R
ISK FACTORS You should carefully consider the risks described below and all of the other information in
this information statement in evaluating us. Our business, financial condition, cash flows and/or results of operations could be materially adversely affected by any of these risks. The trading price of our common stock could decline due to any of
these risks. This information statement also contains forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us described below and elsewhere in this information statement. See “Special Note Regarding
Forward-Looking Statements.” Risks Related to Our Business We face competition from other credit card issuers, and we may not be able to compete effectively, which could result in fewer customers and lower account balances and could materially adversely affect our
financial condition, cash flows and results of operations. The credit card issuing business is highly competitive, and we compete
with other credit card issuers on the basis of a number of factors, including: merchant acceptance, products and services, incentives and reward programs, brand, network, reputation and pricing. This competition, among other things, affects our
ability to obtain applicants for our credit cards, encourage cardmembers to use our credit cards, maximize the revenue generated by card usage and generate cardmember loyalty and satisfaction so as to minimize the number of cardmembers switching to
other credit card brands. Competition is also increasingly based on the value provided to the cardholder by rewards programs. Many credit card issuers have instituted rewards programs that are similar to ours, and issuers may in the future institute
rewards programs that are more attractive to cardmembers than our programs. In addition, because most domestically issued credit cards, other than those issued by American Express, are issued on the Visa and MasterCard networks, most other card
issuers benefit from the dominant position and marketing and pricing power of Visa and MasterCard. If we are unable to compete successfully, or if competing successfully requires us to take aggressive actions in response to competitors’
actions, our financial condition, cash flows and results of operations could be materially adversely affected. We incur considerable expenses in
competing with other credit card issuers, and many of our competitors have greater scale, which may place us at a competitive disadvantage. We incur considerable expenses in competing with other credit card issuers to attract and retain cardmembers and increase card usage. A substantial portion of these expenses relates to marketing expenditures; however, traditional customer
acquisition methods have become increasingly challenging. Telemarketing has been hampered by the Federal Trade Commission’s National Do Not Call Registry, which had increased to over 125 million phone numbers as of June 2006. Direct mail
response rates have fallen, with market researcher Synovate reporting that, in the industry, only three out of every 1,000 offers generated responses in 2005 compared to approximately 28 out of every 1,000 in 1992. Because of the highly competitive nature of the credit card issuing business and increasing marketing challenges, a primary method of competition among
credit card issuers, including us, is to offer low introductory interest rates and balance transfer programs that offer a favorable annual percentage rate or other financial incentives for a specified length of time on account balances transferred
from another credit card. This type of competition has adversely affected credit card yields, and many cardholders now frequently switch credit cards or transfer their balances to another card. There can be no assurance that any of the expenses we
incur or incentives we offer to attempt to acquire and maintain accounts and increase card usage will be effective. Furthermore, many of
our competitors are larger than we are, have greater financial resources than we do and/or have lower capital costs and operating costs than we have and expect to have, and have assets such as
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branch locations and co-brand relationships that may help them compete more effectively. In addition, there is an increasing trend toward consolidation among
credit card issuers, resulting in even greater pooled resources. We may be at a competitive disadvantage as a result of the greater scale of many of our competitors. We face competition from other operators of payment networks, and we may not be able to compete effectively, which could result in reduced transaction volume, limited merchant acceptance of our cards, limited
issuance of cards on our network by third parties and materially reduced earnings. We face substantial and increasingly intense
competition in the payments industry. We compete with other payment networks to attract third-party issuers to issue credit and debit cards and other card products on the Discover and PULSE Networks. Competition with other operators of payment
networks is generally based on issuer interchange fees, other economic terms, merchant acceptance and network functionality. Competition is also based on service quality, brand image, reputation and market share. Many of our competitors are well established, larger than we are and/or have greater financial resources than we do. These competitors have provided
financial incentives to card issuers, such as large cash signing bonuses for new programs, funding for and sponsorship of marketing programs and other bonuses. Visa and MasterCard have each been in existence for more than 40 years and enjoy greater
merchant acceptance and broader global brand recognition than we do. In addition, Visa and MasterCard have entered into long-term arrangements with many financial institutions that may have the effect of preventing them from issuing credit cards on
the Discover Network or issuing debit cards on the PULSE Network. MasterCard recently completed an initial public offering, which provided it with significant capital and may enhance its strategic flexibility, and Visa recently announced its
intention to undertake an initial public offering. American Express is also a strong competitor, with international acceptance, high transaction fees and an upscale brand image. Furthermore, as a result of their dominant market position and considerable marketing and pricing power, in recent years Visa and MasterCard have been
able to aggressively increase transaction fees charged to merchants in an effort to retain and grow their issuer volume. If we are unable to remain competitive on issuer interchange and other incentives, we may be unable to offer adequate pricing to
third-party issuers while maintaining sufficient net revenues. At the same time, increasing the transaction fees charged to merchants in order to increase the interchange fees payable to credit card issuers could adversely affect our effort to
increase merchant acceptance of credit cards issued on the Discover Network and may cause merchant acceptance to decrease. See “—Our transaction volume is concentrated among large merchants, and a reduction in the number of, or rates paid
by, merchants that participate in the Discover Network could materially adversely affect our business, financial condition, results of operations and cash flows.” This, in turn, could adversely affect our ability to attract third-party issuers
and our ability to maintain or grow revenues from our proprietary network. Similarly, the PULSE Network operates in the highly competitive PIN debit business with well established and financially strong network competitors (particularly Visa) that
have the ability to offer more attractive economics and bundled products to financial institutions. In addition, if we are unable to
maintain sufficient network functionality to be competitive with other networks, our ability to attract third-party issuers and maintain or increase the revenues generated by our proprietary card issuing business may be materially adversely
affected. An inability to compete effectively with other payment networks for the reasons discussed above or any other reason could result in reduced transaction volume, limited merchant acceptance of our cards, limited issuance of cards on our
network by third parties and materially reduced earnings. Our business depends on our ability to manage our credit risks, and failing to manage
these risks successfully may result in high charge-off rates or impede our growth. We market our products to a wide range of
consumers, and our success depends on our ability to continue to manage our credit risk while attracting new cardmembers with profitable usage patterns. We select our cardmembers, manage their accounts and establish terms and credit limits using
proprietary scoring models and
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other analytical techniques designed to set terms and credit limits such that we are appropriately compensated for the credit risk we accept, while
encouraging cardmembers to use their available credit. The models and approaches we use to select, manage and underwrite our cardmembers may not accurately predict future charge-offs due to, among other things, inaccurate assumptions or models.
