| E TRADE FINANCIAL CORP ITEM 1A RISK FACTORS Risks Relating to the Nature and Operation of Our Business Many of our competitors have greater financial, technical, marketing and other resources The financial services industry is highly competitive, with multiple industry participants competing for the same customers |
| Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services |
| The impact of competitors with greater name recognition, market acceptance and larger customer bases could adversely affect our revenue growth and customer retention |
| Our competitors may also be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can |
| Competitors may conduct extensive promotional activities, offering better terms, lower prices and/or different products and services that could attract current E*TRADE customers and potentially result in price wars within the industry |
| Some of our competitors may also benefit from established relationships among themselves or with third parties enhancing their products and services |
| If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage There has recently been significant consolidation in the financial services industry and this consolidation is likely to continue in the future |
| Should we be excluded from or fail to take advantage of viable consolidation opportunities, our competitors may be able to capitalize on those opportunities and create greater scale and cost efficiencies to our detriment |
| We have recently acquired a number of businesses, including Harrisdirect and BrownCo |
| The primary assets of these businesses are their customer accounts |
| Our retention of these assets and the customers of businesses we acquire may be impacted by our ability to successfully integrate the acquired operations, products (including pricing) and personnel |
| Diversion of management attention from other business concerns could have a negative impact |
| In the event that we are not successful in our integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition |
| We expect to pursue additional acquisitions of companies in our industry, which may require us to obtain additional financing and subject us to integration risks |
| There can be no assurance that we will realize a positive return on any acquisition or that future acquisitions will not be dilutive to earnings |
| Downturns or disruptions in the securities markets could reduce trade volumes and margin borrowing and increase our dependence on our more active customers who receive lower pricing Online investing services to the retail customer, including trading and margin lending, account for a significant portion of our revenues |
| Although we continue to diversify our revenue sources, we expect online investing services to continue to account for a significant portion of our revenues in the foreseeable future |
| A downturn in or disruption to the securities markets may lead to changes in volume and price levels of securities and futures transactions which may, in turn, result in lower trading volumes and margin lending |
| In particular, a decrease in trading activity within our lower activity accounts would significantly impact revenues and increase dependence on more active trading customers who receive more favorable pricing based on their trade volume |
| A decrease in trading activity or securities prices would also typically be expected to result in a decrease in margin borrowing, which would reduce the revenue that we generate from interest charged on margin borrowing |
| More broadly, any reduction in overall transaction volumes would likely result in lower revenues and may harm our operating results because many of our overhead costs are fixed |
| We depend on payments from our subsidiaries We depend on dividends, distributions and other payments from our subsidiaries to fund payments on our obligations, including our debt obligations |
| Regulatory and other legal restrictions may limit our ability to 7 ______________________________________________________________________ [85]Table of Contents transfer funds to or from our subsidiaries |
| Many of our subsidiaries are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to us, or that prohibit such transfers altogether in certain circumstances |
| These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations |
| We rely heavily on technology to deliver products and services We rely on technology, particularly the Internet, to conduct most of our activity, and our success is dependent upon our ability to process information received through the Internet |
| Our technology operations are vulnerable to disruptions from human error, natural disasters, power loss, computer viruses, spam attacks, unauthorized access and other similar events |
| Disruptions to or instability of our technology, including an actual or perceived breach of the security of our technology, could harm our business and our reputation |
| In addition, recent computer viruses attacking the computers of our customers could create losses for our customers even without any breach in the security of our systems, and could thereby harm our business and our reputation |
| Our business and reputation may also be harmed by events that indirectly affect us |
| For example, changes in technology and the volume of transactions on the Internet could cause information delays resulting in slow trade execution which could in turn cause declines in customer satisfaction and loss of customers |
| In addition, a significant disruption to or the instability of technology systems other than ours, including an actual or perceived breach of the security of a competitor’s system, could have a negative effect on our customer behavior and harm our business |
| Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions We permit customers to purchase securities on margin |
| A downturn in securities markets may impact the value of collateral held in connection with margin loans and may reduce its value below the amount borrowed, potentially creating collections issues with our margin loans |
| In addition, we frequently borrow securities from and lend securities to other broker-dealers |
| Under regulatory guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits |
