flows and results of operations.
The credit card issuing business is highly competitive, and we compete with
other credit card issuers on the basis of a number of factors, including:
merchant acceptance, products and services, incentives and reward programs,
brand, network, reputation and pricing. This competition, among other things,
affects our ability to obtain applicants for our credit cards, encourage
cardmembers to use our credit cards, maximize the revenue generated by card
usage and generate cardmember loyalty and satisfaction so as to minimize the
number of cardmembers switching to other credit card brands. Competition is also
increasingly based on the value provided to the cardholder by rewards programs.
Many credit card issuers have instituted rewards programs that are similar to
ours, and issuers may in the future institute rewards programs that are more
attractive to cardmembers than our programs. In addition, because most
domestically issued credit cards, other than those issued by American Express,
are issued on the Visa and MasterCard networks, most other card issuers benefit
from the dominant position and marketing and pricing power of Visa and
MasterCard. If we are unable to compete successfully, or if competing
successfully requires us to take aggressive actions in response to competitors'
actions, our financial condition, cash flows and results of operations could be
materially adversely affected.
We incur considerable expenses in competing with other credit card issuers, and
many of our competitors have greater scale, which may place us at a competitive
disadvantage.
We incur considerable expenses in competing with other credit card issuers to
attract and retain cardmembers and increase card usage. A substantial portion of
these expenses relates to marketing expenditures; however, traditional customer
acquisition methods have become increasingly challenging. Telemarketing has been
hampered by the Federal Trade Commission's National Do Not Call Registry, which
had increased to almost 152 million phone numbers as of January 2008. Direct
mail response rates have fallen, with market researcher Synovate reporting that,
in the industry, only five out of every 1,000 offers generated responses in 2006
compared to approximately 28 out of every 1,000 in 1992.
Because of the highly competitive nature of the credit card issuing business and
increasing marketing challenges, a primary method of competition among credit
card issuers, including us, is to offer low introductory interest rates and
balance transfer programs that offer a favorable annual percentage rate or other
financial incentives for a specified length of time on account balances
transferred from another credit card. This type of competition has adversely
affected credit card yields, and many cardholders now frequently switch credit
cards or transfer their balances to another card. There can be no assurance that
any of the expenses we incur or incentives we offer to attempt to acquire and
maintain accounts and increase card usage will be effective.
Furthermore, many of our competitors are larger than we are, have greater
financial resources than we do and/or have lower capital costs and operating
costs than we have and expect to have, and have assets such as branch locations
and co-brand relationships that may help them compete more effectively. In
addition, there is an
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increasing trend toward consolidation among credit card issuers, resulting in
even greater pooled resources. We may be at a competitive disadvantage as a
result of the greater scale of many of our competitors.
We face competition from other operators of payment networks, and we may not be
able to compete effectively, which could result in reduced transaction volume,
limited merchant acceptance of our cards, limited issuance of cards on our
network by third parties and materially reduced earnings.
We face substantial and increasingly intense competition in the payments
industry. We compete with other payment networks to attract third-party issuers
to issue credit and debit cards and other card products on the Discover and
PULSE Networks. Competition with other operators of payment networks is
generally based on issuer interchange fees, other economic terms, merchant
acceptance and network functionality. Competition also is based on service
quality, brand image, reputation and market share.
Many of our competitors are well established, larger than we are and/or have
greater financial resources than we do. These competitors have provided
financial incentives to card issuers, such as large cash signing bonuses for new
programs, funding for and sponsorship of marketing programs and other bonuses.
Visa and MasterCard have each been in existence for more than 40 years and enjoy
greater merchant acceptance and broader global brand recognition than we do. In
addition, Visa and MasterCard have entered into long-term arrangements with many
financial institutions that may have the effect of preventing them from issuing
credit cards on the Discover Network or issuing debit cards on the PULSE
Network. MasterCard completed an initial public offering, which provided it with
significant capital and may enhance its strategic flexibility. Visa also intends
to undertake an initial public offering. American Express is also a strong
competitor, with international acceptance, high transaction fees and an upscale
brand image.