While we continually seek to improve our assumptions and models, we may make modifications that unintentionally cause them to be less predictive. We may also incorrectly interpret the data produced by these models in setting our credit policies. Our
ability to manage credit risk may also be adversely affected by economic conditions, legal or regulatory changes (such as bankruptcy laws, minimum payment regulations and re-age guidance), competitors’ actions and consumer behavior, as well as
inadequate collections staffing, techniques, models and vendor performance. A cardmember's ability to repay us can be negatively impacted
by changes in their payment obligations under nontraditional or non-conforming mortgage loans, including subprime mortgage loans. Such changes can result from changes in economic conditions including increases in base lending rates upon which
payment obligations are based, which in turn could adversely impact the ability of our cardmembers to meet their payment obligations to other lenders and to us and could result in higher credit losses in our portfolio. Rising delinquencies and rising rates of bankruptcy are often precursors of future charge-offs. For instance, bankruptcy rates in the United Kingdom have
increased significantly in recent years as a result of the relaxation of the bankruptcy laws, which has contributed to increases in charge-off rates in our U.K. operations. Although our delinquency rates and charge-off rates have generally decreased
in the United States in recent years, and the number of bankruptcy filings has decreased following the October 2005 effective date of the new U.S. bankruptcy legislation, we expect that our loan loss rate will increase from 2006 levels. There can be
no assurance that our lending standards will protect us against high charge-off levels. In addition, because an important source of our funding is the securitization market, an increase in delinquencies and/or charge-offs could increase our cost of
funds or unintentionally cause an early amortization event. See “— We may be unable to securitize our receivables at acceptable rates or at all, which could materially adversely affect our liquidity, cost of funds, reserves and capital
requirements.” We plan to expand in several card and consumer lending sectors. Areas of particular focus include: a small business
card, which we launched in 2006; relaunching the Miles by Discover Card product; and prepaid cards. We also continuously refine and test our credit criteria, which results in some instances in approving applications that did not previously meet our
underwriting criteria. We have less experience in these areas as compared to our traditional products and segments, and there can be no assurance that we will be able to manage our credit risk or generate sufficient revenue to cover our expenses in
these markets. Our failure to manage our credit risks may materially adversely affect our profitability and ability to grow. Economic downturns and
other conditions beyond our control could materially adversely affect our business. Economic downturns may adversely affect
consumer spending, asset values, consumer indebtedness and unemployment rates, which in turn can negatively impact our business. If general economic conditions in the United States or United Kingdom deteriorate or interest rates increase, the number
of transactions, average purchase amount of transactions, or average balances outstanding on our cards may be reduced, which would reduce transaction fees and interest income and thereby adversely affect profitability. In addition, high levels of
unemployment, low levels of spending, recessions or other conditions, including terrorism, natural disasters or the outbreak of diseases such as avian flu, may adversely affect the ability of cardmembers to pay amounts owed to us, which would
increase delinquencies and charge-offs and could materially adversely affect our business. Increases in interest rates could materially adversely
affect our earnings. Higher interest rates cause our interest expense to increase, as certain of our debt instruments carry
interest rates that fluctuate with market benchmarks. If we are unable to pass our higher cost of funds to our customers, the increase in interest expense could materially adversely affect earnings. Some of our managed receivables bear interest at a
fixed rate or do not earn interest, and we may not be able to increase the rate on those loans to
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mitigate our higher cost of funds. At the same time, our variable rate managed receivables, which are based on a market benchmark, may not increase at the
same rate as our floating rate debt instruments or may be subject to a cap. Interest rates may also adversely impact our delinquency and
charge-off rates. Many consumer lending products bear interest rates that fluctuate with certain base lending rates published in the market, such as the prime rate and LIBOR (London Interbank Offered Rate). As a result, higher interest rates often
lead to higher payment requirements by consumers under obligations to us or other lenders, which may reduce their ability to remain current on their obligations to us and thereby lead to loan delinquencies and additions to our loan loss provision,
which could materially adversely affect our earnings. In connection with the distribution, we will incur additional indebtedness that could restrict
our operations. In recent years, Morgan Stanley has provided a significant portion of our funding. Following the distribution, we
will finance our capital needs with third party funding. We are currently negotiating a multi-year unsecured committed credit facility of at least $1.75 billion, which will contain customary restrictions, covenants and events of default. See
“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Changes Related to the Distribution.” The terms of this facility and any future indebtedness may impose
various restrictions and covenants on us (such as tangible net worth requirements) that could have adverse consequences, including,
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limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry; |
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requiring us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for working capital,
capital expenditures, acquisitions and other purposes. | Giving effect to the debt that we expect to incur in connection
with the distribution, our total combined indebtedness will be approximately $25.3 billion, as compared to $22.3 billion at February 28, 2007. The increase in indebtedness primarily represents incremental deposits obtained to establish a
$5 billion liquidity reserve. See “Unaudited Pro Forma Condensed Combined Financial Statements.” We may also incur additional substantial indebtedness in the future. We may be unable to securitize our receivables at acceptable rates or at all, which could materially adversely affect our liquidity, cost of funds, reserves and capital requirements. The securitization of credit card receivables, which involves the transfer of receivables to a trust and the issuance by the trust of beneficial interests
to third-party investors, is our largest single source of funding. Factors affecting our ability to securitize our credit card receivables at acceptable pricing levels, or at all, include the overall credit quality of our receivables, negative
credit ratings action affecting our asset-backed securities (or Discover Bank), the stability of the market for securitization transactions, investor demand, and the legal, regulatory, accounting and tax requirements governing securitization
transactions. In addition, future changes to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, as amended, may make it more
difficult for us to maintain sale accounting treatment for our securitizations under GAAP or may require us to recognize securitizations on our combined statements of financial condition, which could substantially increase Discover Bank’s