| A sharp change in security market values may result in losses if counterparties to the borrowing and lending transactions fail to honor their commitments |
| We may be unsuccessful in managing the effects of changes in interest rates and the interest-earning banking assets in our portfolio Net interest income has become an increasingly important source of our revenue, and will continue to grow in importance as our business model develops |
| Our ability to manage interest rate risk could impact our financial condition |
| Our results of operations depend, in part, on our level of net interest income and our effective management of the impact of changing interest rates and varying asset and liability maturities |
| We use derivatives to help manage interest rate risk |
| However, the derivatives we utilize may not be completely effective at managing this risk and changes in market interest rates and the yield curve could reduce the value of our financial assets and reduce net interest income |
| Many factors affect interest rates, including governmental monetary policies and domestic and international economic and political conditions |
| The diversification of our asset portfolio may increase the level of charge-offs As we diversify our asset portfolio through purchases and originations of higher-yielding asset classes, such as credit card portfolios and other consumer loans, we will have to manage assets that carry a higher risk of default than our mortgage portfolio |
| Consequently, the level of charge-offs associated with these assets may be higher than what we have previously experienced given our asset mix |
| In addition, if the overall economy weakens, we could experience higher levels of charge-offs |
| If expectations of future charge-offs increase, a corresponding increase in the amount of our allowance for loan loss would be required |
| The increased level of 8 ______________________________________________________________________ [86]Table of Contents provision for loan losses recorded to meet additional allowance for loan loss requirements could adversely affect our financial results, if those higher yields do not cover the provision for loan losses |
| An increase in our delinquency rate could adversely affect our results of operations Our underwriting criteria or collection methods may not afford adequate protection against the risks inherent in the loans comprising our consumer loan portfolio |
| In the event of a default, the collateral value of the financed item may not cover the outstanding loan balance and costs of recovery |
| In the event our portfolio of consumer finance receivables experiences higher delinquencies, foreclosures, repossessions or losses than anticipated, our results of operations or financial condition could be adversely affected |
| Risks associated with principal trading transactions could result in trading losses A majority of our specialist and market-making revenues are derived from trading as a principal |
| We may incur trading losses relating to the purchase, sale or short sale of securities for our own account, as well as trading losses in our specialist and market maker stocks |
| From time to time, we may have large positions in securities of a single issuer or issuers engaged in a specific industry |
| Sudden changes in the value of these positions could impact our financial results |
| Reduced grants by companies of employee stock options could adversely affect our results of operations We are a provider of stock plan administration and options management tools, and our revenue from these tools depends in part on the size and complexity of our customers’ employee stock option and stock purchase plans |
| In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS Nodtta 123(R) Share-Based Payment, which among other things requires public companies to expense employee stock options and other share-based payments at their fair value when issued |
| SFAS Nodtta 123(R) may result in companies granting fewer employee options and modifying their existing employee stock purchase plans, potentially reducing the amount of products and services we provide these companies and compelling us to incur additional costs so that our tools comply with the new FASB statement |
| Additionally, we may see a reduction in commission revenues as fewer employee stock options would be available for exercise and sale by the employees of these companies |
| Reduced spreads in securities pricing, levels of trading activity and trading through market makers and/or specialists could harm our specialist and market maker business Computer-generated buy/sell programs and other technological advances and regulatory changes in the marketplace may continue to tighten securities spreads |
| Tighter spreads could reduce revenue capture per share by our specialists and market makers, thus reducing revenues for this line of business |
| In addition, new and enhanced alternative trading systems such as electronic communications networks, or ECNs, have emerged as an alternative for individual and institutional investors, as well as broker-dealers, to avoid directing their trades through market makers and could result in reduced revenue for our specialist and market maker business |
| Advisory services subject us to additional risks We provide advisory services to investors to aid them in their decision making and also provide full service portfolio management |
| Investment decisions and suggestions are based on publicly available documents and communications with investors regarding investment preferences and risk tolerances |
| Publicly available documents may be inaccurate and misleading resulting in recommendations or transactions that are inconsistent with the investors’ intended results |
| In addition, advisors may not understand investor needs and risk tolerances resulting in the recommendation or purchase of a portfolio of assets that may not be well suited for the investor |
| Should we be found to have failed to know our customers or improperly advised them, we could be found liable for losses suffered by customers, which could harm our business |