Furthermore, as a result of their dominant market position and considerable
marketing and pricing power, in recent years Visa and MasterCard have been able
to aggressively increase transaction fees charged to merchants in an effort to
retain and grow their issuer volume. If we are unable to remain competitive on
issuer interchange and other incentives, we may be unable to offer adequate
pricing to third-party issuers while maintaining sufficient net revenues. At the
same time, increasing the transaction fees charged to merchants or increasing
acquirer interchange could adversely affect our effort to increase merchant
acceptance of credit cards issued on the Discover Network and may cause merchant
acceptance to decrease. See "-Our transaction volume is concentrated among large
merchants, and a reduction in the number of, or rates paid by, merchants that
participate in the Discover Network could materially adversely affect our
business, financial condition, results of operations and cash flows." This, in
turn, could adversely affect our ability to attract third-party issuers and our
ability to maintain or grow revenues from our proprietary network. Similarly,
the PULSE Network operates in the highly competitive PIN debit business with
well-established and financially strong network competitors (particularly Visa)
that have the ability to offer more attractive economics and bundled products to
financial institutions.
In addition, if we are unable to maintain sufficient network functionality to be
competitive with other networks, our ability to attract third-party issuers and
maintain or increase the revenues generated by our proprietary card issuing
business may be materially adversely affected. An inability to compete
effectively with other payment networks for the reasons discussed above or any
other reason could result in reduced transaction volume, limited merchant
acceptance of our cards, limited issuance of cards on our network by third
parties and materially reduced earnings.
Our business depends on our ability to manage our credit risks, and failing to
manage these risks successfully may result in high charge-off rates or impede
our growth.
We market our products to a wide range of consumers, and our success depends on
our ability to continue to manage our credit risk while attracting new
cardmembers with profitable usage patterns. We select our cardmembers, manage
their accounts and establish terms and credit limits using proprietary scoring
models and other analytical techniques designed to set terms and credit limits
such that we are appropriately compensated for the credit risk we accept, while
encouraging cardmembers to use their available credit. The models and approaches
we use to select, manage and underwrite our cardmembers may not accurately
predict future charge-
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offs due to, among other things, inaccurate assumptions or models. While we
continually seek to improve our assumptions and models, we may make
modifications that unintentionally cause them to be less predictive. We also may
incorrectly interpret the data produced by these models in setting our credit
policies. Our ability to manage credit risk also may be adversely affected by
economic conditions, legal or regulatory changes (such as bankruptcy laws,
minimum payment regulations and re-age guidance), competitors' actions and
consumer behavior, as well as inadequate collections staffing, techniques,
models and vendor performance.
A cardmember's ability to repay us can be negatively impacted by changes in
their payment obligations under mortgage loans, including subprime mortgage
loans. Such changes can result from changes in economic conditions including
increases in base lending rates upon which payment obligations are based and
structured increases in payment obligations, which in turn could adversely
impact the ability of our cardmembers to meet their payment obligations to other
lenders and to us and could result in higher credit losses in our portfolio.
Rising delinquencies and rising rates of bankruptcy are often precursors of
future charge-offs. For instance, bankruptcy rates in the United Kingdom have
increased significantly in recent years as a result of the relaxation of the
bankruptcy laws, which has contributed to increases in charge-off rates in our
U.K. operations. There can be no assurance that our lending standards will
protect us against high charge-off levels. In addition, because an important
source of our funding is the securitization market, an increase in delinquencies
and/or charge-offs could increase our cost of funds or unintentionally cause an
early amortization event. See "-We may be unable to securitize our receivables
at acceptable rates or at all, which could materially adversely affect our
liquidity, cost of funds, reserves and capital requirements."
We have already launched and plan to expand in several card and consumer lending
sectors. Areas of particular focus include: a small business card, which we
launched in 2006; relaunching the Miles by Discover Card product, which occurred
in 2007; launching personal loan and student lending products, which occurred in
2007; and prepaid cards. We also continuously refine and test our credit
criteria, which results in some instances in approving applications that did not
previously meet our underwriting criteria. We have less experience in these
areas as compared to our traditional products and segments, and there can be no
assurance that we will be able to manage our credit risk or generate sufficient
revenue to cover our expenses in these markets. Our failure to manage our credit
risks may materially adversely affect our profitability and ability to grow.
Economic downturns, financial market events and other conditions beyond our
control could materially adversely affect our business.