regulatory capital requirements. Our results of operations and financial condition could also be materially adversely affected by the
occurrence of events that could result in the early amortization of our securitization transactions. Credit card securitizations are normally structured as “revolving transactions” that do not distribute to securitization investors their
share of monthly principal payment on the receivables during the revolving period, and instead
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use those payments to fund the purchase of replacement receivables. The occurrence of “early amortization events” may result in termination of the
revolving period of our securitization transactions. Early amortization events include, for example, insufficient cash flows in the securitized pool of receivables to meet contractual requirements, certain breaches of representations, warranties or
covenants in the agreements relating to the securitization, and bankruptcy or insolvency. If we are unable to continue to securitize our
credit card receivables at acceptable pricing levels, or at all, including by reason of the early amortization of any of our securitization transactions, we would seek to liquidate investment securities, increase bank deposits and use alternative
funding sources to fund increases in loan receivables and meet our other liquidity needs. In the event of an economic early amortization, receivables that otherwise would have been subsequently purchased by the trust from us would instead
continue to be recognized on our combined statements of financial condition since the cash flows generated in the trust would instead be used to repay investors in the asset-backed securities. Recognizing these receivables would require us
to obtain alternative funding. Our available investment securities and other alternative sources may be insufficient to meet our funding needs, which could materially adversely affect our liquidity, cost of funds, reserves and capital
requirements. Declines in the value of, or income earned from, our retained interests in our securitization transactions could materially adversely
affect our financial condition, results of operations and cash flows. We retain interests in the assets transferred to or created
in our securitization transactions and earn income from these assets. The value of our retained interests and the amount of income that we earn depend on many factors, including, among others, the revenues, performance and credit risk of the
securitized loans, which are subject to the same risks and uncertainties as loans that we have not securitized. The value of our interests may also change because of changes in the assumptions used to estimate their fair value, such as market
interest rates and other conditions, increases in bankruptcy or charge-off rates, payment rates and changes in the interpretation and application of accounting rules relating to such valuation. In 2007, we expect bankruptcy receipts to rise from the
abnormally low levels experienced in 2006, and accordingly to have an adverse impact on our results of operations as compared to 2006. Higher bankruptcy receipts will have the effect of increasing credit losses, increasing provisions to the
allowance for loan losses and decreasing excess spread projections on securitization transactions, thereby adversely impacting the valuation of the interest-only strip receivable. If the income that we earn from our retained interests in
securitization transactions were to decrease or the value of our retained interests were to decrease, our financial condition, results of operations and cash flows could be materially adversely affected. An inability to accept brokered deposits in the future could materially adversely affect our liquidity position and funding costs. The Federal Deposit Insurance Act (“FDIA”) prohibits a bank, including our subsidiaries Discover Bank and Bank of New Castle, from accepting
brokered deposits or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well-capitalized or
(2) it is adequately capitalized and receives a waiver from the Federal Deposit Insurance Corporation (“FDIC”). A bank that is adequately capitalized and that accepts brokered deposits under a waiver from the FDIC may not pay an
interest rate on any deposit in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is well-capitalized. While Discover Bank and Bank of New Castle each met the FDIC’s definition of
“well-capitalized” as of November 30, 2006, there can be no assurance that they will continue to meet this definition. An inability to accept brokered deposits in the future could materially adversely affect our liquidity position and
funding costs. We rely in part on unsecured debt for our funding and the inability to access the U.S. or U.K. debt markets could materially
adversely affect our business, financial condition and results of operations. While our primary sources of funding are
securitizations and brokered deposits, we are also dependent on access to the U.S. and U.K. unsecured debt markets to fund our managed receivables as well as other assets. In
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general, the amount, type and cost of our funding directly affects the cost of operating our business and growing our assets and is dependent upon outside
factors such as our credit rating from ratings agencies. Historically we have benefited from Morgan Stanley’s credit ratings (Morgan Stanley is rated A+ by Standard & Poor’s (“S&P”), Aa3 by Moody’s Investors Service
(“Moody’s”) and AA- by Fitch Ratings (“Fitch”)). Following the announcement of the distribution, Moody’s and Fitch placed Discover Bank’s debt ratings on negative watch. Moody’s and Fitch reports indicated
that if the distribution occurs as planned, they expect to assign a long-term investment grade rating to Discover Bank (Baa2 deposit, Baa3 senior unsecured from Moody’s and BBB from Fitch). Discover Bank’s credit rating as a stand-alone
entity from S&P is expected to be BBB. The difference in ratings categories between Morgan Stanley and us reflects the relative risks associated with the different businesses. While business risks are complex and difficult to compare between
businesses as different as Morgan Stanley’s and ours, generally Morgan Stanley is more diversified and has greater overall scale than us. A rating is not a recommendation to purchase, sell or hold any particular security. In addition, there can
be no assurance that a rating will be maintained for any given period of time or that a rating will not be lowered or withdrawn in its entirety. If our ratings are for any reason further reduced or we are unable to access the U.S. or U.K. unsecured
debt markets for any reason, our business, financial condition and results of operations could be materially adversely affected. In
response to the exploration of the spin-off in 2005, Moody’s placed the asset-backed securities issued domestically by the Discover Card Master Trust under review for a possible downgrade, which we believe contributed to a temporary disruption
in our ability to access the securitization markets, increasing our reliance on intercompany funding and deposit markets. This disruption lasted approximately five months, at which time Moody’s reaffirmed the ratings on the asset-backed
securities. We may be unable to increase or sustain Discover Card usage, which could impair growth in, or lead to diminishing, average balances and
total revenue. A key element of our strategy is to increase the usage of the Discover Card by our cardmembers, including making it
their primary card, and thereby increase our revenue from transaction and service fees and our managed receivables. However, our cardmembers’ use and payment patterns may change because of social, legal and economic factors, and cardmembers may
decide not to increase card usage or may decide to pay the balances within the grace period to avoid finance charges. We face challenges from competing credit card products in our attempts to increase credit card usage by our existing cardmembers.
