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EpilogSchwab AccountFounded as a brokerage for the average investor, Charles Schwab & Co. 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. Stocks rated A are expected to strongly outperform the market and F stocks are expected to strongly underperform the market. Stocks rated A and B are considered buy recommendations, while Ds and Fs are sell recommendations. Stocks rated C are neutral. 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-Schwab will give about 30 percent of stocks the equivalent of a buy rating and 30 percent a sell rating, with a neutral rating going to the rest. The computer-generated ratings also relieve Schwab of the need to hire an army of research analysts. The research comes courtesy of the system run by Chicago Investment Analytics, a company Schwab acquired in 2000. The Schwab rating system crunches twenty-four objective factors, including company fundamentals, historical stock movements, and the opinions of analysts at other firms, to predict how each stock will perform during the next 12 months. 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. It's not easy to offer conflict-free advice. The day after Schwab Equity Ratings was announced, arch-rival Merrill Lynch agreed to pay a $100 million fine, made a statement of contrition, and accepted significant structural reforms to settle charges that the firm's analysts misled investors with their stock advice so the company could win lucrative investment banking fees. Merrill Lynch was caught because internal emails disclosed that some brokers were publicly encouraging customers to buy stocks that the same brokers privately derided. Chuck was determined that Schwab's advice offering be hardened against any such hanky-panky. Even as it rolls out Schwab Equity Ratings, the company will continue to offer its customers the views of other research groups. But what are customers to think when Schwab Equity Ratings contradicts the analysts at the Goldman Sachs Group, the investment bank whose research Schwab makes available to its best customers? As this book went to press, Schwab had assigned an F to the American Tower Corporation, one of Goldman's preferred stocks and prominently displayed on its list of investment banking clients. General Electric's stock was also on Goldman's recommended list, but earned a C rating from Schwab. 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 email alert program that is in reality "warm calling" in disguise. Customers can expect to be bombarded by emails alerting them to a variety of conditions that Schwab believes can inspire a trade. For example, customers will get emails 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 emails 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 noncash 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 recreate 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. Preface
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