Discover admits to overcharging merchants for 16 years

Discover Financial Services CEO Roger Hochschild said that beginning in 2007, the company incorrectly classified some credit card accounts in its highest merchant pricing tier.


Compliance concerns dominated Thursday’s earnings call from Discover Financial Services, as the institution faces a potential FDIC consent order over consumer compliance while juggling regulatory fallout from an earlier investigation into student loan servicing. The credit card giant also admitted to overcharging merchants for nearly 16 years.

“Beginning around mid-2007, we incorrectly classified certain card accounts in our highest pricing tier for merchants and acquirers,” Roger Hochschild, Discover’s president and chief executive, told investors Thursday when discussing second-quarter results.

Shares of Discover fell 18% to $102 per share after the company released information on its regulatory and merchant fee pricing issues on Wednesday. The company also said it was ending its share buyback program due to these issues.

Hochschild declined to provide details about the FDIC’s draft consent order, which it says is separate from the merchant fee error.

Discover has already received two consent orders from the Consumer Financial Protection Bureau around student loan service and one is still relevant. The FDIC’s proposed consent order relates to the company’s compliance management system “and other matters,” Hochschild said in an interview.

The merchant fee pricing error was discovered internally and Discover is conducting an independent investigation to assess its effect, Hochschild said. Discover plans to reimburse affected merchants and acquirers, and the total amount of compensation will likely be less than 1% of Discover’s merchant revenue and less than two basis points of what merchants typically pay to accept Discover’s credit cards, he said.

Find out regulators briefed on misclassification of merchant card acceptance fees, Hochschild said, noting, “That doesn’t mean misclassification may not result in further regulatory action, but I don’t want to speculate on that.”

Card network merchant fees have been a hot topic this week, with Square’s parent Block lawsuits against Visa and Mastercard for unfairly influencing card acceptance fees. Traders also tried to tack on a merchant swipe fee invoice other laws to change credit card network routing rules so that merchants have lower cost options.

Analysts were appalled by Discover’s compliance issues, although one noted that regulatory issues are becoming more common in the financial services industry.

“The regulatory issues are a big disappointment, but FDIC consent orders are not uncommon these days as there were 10 consent orders in the month of April and Wells Fargo itself is currently the subject of 10 separate consent orders,” Robert Napoli, a partner at equity research firm William Blair, said in a note to investors Thursday.

Partly due to escalating compliance issues, Discover’s operating expenses soared 15% in the quarter ended June 30, driven by new investments in compliance management systems, said John Greene, Discover’s chief financial officer. Compensation expense increased $73 million, or 14%, due to increased headcount. The company’s compliance costs will increase this year by about $300 million, Greene said.

The strong loan growth that Discover experienced in the first quarter is slowing. Discover’s credit card sales volume rose 2.5% in the second quarter from the same period a year earlier, but this month loan growth slowed to around 1%, Green told analysts.

Total loans increased 18.7% in the quarter to $118 billion from $100 billion in the same period a year earlier, with personal loan volume up 27% and student loan growth of 2%.

The loan loss provision charge was $1.3 billion at the end of the quarter, roughly equal to the same period a year earlier, and the company said the outlook for losses was improving, with net write-offs now forecast in the lower range of 3.4% to 3.6% for this year compared to the company’s previous projection of 3.5% to 3.8%.

Discover’s payment services volume for the second quarter was $89.3 billion, up 8% from the same period a year ago. Pulse debit volume increased 10% in the quarter and Diners Club payment card volume increased 18% from a year ago, reflecting an increase in corporate travel spending.

Deposits grew 4% in the second quarter as Discover continues its mission to become a major player digital banking center, says Hochschild. The company plans to launch a mass marketing campaign this fall for its refund debit program, which launched in May and attracted 30,000 new accounts in the first few weeks, he said.

Total revenue for the quarter ended June 30 was $3.87 billion, up 21% from $3.2 billion in the same period a year ago. The credit card charge-off rate jumped to 3.22%, up 142 basis points from a year earlier, and net income fell 18% to $901 million.

Despite its regulatory setbacks, Discover’s balance sheet is sound, John Hecht, an equity analyst at Jefferies, said in a note to investors Thursday. “Basically the business was unchanged given that the second quarter results were okay and the guidance update was in line with expectations,” Hecht wrote.