Economic downturns, financial market events and other conditions beyond our
control may adversely affect consumer spending, asset values, investments,
financial market liquidity, consumer indebtedness and unemployment rates, which
in turn can negatively impact our business. If general economic conditions in
the United States or United Kingdom deteriorate or interest rates increase, the
number of transactions, average purchase amount of transactions, or average
balances outstanding on our cards may be reduced, which would reduce transaction
fees and interest income and thereby adversely affect profitability. In
addition, high levels of unemployment, low levels of spending, deteriorating
housing markets, recessions or other conditions, including terrorism, natural
disasters or the outbreak of diseases, may adversely affect the ability and
willingness of cardmembers to pay amounts owed to us, which would increase
delinquencies and charge-offs and could materially adversely affect our
business.
Changes in the level of interest rates could materially adversely affect our
earnings.
Changes in interest rates cause our interest expense to increase or decrease, as
certain of our debt instruments carry interest rates that fluctuate with market
benchmarks. If we are unable to pass our higher cost of funds to our customers,
the increase in interest expense could materially adversely affect earnings.
Some of our managed receivables bear interest at a fixed rate or do not earn
interest, and we may not be able to increase the rate on those loans to mitigate
our higher cost of funds. At the same time, our variable rate managed
receivables, which are based on a market benchmark, may not change at the same
rate as our floating rate debt instruments or may be subject to a cap.
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Interest rates may also adversely impact our delinquency and charge-off rates.
Many consumer lending products bear interest rates that fluctuate with certain
base lending rates published in the market, such as the prime rate and the
London Interbank Offered Rate ("LIBOR"). As a result, higher interest rates
often lead to higher payment requirements by consumers under obligations to us
or other lenders, which may reduce their ability to remain current on their
obligations to us and thereby lead to loan delinquencies and additions to our
loan loss provision, which could materially adversely affect our earnings.
In connection with our spin-off from Morgan Stanley, we have incurred additional
indebtedness that could restrict our operations.
In recent years, Morgan Stanley provided a significant portion of our funding.
Since our spin-off from Morgan Stanley, we finance our capital needs with third
party funding. We have entered into a multi-year unsecured committed credit
facility of $2.5 billion, which contains customary restrictions, covenants and
events of default. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Liquidity and Capital Resources." The terms
of this facility and any future indebtedness impose various restrictions and
covenants on us (such as tangible net worth requirements) that could have
adverse consequences, including,
limiting our ability to pay dividends to our stockholders;
increasing our vulnerability to changing economic, regulatory and industry
conditions;
limiting our ability to compete and our flexibility in planning for, or
reacting to, changes in our business and the industry;
limiting our ability to borrow additional funds; and
requiring us to dedicate a substantial portion of our cash flow from
operations to payments on our debt, thereby reducing funds available for
working capital, capital expenditures, acquisitions and other purposes.
Our total combined indebtedness as of November 30, 2007 was approximately
$30.0 billion, as compared to $21.6 billion at November 30, 2006. The increase
in indebtedness primarily represents incremental deposits obtained to establish
a liquidity reserve, the balance of which was approximately $8.3 billion and was
included in cash and cash equivalents at November 30, 2007. We may also incur
additional substantial indebtedness in the future.
We may be unable to securitize our receivables at acceptable rates or at all,
which could materially adversely affect our liquidity, cost of funds, reserves
and capital requirements.
The securitization of credit card receivables, which involves the transfer of
receivables to a trust and the issuance by the trust of beneficial interests to
third-party investors, is our largest single source of funding. Factors
affecting our ability to securitize our credit card receivables at acceptable
pricing levels, or at all, include the overall credit quality of our
receivables, negative credit ratings action affecting our asset-backed
securities (or Discover Bank), the stability of the market for securitization
transactions, investor demand, and the legal, regulatory, accounting and tax
requirements governing securitization transactions. For example, the current
subprime mortgage crisis has created a disruption in the capital markets and
caused a weakening in demand for asset-backed securities, including those for
credit card receivables. In addition, changes to Statement of Financial
Accounting Standards No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, as amended ("Statement No.
140"), are being discussed which may make it more difficult for us to maintain
sale accounting treatment for our securitizations under accounting principles
generally accepted in the United States ("GAAP") or may require us to recognize
securitized receivables on our consolidated and combined statements of financial
condition, which could substantially increase the allowance for loss
requirements and Discover Bank's regulatory capital requirements and result in
changes in the timing of the recognition of income from securitization
transactions.
