Requiem for Charles Schwab's Past

An excerpt from Charles Schwab: How One Company Beat Wall Street and Reinvented the Brokerage Industry, by John Kador

Charles Schwab: How One Company Beat Wall Street and Reinvented the Brokerage Industry (Wiley; $24.95) is, for the most part, a quite flattering portrayal of a company that revolutionized the brokerage industry and the man who built it. Author John Kador traces the company's history from its San Francisco roots as a renegade discount brokerage to its ascendance as the king of online brokerage in the '90s -- and finally to its latest transformation into what is darn close to becoming a full-service brokerage and money-management firm.

As Kador concludes Schwab's story, he sees plenty of warning signs in the company's latest incarnation. By doing things like raising fees for small investors, offering stock advice (which Schwab promises will remain conflict-free), and marketing directly to customers via e-mail, Kador worries that the firm is straying too far from the founding values that led to its earlier success (see BW Online, 1/31/03, "Schwab: Pick It While It's Down?"). The following epilogue, which has been edited for length, acts as a kind of requiem for the Charles Schwab of a prior era.

Epilogue: Schwab Account

Founded as a brokerage for the average investor, Charles Schwab & Co. (SCH ) prided itself on three standards: no advice, no cold calling, no commission-paid brokers. In its desire to recreate itself as a full-service brokerage, Schwab is systematically abandoning the principles on which it was established.

The first pillar to go: no advice. It died shamelessly in front of news cameras on May 16, 2002. The company that was founded on the principle that brokerages are incapable of delivering conflict-free advice formally buried the first of its founding values at a New York City press event. Ailing for many years, the no-advice principle survived for 28 years before it finally succumbed to market forces.

Chuck Schwab and David Pottruck were among the pallbearers. There was no eulogy. "We will be reaching out to investors with more advice than we ever have before," Chuck told the financial reporters already itchy from reports that Merrill Lynch was about to accept a $100 million fine for giving investors the kind of tainted advice and research that Chuck harped against. There was no mention of Schwab's legacy of disdain for brokers offering advice.

So it was that Schwab announced Schwab Equity Ratings as its vehicle into the conflict-ridden world of full-service brokerages. Schwab Equity Ratings is a stock research and advice service that assigns a letter grade of A through F to each of the 3,000 U.S. equities that the firm will cover. "This is perhaps the most significant moment in the company's history," Chuck said. "We are moving from the edges of client's investment decisions to helping them make those decisions."

Note how Schwab Equity Ratings finesses the advice game as it meshes with the remnants of the company's fraying principles. First, it avoids the unappetizing spectacle of individual Schwab brokers actually touting stocks. By automating and objectifying the process, the service lets computers do the dirty work.

Second, it allows all of Schwab's 3,000 or so brokers to speak with one voice on the ratings. Third, the program avoids camouflaging drab facts in trendy broker-speak: labeling a company a "transitional category underperformer" when the broker really means "a nest of dirtballs." Schwab Equity Ratings grades stocks the same way a student gets scored on a test-with A for outstanding and F for failures.

A gutsy and welcome part of this service is that the number of sell recommendations will be equal to the number of buy recommendations. In contrast to its Wall Street rivals -- which almost always recommend buying, and almost never selling, stocks of their firm's clients. The computer-generated ratings also relieve Schwab of the need to hire an army of research analysts.

Schwab insists that these ratings really give investors an edge. But if that's true, why doesn't Schwab simply close down its retail practice and make money trading stock? Of course, that observation is not a criticism solely of Schwab's financial management practices; it's applicable to the entire financial services industry. On the one hand, at least Schwab makes it relatively cheap for customers to churn themselves to death. On the other, people want relationships with people they trust, not computers.

And what of Schwab's remaining founding values? The no-selling principle will be the next to go. Pottruck insists that Schwab brokers will never "cold call" customers. But market forces are forcing Schwab to encroach on this taboo, as well. The company is gearing up for an aggressive E-mail alert program that is in reality "warm calling" in disguise. Customers can expect to be bombarded by E-mails alerting them to a variety of conditions that Schwab believes can inspire a trade.

For example, customers will get e-mails when a stock they own has been downgraded by Schwab's rating system, when the cash in their account exceeds a threshold, or when an account triggers a portfolio asset allocation recommendation. The question is, Will customers be any less distressed by such E-mails than they are by unsolicited telephone calls from their brokers? Schwab is very concerned about the privacy implications and is proceeding cautiously.

Another value -- that of paying brokers by salary instead of by commission -- continues to be respected. The conflicts of interest manifested by brokers compensated by commissions are so execrable that Schwab will never link employee compensation to commissions. The company's proxies and partners, however, are not bound by the standard, and Schwab will likely offload much of the sales burden to them. Moreover, linking Branchland bonuses to the assets an employee aggregates can also expose the company to unintended conflicts. For now, however, the no-commission standard remains an integral part of Schwab's commitment.

Finally, Schwab's transformation as a broker to the wealthy continues without a glance at the customers of modest means being left behind. The evidence is everywhere. Schwab no longer provides postage-paid envelopes for customers to use to mail in checks. While other brokerages are reducing trading fees, Schwab is raising them.

Schwab, which battles with Merrill, UBS PaineWebber, and other rivals to get the nation's wealthiest investors, announced a private client group that features one-on-one services from a broker for a minimum annual fee of $1,500 plus 0.6 percent of their non-cash holdings. This service is for customers with $500,000 to $5 million in assets. Schwab's super-wealthy clients are encouraged to go to U.S. Trust, where they have access to a full range of wealth management, financial planning, trust and estate planning, and private banking services. Schwab no longer welcomes customers with accounts of less than $50,000.

Inside Schwab, these changes do not go down easily. As much as Schwab people throughout the organization acknowledge the need for these changes, it is not easy to give up the practices and values that have defined the company. The company, desperate to re-create itself, is not being sensitive to the needs of employees to grieve for the precious values being lost. Thousands of employees have retired, preferring to cherish the noble causes that Schwab stood for rather than work to make rich people even richer.

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