Our ability to increase cardmember usage is also dependent on cardmember satisfaction, which may be adversely affected by factors outside of our control, including competitors’ actions. As part of our strategy to increase usage, we are seeking
to increase the number of merchants who accept cards issued on the Discover Network. If we are unable to increase merchant acceptance of our cards, our ability to grow usage of Discover Cards may be hampered. As a result of these factors, we may be
unable to increase or sustain credit card usage, which could impair growth in, or lead to diminishing, average balances and total revenue. We may be
unable to grow earnings if we do not attract new cardmembers, or if we attract cardmembers with unfavorable spending and payment habits. We are seeking to increase managed receivables by attracting new cardmembers who will use their Discover Cards, meet their monthly payment obligations and maintain balances that generate interest and fee income for us. We are subject to
substantial competition from other credit card issuers for these new cardmembers. We plan to continue marketing the Discover Card, but we may not have adequate financial resources to permit us to incur all of the marketing costs that may be
necessary to maintain or grow our managed receivables or to attract new accounts. The spending and payment habits of these new cardmembers may not be sufficient to make their accounts as profitable as we expect. In addition, our risk models may not
accurately predict the credit risk for these new cardmembers, which could result in unanticipated losses in future periods. To the extent that the spending and payment habits of new cardmembers do not meet our expectations, our earnings and growth
may be negatively affected.
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Our transaction volume is concentrated among large merchants, and a reduction in the number of, or rates paid by,
merchants that participate in the Discover Network could materially adversely affect our business, financial condition, results of operations and cash flows. Discover Card transaction volume was concentrated among our top 100 merchants in 2006. These merchants may pressure us to reduce our rates by continuing to participate in the Discover Network only on the condition
that we change the terms of their economic participation. At the same time, we are subject to increasing pricing pressure from third-party issuers as a result of the continued consolidation in the banking industry, which results in fewer large
issuers that, in turn, generally have a greater ability to negotiate pricing discounts. In addition, many of our merchants, primarily our small and mid-size merchants, are not contractually committed to us for any period of time and may cease to
participate in the Discover Network at any time on short notice. In addition, actual and perceived limitations on acceptance of credit
cards issued on the Discover Network could adversely affect the use of the Discover Card by existing cardmembers and the attractiveness of the Discover Card to prospective new cardmembers. Furthermore, we may have difficulty attracting and retaining
third-party issuers if we are unable to add and retain merchants on the Discover or PULSE Networks. As a result of these factors, a reduction in the number of, or rates paid by, our merchants could materially adversely affect our business, financial
condition, results of operations and cash flows. We may be unable to grow earnings if we are unable to increase the number of small and mid-size
merchants that participate in the Discover Network. In seeking to expand our merchant acceptance among small and mid-size
merchants, we have recently started to use third-party acquirers and processors to obtain merchants and process payments for these merchants on an integrated basis with Visa and MasterCard payments. This strategy could have results that we do not
anticipate, such as decreased revenues, higher expenses, degraded service levels and retaliatory responses from competitors. There can be no assurance that the use of third-party acquirers and processors will increase merchant acceptance among small
or mid-size merchants. If we are unable to increase small and mid-size merchant acceptance, our ability to grow earnings could be adversely affected. Our business, financial condition and results of operations may be adversely affected by the increasing focus of merchants on the fees charged by credit card networks. Merchant acceptance and fees are critical to the success of both our card issuing and payment processing businesses. Merchants have shown increasing
concern with the levels of fees charged by credit card companies, and have in the past and may in the future seek to negotiate better pricing or other financial incentives as a condition to continued participation in the Discover Network. During the
past few years, merchants and their trade groups have filed approximately 50 lawsuits against Visa, MasterCard, American Express and their card-issuing banks, claiming that their practices toward merchants, including interchange fees, violate
federal antitrust laws. There can be no assurance that they will not in the future bring legal proceedings against other credit card issuers and networks, including us. Merchants may also promote forms of payment with lower fees, such as PIN debit,
or seek to impose surcharges at the point of sale for use of credit cards. Merchants may also route debit transactions to other networks in order to achieve more favorable pricing. The heightened focus by merchants on the fees charged by credit card
networks, including us, could lead to reduced merchant acceptance of Discover Network cards or reduced fees, either of which could adversely affect our business, financial condition and results of operations. Our U.K. operations are currently not profitable, and there can be no assurance when or if they will become profitable. Our U.K. operations are an important part of our business strategy, and strengthening these operations is one of our primary goals. However, the U.K.
market is currently experiencing high delinquencies and rising bankruptcy levels, compounded by changing regulations, which have resulted in losses in our U.K. operations.
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Additionally, the United Kingdom has relatively low levels of interchange and fee income and lower net interest margin, which has resulted in and may
continue to result in insufficient revenues to compensate for the current levels of loan losses. Our U.K. operations also have a relatively higher cost structure given their smaller scale. In addition, we recorded significant goodwill on our combined statements of financial condition in connection with our acquisition of Goldfish in 2006.
We may in the future be required to write down goodwill associated with this acquisition. Our strategy to expand our operations in the
United Kingdom may also be unsuccessful for several other reasons, including many of those that are applicable to our attempts to expand our business domestically. In addition to the challenging market conditions described above, U.K. and European
regulators have recently increased their focus on the credit card industry. There can be no assurance when or if our U.K. operations will become profitable. We expect to continue to incur significant expenses in the litigation we are pursuing against Visa and MasterCard, and there can be no assurance that we will ultimately be successful in this action. In October 2004, the DOJ prevailed in its antitrust litigation against Visa and MasterCard which challenged their exclusionary practices. Following this
ruling, we filed a complaint against Visa and MasterCard seeking substantial damages for the market foreclosure caused by their anticompetitive rules. The trial date is expected to be no later than Fall 2008. We expect to continue to incur
substantial legal expenses in the litigation we are pursuing against Visa and MasterCard. Outside counsel and consultant legal expenses for this litigation were approximately $51 million and $8 million in 2006 and 2005, respectively, with the
year-over-year increase primarily due to discovery-related expenses incurred in 2006. Fact discovery is scheduled to be completed in May 2007 and as such, 2007 expenses associated with this litigation are expected to be lower than 2006 expenses.