Our results of operations and financial condition could also be materially
adversely affected by the occurrence of events that could result in the early
amortization of our securitization transactions. Credit card
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securitizations are normally structured as "revolving transactions" that do not
distribute to securitization investors their share of monthly principal payment
on the receivables during the revolving period, and instead use those payments
to fund the purchase of replacement receivables. The occurrence of "early
amortization events" may result in termination of the revolving period of our
securitization transactions. Early amortization events include, for example,
insufficient cash flows in the securitized pool of receivables to meet
contractual requirements, certain breaches of representations, warranties or
covenants in the agreements relating to the securitization, and bankruptcy or
insolvency.
If we are unable to continue to securitize our credit card receivables at
acceptable pricing levels, or at all, including by reason of the early
amortization of any of our securitization transactions, we would seek to
liquidate investment securities, increase bank deposits and use alternative
funding sources to fund increases in loan receivables and meet our other
liquidity needs. In the event of an economic early amortization, receivables
that otherwise would have been subsequently purchased by the trust from us would
instead continue to be recognized on our consolidated and combined statements of
financial condition since the cash flows generated in the trust would instead be
used to repay investors in the asset-backed securities. Recognizing these
receivables would require us to obtain alternative funding.
The inability to continue to securitize our credit card receivables at
acceptable pricing levels, or at all, could materially adversely affect our
liquidity, cost of funds, reserves and capital requirements. In addition,
liquidation of investment securities and available alternative funding sources
may be insufficient to meet the ongoing funding needs of our business if we are
unable to continue to securitize our credit card receivables. For a further
discussion of our liquidity and funding needs, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Liquidity and Capital
Resources."
An inability to accept or obtain brokered deposits in the future could
materially adversely affect our liquidity position and funding costs.
The FDIA prohibits a bank, including our subsidiaries Discover Bank and Bank of
New Castle, from accepting brokered deposits or offering interest rates on any
deposits significantly higher than the prevailing rate in its normal market area
or nationally (depending upon where the deposits are solicited), unless (1) it
is well-capitalized or (2) it is adequately capitalized and receives a waiver
from the FDIC. A bank that is adequately capitalized and that accepts brokered
deposits under a waiver from the FDIC may not pay an interest rate on any
deposit in excess of 75 basis points over certain prevailing market rates. There
are no such restrictions on a bank that is well-capitalized. While Discover Bank
and Bank of New Castle each met the FDIC's definition of "well-capitalized" as
of November 30, 2007, there can be no assurance that they will continue to meet
this definition. We rely on third-party brokers to access the brokered deposit
market, and brokered deposits may become unavailable to us due to the
unwillingness of brokers to sell our deposits, as a result of a decline in our
credit ratings or for other reasons. An inability to accept or obtain brokered
deposits in the future could materially adversely affect our liquidity position
and funding costs.
We rely in part on unsecured and secured debt for our funding and the inability
to access the U.S. or U.K. debt markets could materially adversely affect our
business, financial condition and results of operations.
While our primary sources of funding are securitizations and brokered deposits,
we also are dependent on access to the U.S. and U.K. unsecured debt markets to
fund our managed receivables as well as other assets. In general, the amount,
type and cost of our funding directly affects the cost of operating our business
and growing our assets and is dependent upon outside factors such as our credit
rating from ratings agencies. Historically we have benefited from Morgan
Stanley's credit ratings. Since our spin-off, Discover Bank has maintained its
BBB rating from Standard &Poor's ("S&P") and has been assigned a Baa2 deposit
and Baa2 senior unsecured rating from Moody's Investor Service ("Moody's") and a
BBB rating from Fitch Ratings ("Fitch"). We have been assigned a BBB- long-term
rating from S&P, a Baa3 senior unsecured rating from Moody's and a BBB long-term
rating from Fitch. A rating is not a recommendation to purchase, sell or hold
any particular security. In addition, there can be no assurance that a rating
will be maintained for any given period of time or that a rating will not be
lowered or withdrawn in its entirety. If our ratings are for any reason reduced
or we are unable
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to access the U.S. or U.K. unsecured debt markets for any reason, our business,
financial condition and results of operations could be materially adversely
affected.
