Anti-Money Laundering Violation Charges Could Have Short-Term Implications For Charles Schwab

According to recent reports, U.S. regulatory authorities including the Securities and Exchange Commission (SEC) are investigating major brokerages Charles Schwab (NYSE:SCHW) and Bank of America-Merrill Lynch (NYSE:BAC) for inadequate investigation of their customers’ identities. These companies allegedly violated anti-money laundering laws by failing to identify the true beneficial owners of their accounts. Some of these accounts have been linked to fake addresses and identified as shell companies, which were possibly involved in funding illicit criminal activities in Mexico. ^[1]

News on these alleged links comes at a bad time since brokerage firms such as of E*Trade (NASDAQ:ETFC), Charles Schwab and TD Ameritrade’s (NYSE:AMTD) were already under scrutiny related to high-frequency trading (HFT), which led to a 10-12% decline in their stock prices back in April.((High Frequency Trading Probe Spooks E*Trade Investors, 24/7 Wall street, April 2014)) More than directly impacting investment fees or transaction revenues, the news could impact investor sentiment and hurt these companies if it impacts their customer bases.

Charles Schwab is one of the largest brokerage firms in the U.S, with a market cap of about $33 billion and over 9 million brokerage accounts. We have a price estimate of just over $25, which is in line with the current market price.

See our full analysis for brokerages | Charles Schwab Corporation | TD Ameritrade | E*Trade Financial

Allegations Could Impact Customer Sentiment

The SEC is looking into Charles Schwab and Merrill Lynch for violation of anti money laundering rules that mandate brokerages to know their customers’ identities before allowing them to trade or raise money through their platforms. For both Schwab and Lynch, certain accounts with unverified owner were allegedly linked to shell companies with fake addresses which were eventually linked with funding Mexican drug cartels. ^[2] Most of the suspect Schwab account holders were located near the U.S.-Mexico border.

Earlier this week, it was reported that various New York and U.S. regulators were threatening the French bank BNP Paribas (EPA:BNP) with a range of sanctions in an effort to get it to plead guilty to moving client funds to Sudan, Iran and Cuba, in violation of U.S. sanctions.  These sanctions are said to include a fine of $5 billion by U.S. regulators, along with a temporary ban on transferring money into and out of the U.S.   As seems to be the case in these situations, what the bank is charged with will depend on how much it is willing to pay the government and what it is willing to plead guilty to. The $5 billion payment could hurt the company to  a large extent and, if much larger, could affect the company’s dividend payment scheme.  A money-transfer ban is likely to hurt the bank even further since it could end up losing customers. Additionally, the overall costs incurred by BNP Paribas to pay another financial institution to handle transactions could be up to a few hundred million dollars. ^[3]

In another such incident six years ago, E*Trade Financial Corporation was fined $1 million for failing to document customer identification practices or false reporting of secondary accounts with joint holders for about one-fourth of its 2.5 million accounts. ^[4] Again, the bigger concern for the brokerage firm was skepticism among investors and a possible loss in customer base rather than the fine incurred.

While these allegations surrounding Charles Schwab do not imply a long-term trend or a definite malpractice by the company, it could affect customer sentiment in the short term. Moreover, if deemed guilty of negligence, the company may be required to improve its verification process and forced to incur higher expenses on that front. An increase in operating costs could cut down margins. We currently project a 3% improvement in the company’s EBITDA margin for 2014 compared to the previous year. If the margins fail to improve by that extent and remain flat, there could be a 4-5% downside to our price estimate for the company’s stock.

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1. Merrill Lynch, Charles Schwab Accounts Linked To Mexican Drug Cartels: SEC, Huffington Post, May 2014 [↩]
2. SEC Probes Schwab, Merrill, For Anti-Money Laundering Violations, Reuters, May 2014 [↩]
3. BNP Paribas Risks $5 Billion Fine, Customer Flight, Bloomberg, May 2014 [↩]
4. E-Trade Hit With $1 Million Fine Over Money Laundering, Market Watch, July 2008 [↩]