Furthermore, there can be no assurance that we will be successful in recovering any damages in this action. Upon successful resolution of the litigation, after expenses, we will be required to pay Morgan Stanley the first $700 million of value of
cash or non-cash proceeds (increased at the rate of 6% per annum until paid in full) (the “minimum proceeds”), plus 50% of any proceeds in excess of $1.5 billion, subject to certain limitations and a maximum potential payment to
Morgan Stanley of $1.5 billion. All payments by Discover to Morgan Stanley will be net of taxes payable by Discover with respect to such proceeds. If, in connection with or following a change of control of Discover, the litigation is settled for an
amount less than the minimum proceeds, Discover will be required to pay Morgan Stanley an amount equal to the minimum proceeds. As a result of our agreement to pay the value of non-cash proceeds, we may be required to pay amounts to Morgan Stanley
in excess of cash received in connection with the litigation. The value of non-cash proceeds will be determined by an independent third party. Visa
and MasterCard may enact additional restrictions on issuing banks, merchants or merchant acquirers that materially adversely affect the Discover or PULSE Networks, or the Discover Card issuing business. Visa and MasterCard aggressively seek to protect their networks from competition and have used their rules and policies to do so. For example, in the past
they enacted and enforced rules that prohibited their member banks from issuing cards on competing payment networks such as Discover. These rules were ultimately found to violate the antitrust laws. They have adversely affected our business in the
past, and they may have lingering effects going forward. Visa and MasterCard also may enact new rules or enforce other rules in the future, including limiting the ability of issuing banks to use the PULSE Network, which may materially adversely
affect our ability to compete. If fraudulent activity associated with our cards increases, our brands could suffer reputational damage, the use of
our cards could decrease and our fraud losses could be materially adversely affected. We are subject to the risk of fraudulent
activity associated with merchants, cardmembers and other third parties handling cardmember information. Credit and debit card fraud, identity theft and related crimes are
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prevalent and perpetrators are growing ever more sophisticated. Our financial condition, the level of our fraud charge-offs and other results of operations
could be materially adversely affected if fraudulent activity were to significantly increase. In addition, significant increases in fraudulent activity could lead to regulatory intervention (such as mandatory card reissuance) and reputational and
financial damage to our brands, which could negatively impact the use of our cards and thereby have a material adverse effect on our business. If
our security systems, or those of merchants, merchant acquirers or other third parties containing information about cardholders, are compromised, we may be subject to liability and damage to our reputation. Our security protection measures, including the security of transaction information processed on our systems or the systems or processing technology of
third parties participating in the Discover or PULSE Networks, may not be sufficient to protect the confidentiality of information relating to cardholders or transactions processed on the Discover or PULSE Networks. Cardholder data is also stored on
systems of third-party service providers and merchants that may not have adequate security systems. Third-party carriers regularly transport cardholder data, and they may lose sensitive cardholder information. Unauthorized access to the Discover or
PULSE Networks or any other Discover information systems potentially could jeopardize the security of confidential information stored in our computer systems or transmitted by our cardmembers or others. If our security systems or those of merchants,
processors or other third-party service providers are compromised such that this confidential information is disclosed to unauthorized parties, we may be subject to liability. The preventive measures we take to address these factors are costly, and
may become more costly in the future. Moreover, these measures may not protect us from liability, which may not be adequately covered by insurance, or from damage to our reputation. The financial services and payment services industries are rapidly evolving, and we may be unsuccessful in introducing new products or services in response to this evolution. The financial services and payment services industries experience constant and significant technological changes, such as continuing development of
technologies in the areas of smart cards, radio frequency and proximity payment devices, electronic commerce and mobile commerce, among others. The effect of technological changes on our business is unpredictable. We depend in part on third parties for the development of and access to new technologies. We expect that new services and technologies relating to the
payments business will continue to appear in the market, and these new services and technologies may be superior to, or render obsolete, the technologies that we currently use in our card products and services. As a result, our future success is in
part dependent on our ability to identify and adapt to technological changes and evolving industry standards and to provide payment solutions for our cardmembers and merchant and financial institution customers. Difficulties or delays in the development, production, testing and marketing of new products or services may be caused by a number of factors including,
among other things, operational, capital and regulatory constraints. The occurrence of such difficulties may affect the success of our products or services, and developing unsuccessful products and services could result in financial losses, as well
as decreased capital availability. In addition, the new products and services offered may not be attractive to our cardmembers and merchant and financial institution customers. If key technology platforms such as our transaction authorization and settlement systems become obsolete, or if we encounter difficulties processing transactions efficiently or at all, our revenue or results of
operations could be materially adversely affected. Our transaction authorization and settlement systems may encounter service
interruptions due to system or software failure, fire, natural disasters, power loss, disruptions in long distance or local telecommunications access, terrorism or accident. Some of our transaction processing systems are operated at a single
facility and
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could be subject to service interruptions in the event of failure. Our services could be disrupted by a natural disaster or other problem at any of our
primary or back-up facilities or our other owned or leased facilities. We also depend on third-party service providers for the timely
transmission of information across our data transportation network and for other telecommunications and technology services, including ancillary transaction processing services for the PULSE Network. Regardless of whether as a result of natural
disaster, operational disruption, terrorism, termination of its relationship with us, or any other reason, if a service provider fails to provide the communications capacity or deliver services that we require or expect, the failure could interrupt
our services and operations and hamper our ability to process cardholders’ transactions in a timely and accurate manner or to maintain thorough and accurate records of those transactions. Such a failure could adversely affect the perception of
the reliability of the Discover and PULSE Networks and the quality of our brands, and could materially adversely affect our revenues or results of operations. Merchant defaults may adversely affect our business, financial condition, cash flows and results of operations. As
an issuer and merchant acquirer in the United States on the Discover Network, and an issuer in the United Kingdom on the MasterCard and Visa networks, we may be contingently liable for certain disputed credit card sales transactions that arise
between cardholders and merchants. If a dispute is resolved in the cardholder’s favor, we will cause a credit or refund of the amount to be issued to the cardholder and charge back the transaction to the merchant. If we are unable to collect
this amount from the merchant or a third-party acquirer, we will bear the loss for the amount credited or refunded to the cardholder. Where the purchased product or service is not provided until some later date following the purchase, such as an
airline ticket, the likelihood of potential liability increases. See Note 20: Commitments, Contingencies and Guarantees to the audited combined financial statements and Note 7: Commitments, Contingencies and Guarantees to the unaudited condensed
combined financial statements. Our success is dependent, in part, upon our executive officers and other key personnel, and the loss of key personnel
could materially adversely affect our business. Our success depends, in part, on our executive officers and other key personnel.