In response to the exploration of the spin-off in 2005, Moody's placed the
asset-backed securities issued domestically by the Discover Card Master Trust I
under review for a possible downgrade, which we believe contributed to a
temporary disruption in our ability to access the securitization markets,
increasing our reliance on intercompany funding and deposit markets. This
disruption lasted approximately five months, at which time Moody's reaffirmed
the ratings on the asset-backed securities.
Declines in the value of, or income earned from, our retained interests in our
securitization transactions could materially adversely affect our financial
condition, results of operations and cash flows.
We retain interests in the assets transferred to or created in our
securitization transactions and earn income from these assets. The value of our
retained interests and the amount of income that we earn depend on many factors,
including, among others, the revenues, performance and credit risk of the
securitized loans, which are subject to the same risks and uncertainties as
loans that we have not securitized. The value of our interests may also change
because of changes in the assumptions used to estimate their fair value, such as
market interest rates and other conditions, increases in bankruptcy or
charge-off rates, payment rates and changes in the interpretation and
application of accounting rules relating to such valuation. If the income that
we earn from our retained interests in securitization transactions were to
decrease or the value of our retained interests were to decrease, our financial
condition, results of operations and cash flows could be materially adversely
affected.
Our investment portfolio may be adversely affected by market fluctuations, which
could negatively impact our financial condition.
We have an investment portfolio that we manage in accordance with our internal
policies and procedures, including the investment of our liquidity reserve,
which had a balance of approximately $8.3 billion as of November 30, 2007. Our
investment portfolio may be adversely affected by market fluctuations including,
without limitation, changes in interest rates, prices, credit risk premiums and
overall market liquidity. Also, investments backed by collateral could be
adversely impacted by changes in the value of the underlying collateral. Our
fixed income investments are subject to market valuation risks from changes in
the general level of interest rates. Recent increases in credit risk premiums
can negatively impact the value of our securities. Certain markets have been
experiencing disruptions in market liquidity, and the lack of a secondary market
may adversely affect the valuation of certain of our investments. In addition,
deteriorating economic conditions may cause certain of the obligors,
counterparties and underlying collateral on our investments to incur losses of
their own, thereby increasing our credit risk exposure to these investments.
These risks could result in a decrease in the value of our investment portfolio,
which could negatively impact our financial condition. For example, we recorded
a loss on an investment in certain asset-backed commercial paper notes during
the year ended November 30, 2007. See Note 4: Investment Securities to the
audited consolidated and combined financial statements for further details.
We may be unable to increase or sustain Discover Card usage, which could impair
growth in, or lead to diminishing, average balances and total revenue.
A key element of our strategy is to increase the usage of the Discover Card by
our cardmembers, including making it their primary card, and thereby increase
our revenue from transaction and service fees and our managed receivables.
However, our cardmembers' use and payment patterns may change because of social,
legal and economic factors, and cardmembers may decide not to increase card
usage or may decide to pay the balances within the grace period to avoid finance
charges. We face challenges from competing credit card products in our attempts
to increase credit card usage by our existing cardmembers. Our ability to
increase cardmember usage also is dependent on cardmember satisfaction, which
may be adversely affected by factors outside of our control, including
competitors' actions. As part of our strategy to increase usage, we are seeking
to increase the number of merchants who accept cards issued on the Discover
Network. If we are unable to increase merchant acceptance of our cards, our
ability to grow usage of Discover Cards may be hampered. As a result of these
factors, we may be unable to increase or sustain credit card usage, which could
impair growth in, or lead to diminishing, average balances and total revenue.
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We may be unable to grow earnings if we do not attract new cardmembers, or if we
attract cardmembers with unfavorable spending and payment habits.
We are seeking to increase managed receivables by attracting new cardmembers who
will use their Discover Cards, meet their monthly payment obligations and
maintain balances that generate interest and fee income for us. We are subject
to substantial competition from other credit card issuers for these new
cardmembers. We plan to continue marketing the Discover Card, but we may not
have adequate financial resources to permit us to incur all of the marketing
costs that may be necessary to maintain or grow our managed receivables or to
attract new accounts. The spending and payment habits of these new cardmembers
may not be sufficient to make their accounts as profitable as we expect. In
addition, our risk models may not accurately predict the credit risk for these
new cardmembers, which could result in unanticipated losses in future periods.
To the extent that the spending and payment habits of new cardmembers do not
meet our expectations, our earnings and growth may be negatively affected.