| Our international efforts subject us to additional risks and regulation, which could impair our business growth One component of our strategy has been an effort to build an international business |
| We have established certain joint venture and/or licensee relationships |
| We have limited control over the management and direction of 9 ______________________________________________________________________ [87]Table of Contents these venture partners and/or licensees, and their action or inaction, including their failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation |
| Risks Relating to the Regulation of Our Business We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices The securities and banking industries are subject to extensive regulation |
| All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to possession and control of customer funds and securities, margin lending and execution and settlement of transactions |
| We are also subject to additional laws and rules as a result of our specialist and market maker operations |
| To the extent that, now or in the future, we solicit orders from our customers or make investment recommendations (or are deemed to have done so), or offer products and services, such as investing in futures, that are not suitable for all investors, we would become subject to additional rules and regulations governing, among other things, sales practices and the suitability of recommendations to customers |
| As part of our institutional business we provide clients access to certain third-party research tools and other services in exchange for commissions earned |
| Currently, these activities are allowed by various regulatory bodies |
| However, changes to the regulations governing these activities have been proposed in the United Kingdom and the United States |
| If the regulations are changed in a way that limits or eliminates altogether the services we could provide to clients in exchange for commissions, we may realize a decrease in our institutional commission revenues |
| Similarly, E*TRADE Financial Corporation, E*TRADE Re, LLC and ETB Holdings, Inc, as savings and loan holding companies, and the Bank, as a Federally chartered savings bank, are subject to extensive regulation, supervision and examination by the Office of Thrift Supervision (“OTS”) and, in the case of the Bank, also the Federal Deposit Insurance Corporation (“FDIC” |
| ) Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel |
| If we fail to comply with applicable securities, banking and insurance laws, rules and regulations, either domestically or internationally, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business The Securities and Exchange Commission (“SEC”), the New York Stock Exchange (“NYSE”), the NASD, Inc |
| (“NASD”) and other self-regulatory organizations and state securities commissions can, among other things, censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees |
| The OTS may take similar action with respect to our banking activities |
| Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws |
| Regulatory agencies in countries outside of the United States have similar authority |
| The ability to comply with applicable laws and rules is dependent in part on the establishment and maintenance of a reasonable compliance system |
| The failure to establish and enforce reasonable compliance procedures, even if unintentional, could subject us to significant losses or disciplinary or other actions |
| If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business The SEC, NYSE, NASD, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and regulatory capital by banks |
| Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets |
| Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC 10 ______________________________________________________________________ [88]Table of Contents and suspension or expulsion by the NYSE and/or NASD, and could ultimately lead to the firm’s liquidation |
| In the past, our broker-dealer subsidiaries have depended largely on capital contributions by us in order to comply with net capital requirements |
| If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require an intensive use of capital could be limited |
| Such operations may include investing activities, marketing and the financing of customer account balances |
| Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock |
| Similarly, the Bank is subject to various regulatory capital requirements administered by the OTS Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm a bank’s operations and financial statements |
| A bank must meet specific capital guidelines that involve quantitative measures of a bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices |
| A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors |
| Quantitative measures established by regulation to ensure capital adequacy require a bank to maintain minimum amounts and ratios of Total and Tier 1 Capital to Risk-weighted Assets and of Tier 1 Capital to adjusted total assets |
| To satisfy the capital requirements for a “well capitalized” financial institution, a bank must maintain higher Total and Tier 1 Capital to Risk-weighted Assets and Tier 1 Capital to adjusted total assets ratios |
| As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities We are required to file periodic reports with the OTS and are subject to examination by the OTS The OTS also has certain types of enforcement powers over us, ETB Holdings, Inc |
| and E*TRADE Re, LLC, including the ability to issue cease-and-desist orders, force divestiture of the Bank and impose civil and monetary penalties for violations of Federal banking laws and regulations or for unsafe or unsound banking practices |
| In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities |
| We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company |
| Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements |
| We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act, but the OTS has not yet fully interpreted these provisions |
| Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature |
| In addition, the Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies |
| Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new Bank subsidiaries and the commencement of new activities by Bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity |
| These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent |
| Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services |
| 11 ______________________________________________________________________ [89]Table of Contents Risks Relating to Owning Our Stock We have incurred losses in the past and we cannot assure you that we will be profitable We have incurred losses in the past and we may do so in the future |
| While we reported net income for the past three years, we reported a net loss of dlra186dtta4 million in 2002 |
| We may incur losses in the future |
| We expect that expensing stock options granted to our employees will have an impact on our financial results In December 2004, the FASB issued SFAS Nodtta 123(R), which among other things requires public companies to expense employee stock options and other share-based payments at their fair value when issued |
| Although we are not currently required to record any compensation expense in connection with stock option grants to employees that have an exercise price at or above fair market value, we have voluntarily elected to adopt stock option expensing for reporting periods beginning on July 1, 2005 |
| We are substantially restricted by the terms of our senior notes In June 2004, we issued an aggregate principal amount of dlra400 million of senior notes due June 2011 |
| In September and November 2005, we issued an additional aggregate principal amount of dlra100 million of senior notes due June 2011, dlra600 million of senior notes due September 2013 and dlra300 million of senior notes due December 2015 |
| The indentures governing these senior notes contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things: • incur additional indebtedness; • create liens; • pay dividends or make other distributions; • repurchase or redeem capital stock; • make investments or other restricted payments; • enter into transactions with our stockholders or affiliates; • sell assets or shares of capital stock of our subsidiaries; • restrict dividend or other payments to us from our subsidiaries; and • merge, consolidate or transfer substantially all of our assets |
| As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities |
| The terms of any future indebtedness could include more restrictive covenants |
| We cannot assure you that we will be able to remain in compliance with these covenants in the future and, if we fail to do so, that we will be able to obtain waivers from the appropriate parties and/or amend the covenants |
| Our corporate debt levels may limit our ability to obtain additional financing At December 31, 2005, we had an outstanding balance of dlra1cmam401dtta9 million in senior notes, dlra435dtta6 million in mandatory convertible notes, dlra185dtta2 million in convertible subordinated notes and dlra40dtta5 million in term loans |
| Excluding the mandatory convertible notes, our ratio of debt (our senior debt, convertible subordinated debt and term loans) to equity (expressed as a percentage) was 48prca at December 31, 2005 |
| 12 ______________________________________________________________________ [90]Table of Contents We may incur additional indebtedness in the future, including in connection with further acquisitions |
| Our level of indebtedness, among other things, could: • make it more difficult or costly for us to obtain any necessary financing in the future for working capital, capital expenditures, debt service requirements or other purposes; • make it more difficult to refinance outstanding debt; • limit our flexibility in planning for, or reacting to, changes in our business; or • make us more vulnerable in the event of a downturn in our business |
| The market price of our common stock may continue to be volatile From January 1, 2003 through December 31, 2005, the price per share of our common stock ranged from a low of dlra3dtta65 to a high of dlra21dtta71 |
| The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations |
| In the past, volatility in the market price of a company’s securities has often led to securities class action litigation |
| Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business |
| Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital and otherwise harm our business |
| We may need additional funds in the future, which may not be available and which may result in dilution of the value of our common stock In the future, we may need to raise additional funds via debt and/or equity instruments, which may not be available on favorable terms, if at all |
| If adequate funds are not available on acceptable terms, we may be unable to fund our plans for the growth of our business |
| In addition, if funds are available, the issuance of equity securities could dilute the value of our shares of our common stock and cause the market price of our common stock to fall |
| We have various mechanisms in place that may discourage takeover attempts Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable |
| Such provisions include: • authorization for the issuance of “blank check” preferred stock; • provision for a classified Board of Directors with staggered, three-year terms; • the prohibition of cumulative voting in the election of directors; • a super-majority voting requirement to effect business combinations or certain amendments to our certificate of incorporation and bylaws; • limits on the persons who may call special meetings of shareholders; • the prohibition of shareholder action by written consent; and • advance notice requirements for nominations to the Board of Directors or for proposing matters that can be acted on by shareholders at shareholder meetings |
| Attempts to acquire control of the Company may also be delayed or prevented by our stockholder rights plan, which is designed to enhance the ability of our Board of Directors to protect shareholders against unsolicited attempts to acquire control of the Company that do not offer an adequate price to all shareholders or are otherwise not in the best interests of the Company and our shareholders |
| In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), and Delaware law may also discourage, delay or prevent someone from acquiring or merging with us |