Our senior management team has significant industry experience and would be difficult to replace. Moreover, our senior management team is relatively small and we believe we are in a critical period of competition in the financial services and
payments industry. The market for qualified individuals is highly competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. The
loss of key personnel could materially adversely affect our business. We may be unsuccessful in protecting our intellectual property, including our
brands. The Discover, Goldfish and PULSE brands are very important assets, and our success is dependent on our ability to protect
these and our other intellectual property. We may not be able to successfully protect our intellectual property. If others misappropriate, use or otherwise diminish the value of our intellectual property, our business could be adversely affected.
Increased usage by consumers of credit sources such as home equity loans and mortgage refinancings instead of credit card borrowings could adversely
affect our business. During the last few years, lower interest rates and other factors have led to increased availability to
consumers of credit sources such as home equity loans and mortgage refinancings at comparatively attractive interest rates. These and other options for consumer credit compete with our card products as alternative sources for consumer borrowing, as
consumers may finance expenditures or refinance account balances with these alternative sources of credit. Increased usage by consumers of such alternative sources of credit could adversely affect our businesses.
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Acquisitions that we pursue could disrupt our business and harm our financial condition. We may consider or undertake strategic acquisitions of businesses, products or technologies. If we do so, we may not be able to successfully finance or
integrate any such businesses, products or technologies. In addition, the integration of any acquisition may divert management’s time and resources from our core business and disrupt our operations. We may allocate resources, such as time and
money, on projects that do not increase our earnings. To the extent we pay the purchase price of any acquisition in cash, it would reduce our cash balances; similarly, if the purchase price is paid with our stock, it could be dilutive to our
stockholders. We are subject to regulation by a number of different regulatory agencies, which have broad discretion to require us to alter our
operations in ways that could adversely affect our business or subject us to penalties for noncompliance. We must comply with an
array of banking and consumer lending laws and regulations at the state, federal, U.K. and European levels, and these laws and regulations apply to almost every aspect of our business. We are subject to regulation and regular examinations by the
FDIC, the Office of the Delaware State Bank Commissioner and the Financial Services Authority of the United Kingdom (“FSA”). In addition, we are subject to regulation by the Federal Reserve Board, the Federal Trade Commission, state
banking regulators and European regulators. From time to time, these regulations and regulatory agencies have required us to alter certain of our operating practices, and may require us to do the same in the future. Our ability to introduce new
products may be impaired or delayed as a result of regulatory review or failure to obtain required regulatory approvals. We conduct our business primarily through our banks, and various federal, state and European regulators have broad discretion to
impose restrictions on our operations. U.S. federal and state consumer protection laws and rules, and laws and rules of foreign jurisdictions where we conduct business limit the manner and terms on which we may offer and extend credit. Failure to
comply with these laws and regulations could lead to consequences such as financial, structural, reputational and operational penalties, including receivership. In addition, efforts to abide by these laws and regulations may increase our costs of
operations or limit our ability to engage in certain business activities, including affecting our ability to generate or collect receivables from cardmembers. Changes in regulations, or the application thereof, may adversely affect our business, financial condition and results of operations. Periodically, regulatory authorities may enact new laws or amend existing laws to further regulate the industries in which we operate. Such new laws or rules could impose limits on the amount of interest or fees we
can charge, curtail our ability to collect on account balances, increase compliance costs or materially affect us or the credit card industry in some other manner. For instance, in the past we have been obligated by industry-wide regulatory guidance
to change our re-age policy to alter the terms under which delinquent accounts are returned to a current status, which negatively affected our charge-off and delinquency rates. Also, in response to industry-wide regulatory guidance, we increased
minimum payment requirements on certain credit card loans and modified our overlimit fee policies and procedures to stop charging such fees for accounts meeting specific criteria, which have impacted, and we believe will continue to negatively
impact, balances of credit card loans and related interest and fee revenue and charge-offs. We cannot predict whether any additional or similar regulatory changes will occur in the future. Members of Congress are currently holding hearings on certain practices in the credit card industry, including those relating to grace periods, two-cycle
billing method (which we utilize on most of our products), interest rates and fees. It is not clear at this time whether new limitations on credit card practices will be adopted by Congress or at the state level and, if adopted, what impact such new
limitations would have on us. In addition, the laws governing bankruptcy and debtor relief in the United States, the United Kingdom or other countries where we have cardmembers, could also change, making it more expensive or more difficult for us to
collect from our cardmembers. Also, Congress may move to regulate holding companies that own depository institutions, such as us, which could result in additional complexity and expense. Furthermore, various federal and state agencies and
standard-setting bodies may, from time to time, enact new or amend existing accounting rules or standards that could impact our business practices or funding transactions.