Our transaction volume is concentrated among large merchants, and a reduction in
the number of, or rates paid by, merchants that participate in the Discover
Network could materially adversely affect our business, financial condition,
results of operations and cash flows.
Discover Card transaction volume was concentrated among our top 100 merchants in
2007. These merchants may pressure us to reduce our rates by continuing to
participate in the Discover Network only on the condition that we change the
terms of their economic participation. At the same time, we are subject to
increasing pricing pressure from third-party issuers as a result of the
continued consolidation in the banking industry, which results in fewer large
issuers that, in turn, generally have a greater ability to negotiate pricing
discounts. In addition, many of our merchants, primarily our small and mid-size
merchants, are not contractually committed to us for any period of time and may
cease to participate in the Discover Network at any time on short notice.
In addition, actual and perceived limitations on acceptance of credit cards
issued on the Discover Network could adversely affect the use of the Discover
Card by existing cardmembers and the attractiveness of the Discover Card to
prospective new cardmembers. Furthermore, we may have difficulty attracting and
retaining third-party issuers if we are unable to add and retain acquirers or
merchants who accept cards issued on the Discover or PULSE Networks. As a result
of these factors, a reduction in the number of, or rates paid by, our merchants
could materially adversely affect our business, financial condition, results of
operations and cash flows.
We may be unable to grow earnings if we are unable to increase the number of
small and mid-size merchants that participate in the Discover Network.
In seeking to expand our merchant acceptance among small and mid-size merchants,
we have recently entered into agreements with and have started to use
third-party acquirers and processors to add merchants to the Discover Network
and accept and process payments for these merchants on an integrated basis with
Visa and MasterCard payments. This strategy could have unanticipated results,
such as decreased revenues, higher expenses, degraded service and signage
placement levels and retaliatory responses from competitors. There can be no
assurance that the use of third-party acquirers and processors will continue to
increase merchant acceptance among small or mid-size merchants, or that such
third-party acquirers will continue to participate with us if more attractive
opportunities arise. If we are unable to increase small and mid-size merchant
acceptance, our ability to grow earnings could be adversely affected.
Our business, financial condition and results of operations may be adversely
affected by the increasing focus of merchants on the fees charged by credit card
networks.
Merchant acceptance and fees are critical to the success of both our card
issuing and payment processing businesses. Merchants have shown increasing
concern with the levels of fees charged by credit card companies, and have in
the past and may in the future seek to negotiate better pricing or other
financial incentives as a condition to continued participation in the Discover
Network. During the past few years, merchants and their trade groups have filed
approximately 50 lawsuits against Visa, MasterCard, American Express and their
card issuing banks, claiming that their practices toward merchants, including
interchange fees, violate federal antitrust
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laws. There can be no assurance that they will not in the future bring legal
proceedings against other credit card issuers and networks, including us.
Merchants also may promote forms of payment with lower fees, such as PIN debit,
or seek to impose surcharges at the point of sale for use of credit cards. The
heightened focus by merchants on the fees charged by credit card networks,
including us, could lead to reduced merchant acceptance of Discover Network
cards or reduced fees, either of which could adversely affect our business,
financial condition and results of operations.
Our U.K. operations are currently not profitable, and there can be no assurance
when or if they will become profitable.
The U.K. market is currently experiencing high delinquencies and bankruptcy
levels, compounded by changing regulations, which have resulted in losses in our
U.K. operations. Additionally, the United Kingdom has relatively low levels of
interchange and fee income and lower net interest margin, which has resulted in
and may continue to result in insufficient revenues to compensate for the
current levels of loan losses. Our U.K. operations also have a relatively higher
cost structure given their smaller scale. In addition to the challenging market
conditions described above, U.K. and European regulators have recently increased
their focus on the credit card industry.
On February 7, 2008, we entered into an agreement to sell our credit card
business in the United Kingdom to Barclays Bank Plc. The closing is expected to
occur by the end of our second quarter of 2008 and is subject to the
satisfaction of a number of conditions. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Sale of International
Card Segment; First Quarter 2008 Charge" for more information relating to the
sale of our Goldfish business.
Our pending sale of our U.K. credit card business is subject to a variety of
conditions and may not be completed.