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Regulation of the credit card industry, including regulation applicable to Discover Card and merchants
that accept it, has expanded significantly in recent years. For instance, financial institutions, including us, were required to implement an enhanced anti-money laundering program in 2002 pursuant to the USA PATRIOT Act. Various U.S. federal and
state regulatory agencies and state legislatures are considering new legislation or regulations relating to the use of credit cards to purchase online prescription drugs and to finance Internet gambling, patent reform, identity theft, account
maintenance guidelines, privacy, disclosure rules, data security and marketing that could have a direct effect on us and our merchant and financial institution customers. In the United Kingdom, during the last three years there have been increasing regulatory initiatives with respect to late and overlimit fees, interchange fees and the sale of retail insurance products, a relaxation of
bankruptcy laws and an increase in industry-wide consumer protection measures. We expect that these initiatives and measures will continue to increase our compliance costs and the risk of consumer complaints, litigation and regulatory inquiries, as
well as materially adversely affect the economics of our business. Current and proposed regulation addressing consumer privacy and data use and
security could inhibit the number of payment cards issued and increase our costs. Regulatory pronouncements relating to consumer
privacy, data use and security affect our business. In the United States, we are subject to the Federal Trade Commission’s and the banking regulators’ information safeguard rules under the Gramm-Leach-Bliley Act. The rules require that
financial institutions (including us) develop, implement and maintain a written, comprehensive information security program containing safeguards that are appropriate to the financial institution’s size and complexity, the nature and scope of
the financial institution’s activities, and the sensitivity of any customer information at issue. Both the United States and the United Kingdom have experienced a heightened legislative and regulatory focus on data security, including requiring
consumer notification in the event of a data breach. In the United States, there are a number of bills pending in Congress and in individual states, and there have been numerous legislative hearings focusing on these issues. In addition, a number of
states have enacted security breach legislation requiring varying levels of consumer notification in the event of certain types of security breaches, and several other states are considering similar legislation. In the United Kingdom, there are
detailed regulations on data privacy under the European Commission Data Protection Directive (Directive 95/46/EC) and the U.K. Data Protection Act of 1998, which are enforced by the Information Commissioner, the United Kingdom’s privacy
regulator. Regulation of privacy and data use and security may cause an increase in the costs to issue payment cards and/or may decrease
the number of our cards that we or third parties issue. New regulations in these areas may also increase our costs to comply with such regulations, which could materially adversely affect our earnings. In addition, failure to comply with the privacy
and data use and security laws and regulations to which we are subject, including by reason of inadvertent disclosure of confidential information, could result in fines, sanctions or other penalties and loss of consumer confidence, which could
materially adversely affect our results of operations, overall business and reputation. Legislation or regulation could be enacted requiring us to
hold higher levels of capital, which we may not be able to obtain and which would reduce our return on capital. Discover Bank and
Bank of New Castle are subject to capital, funding and liquidity requirements prescribed by statutes, regulation and orders. If new legislation or regulations are enacted that increase the levels of regulatory capital that are required, we may be
required to obtain additional capital. In addition, regulators have broad discretion to impose additional capital and other requirements on us, including imposing restrictions on the ability of our regulated subsidiaries to pay dividends. Our
ability to obtain additional capital would be dependent upon, among other things, general economic conditions, our financial performance and prospects, and our ability and willingness to make capital contributions to Discover Bank and Bank of New
Castle. If we were required to increase capital for Discover Bank or Bank of New Castle, it would have the effect of reducing our return on capital. In addition, if Discover Bank and Bank of New Castle were to fail to meet these regulatory capital
requirements, it would become subject to restrictions that could materially adversely affect our ability to conduct normal operations.
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Litigation and regulatory actions could subject us to significant fines, penalties and/or requirements resulting in
increased expenses. Businesses in the credit card industry have historically been subject to various significant legal actions,
including class action lawsuits. Many of these actions have included claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. While we have historically relied on our arbitration clause in
agreements with cardmembers, which has limited our exposure to consumer class action litigation, there can be no assurance that we will continue to be successful in enforcing our arbitration clause in the future or that we will not be subject to
significant legal actions such as those to which some of our competitors have been subject. In addition, we may be involved in various actions or proceedings brought by governmental regulatory agencies in the event of noncompliance with laws or
regulations, which could subject us to significant fines, penalties and/or requirements resulting in increased expenses. Risks Related
to Our Separation from and Relationship with Morgan Stanley After our separation from Morgan Stanley, our cost of funding will increase and our
liquidity may decrease. In recent years, Morgan Stanley has provided a significant portion of our funding and is not expected to
continue to do so following the distribution. As of February 28, 2007, we had approximately $22.3 billion of indebtedness outstanding, of which approximately $6.5 billion was funding sourced through Morgan Stanley. We are expected to have lower
credit ratings and more constrained liquidity than our current parent company, Morgan Stanley. A credit ratings downgrade to below investment grade would reduce our investor base and increase our cost of funding. Our liquidity may also decrease, and
we may be less able to withstand a liquidity stress event. We may also face additional challenges in the future, including more limited capital resources to invest in or expand our businesses. See “Arrangements Between Us and Morgan
Stanley.” As part of the separation from Morgan Stanley, we will refinance existing intercompany funding and make certain payments to Morgan
Stanley. In connection with the distribution, we expect to replace funding provided through Morgan Stanley intercompany
arrangements, which totaled $6.5 billion at February 28, 2007, with alternative sources at market rates available to us, including certificates of deposit, external deposits from broker-dealers, asset-backed financing and unsecured long-term debt.
We also expect to settle any intercompany payables with Morgan Stanley, which amounted to $200 million as of February 28, 2007. If we are unable to replace the funding sourced through Morgan Stanley, our financial condition and results of operations
would be negatively affected. In addition, to the extent the capital on our combined statements of financial condition exceeds our capital
requirements prior to the distribution as determined by us and Morgan Stanley, such excess amounts will be distributed to Morgan Stanley in the form of a dividend prior to the distribution. For additional information regarding our anticipated financing arrangements and payments to Morgan Stanley, see “Unaudited Pro Forma Condensed
Combined Financial Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” Our historical financial results are as a business segment of Morgan Stanley and therefore may not be representative of our results as a separate, stand-alone company. The historical financial information we have included in this information statement has been derived from Morgan Stanley’s consolidated financial
statements and does not necessarily reflect what our financial condition, results of operations or cash flows would have been had we operated as a separate, stand-alone company during the periods presented. The historical costs and expenses
reflected in our audited combined financial statements include an allocation for certain corporate functions historically provided by Morgan Stanley, including general
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corporate expenses, employee benefits and incentives. These allocations were based on what we and Morgan Stanley considered to be reasonable reflections of
the historical utilization levels of these services required in support of our business. The historical information does not necessarily indicate what our results of operations, financial condition, cash flows or costs and expenses will be in the
future. Our pro forma adjustments reflect changes that may occur in our funding and operations as a result of the separation. However, we cannot assure you that these adjustments will reflect our costs as a publicly traded, stand-alone company. For
additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Selected Historical and Pro Forma Combined Data,” “Unaudited Pro Forma Condensed Combined Financial
Statements” and the notes to those statements included elsewhere in this information statement. The obligations associated with being a public
company will require significant resources and management attention. In connection with the distribution, we will become subject to
the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). The Exchange Act requires that we file annual, quarterly and
current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires, among other things, that we establish and maintain effective internal controls and procedures for financial reporting. All of the procedures and
practices required as a subsidiary of Morgan Stanley were previously established but we will have additional procedures and practices to establish as a separate, stand-alone public company. As a result, we will incur significant legal, accounting
and other expenses that we did not previously incur. Furthermore, the need to establish the corporate infrastructure demanded of a public company may divert management’s attention from implementing our growth strategy, which could prevent us
from improving our business, results of operations and financial condition. We have made, and will continue to make, changes to our internal controls and procedures for financial reporting and accounting systems to meet our reporting obligations.