On February 7, 2008, we and Barclays Bank Plc entered into a definitive sale and
purchase agreement relating to the sale of our U.K. credit card business, which
represents substantially all of our International Card segment. Completion of
this sale is subject to a variety of conditions, many of which are outside of
our control. If the transaction is not completed, we may have difficulty
retaining key personnel of this business.
We expect to continue to incur significant expenses in the litigation we are
pursuing against Visa and MasterCard, and there can be no assurance that we will
ultimately be successful in this action.
In October 2004, the DOJ prevailed in its antitrust litigation against Visa and
MasterCard which challenged their exclusionary practices. Following this ruling,
we filed a complaint against Visa and MasterCard seeking substantial damages for
the market foreclosure caused by their anticompetitive rules. The trial date is
expected to be no later than Fall 2008. We expect to continue to incur
substantial legal expenses in the litigation we are pursuing against Visa and
MasterCard. Outside counsel and consultant legal expenses for this litigation
were approximately $42 million, $51 million and $8 million in 2007, 2006 and
2005, respectively. Expenses associated with this litigation in 2008 are
expected to be slightly lower than 2007 expenses. Furthermore, there can be no
assurance that we will be successful in recovering any damages in this action.
Upon resolution of the litigation, after expenses, we will be required to pay
Morgan Stanley the first $700 million of value of cash or non-cash proceeds
(increased at the rate of 6% per annum until paid in full) (the "minimum
proceeds"), plus 50% of any proceeds in excess of $1.5 billion, subject to
certain limitations and a maximum potential payment to Morgan Stanley of
$1.5 billion. All payments by Discover to Morgan Stanley will be net of taxes
payable by Discover with respect to such proceeds. If, in connection with or
following a change of control of Discover, the litigation is settled for an
amount less than the minimum proceeds, Discover will be required to pay Morgan
Stanley an amount equal to the minimum proceeds. As a result of our agreement to
pay the value of non-cash proceeds, we may be required to pay amounts to Morgan
Stanley in excess of cash received in connection with the litigation. The value
of non-cash proceeds will be determined by an independent third party.
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Visa and MasterCard may impose additional restrictions on issuing banks,
merchants or merchant acquirers that materially adversely affect the Discover or
PULSE Networks, or the Discover Card issuing business.
Visa and MasterCard aggressively seek to protect their networks from competition
and have used their rules and policies to do so. For example, in the past they
enacted and enforced rules that prohibited their member banks from issuing cards
on competing payment networks such as Discover. These rules were ultimately
found to violate the antitrust laws. They have adversely affected our business
in the past, and they may have lingering effects going forward. Visa and
MasterCard also may enact new rules or enforce other rules in the future,
including limiting the ability of issuing banks to use the PULSE Network, which
may materially adversely affect our ability to compete.
If fraudulent activity associated with our cards increases, our brands could
suffer reputational damage, the use of our cards could decrease and our fraud
losses could be materially adversely affected.
We are subject to the risk of fraudulent activity associated with merchants,
cardmembers and other third parties handling cardmember information. Credit and
debit card fraud, identity theft and related crimes are prevalent and
perpetrators are growing ever more sophisticated. Our financial condition, the
level of our fraud charge-offs and other results of operations could be
materially adversely affected if fraudulent activity were to significantly
increase. In addition, significant increases in fraudulent activity could lead
to regulatory intervention (such as mandatory card reissuance) and reputational
and financial damage to our brands, which could negatively impact the use of our
cards and thereby have a material adverse effect on our business.
If our security systems, or those of merchants, merchant acquirers or other
third parties containing information about cardholders, are compromised, we may
be subject to liability and damage to our reputation.
Our security protection measures, including the security of transaction
information processed on our systems or the systems or processing technology of
third parties participating in the Discover or PULSE Networks, may not be
sufficient to protect the confidentiality of information relating to cardholders
or transactions processed on the Discover or PULSE Networks. Cardholder data
also may be stored on systems of third-party service providers and merchants
that may have inadequate security systems. Third-party carriers regularly
transport cardholder data, and they may lose sensitive cardholder information.
Unauthorized access to the Discover or PULSE Networks or any other Discover
information systems potentially could jeopardize the security of confidential
information stored in our computer systems or transmitted by our cardmembers or
others. If our security systems or those of merchants, processors or other
third-party service providers are compromised such that this confidential
information is disclosed to unauthorized parties, we may be subject to
liability. The preventive measures we take to address these factors are costly,
and may become mo