However, the measures we take may not be sufficient to satisfy our obligations as a public company. In addition, we cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements. Section 404 of the Sarbanes-Oxley Act requires annual management assessments of the effectiveness of our internal control over financial reporting,
starting with the second annual report that we file with the SEC, and, in the annual report for the next succeeding year, a report by our independent auditors addressing such assessments. However, if we determine that we are eligible to use, and
decide during 2007 to file, a short form registration statement, we will be required to comply with Section 404 as of November 30, 2007. In connection with the implementation of the necessary procedures and practices related to internal
controls over financial reporting, we may identify deficiencies that we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. We will be unable to issue
securities in the public markets through the use of a shelf registration statement if we are not in compliance with Section 404. In addition, failure to achieve and maintain an effective internal control environment could have a material
adverse effect on our business and stock price. After our separation from Morgan Stanley, we may experience increased costs resulting from a
decrease in the purchasing power and other operational efficiencies we currently have due to our association with Morgan Stanley. We have been able to take advantage of Morgan Stanley’s purchasing power in procuring goods, technology and services, including insurance, employee benefit support and audit services, and as a smaller separate, stand-alone company, we
may be unable to obtain goods, technology and services at prices and on terms as favorable as those available to us prior to the separation, which could have a material adverse effect on our business, financial condition, cash flows and results of
operations. Our tax liability may also increase due to increased state income taxes in the jurisdictions where combined filings were previously made with Morgan Stanley.
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In connection with our separation from Morgan Stanley, we will assume past, present and future liabilities related
to our business, and will enter into agreements relating to the ongoing provision of services and other matters which may be on terms less favorable to us than if they had been negotiated with another party. Pursuant to certain agreements we will enter into with Morgan Stanley prior to the distribution, we will agree to indemnify Morgan Stanley for, among
other matters, past, present and future liabilities related to our business. Such liabilities will include unknown liabilities, which could be significant. We will enter into these agreements and other agreements relating to the ongoing provision of services and other matters with Morgan Stanley while still a wholly-owned subsidiary of Morgan Stanley. Accordingly, the
terms of those agreements may not reflect those that would have been reached with another party. If these agreements were to be entered into with another party, we may have obtained more favorable terms than under these agreements. We must abide by certain restrictions to preserve the tax treatment of the distribution and we must indemnify Morgan Stanley for taxes resulting from certain
actions we take that cause the distribution to fail to qualify as a tax-free transaction. Morgan Stanley has received a ruling from
the Internal Revenue Service that, based on customary representations and qualifications, the distribution will be tax-free to Morgan Stanley stockholders for U.S. federal income tax purposes. These representations include representations as to the
satisfaction of certain requirements that must be met in order for the distribution to qualify for tax-free treatment under the Internal Revenue Code of 1986, as amended (the “Code”), and state law. If any of the representations and
assumptions upon which the ruling is based is untrue or incomplete in any material respect, Morgan Stanley may not be able to rely upon the ruling. If the distribution were not to qualify for tax-free treatment under sections 355, 368 and related provisions of the Code, Morgan Stanley would recognize taxable gain equal to the excess of the fair market value of our stock over Morgan
Stanley’s tax basis in our stock. Under certain circumstances, we would be required under the U.S. tax sharing agreement to be entered into between Morgan Stanley and us to indemnify Morgan Stanley for all or a portion of this liability. In
addition, each holder who receives our common stock in the distribution would be treated as receiving a taxable distribution in an amount equal to the fair market value of our common stock received. Even if the distribution otherwise qualifies as a tax-free distribution under the Code, current tax law generally creates a presumption that the
distribution would be taxable to Morgan Stanley (but not to its stockholders) if we engage in, or enter into an agreement to engage in, a transaction that would result in a 50% or greater change, by vote or by value, in our stock ownership during
the four-year period beginning on the date that begins two years before the distribution date, unless it is established that the transaction is not pursuant to a plan or series of transactions related to the distribution. Treasury regulations
currently in effect generally provide that whether an acquisition transaction and a distribution are part of a plan is determined based on all of the facts and circumstances including, but not limited to, specific factors listed in the regulations.
In addition, the regulations provide several “safe harbors” for acquisition transactions that are not considered to be part of a plan. Under the U.S. tax sharing agreement to be entered into between Morgan Stanley and us, for a period of two years following the distribution, generally we may not take certain actions unless Morgan Stanley provides us with prior written
consent for such action, or we provide Morgan Stanley with a tax ruling or rulings, or an unqualified opinion of counsel, in each case acceptable to Morgan Stanley, to the effect that the action will not affect the tax-free nature of the separation
and distribution, but we will remain liable for any taxes and other liabilities imposed as a result of the separation and distribution failing to qualify as a tax-free transaction, as a result of such action. These restrictions may prevent us from
entering into strategic or other transactions which might be advantageous to us or to our stockholders, such as issuing equity securities to satisfy our financing needs, acquiring businesses or assets by issuing equity securities, or mergers or
other business combinations. For additional information, see “Arrangements Between Us and Morgan Stanley—Tax Sharing Agreements.”
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Our ability to operate our business effectively may suffer if we do not, quickly and cost effectively, establish
our own financial, administrative and other support functions to operate as a stand-alone company. Historically, we have relied on
certain financial, administrative and other resources of Morgan Stanley to operate our business. In conjunction with our separation from Morgan Stanley, we will need to enhance our own financial, administrative and other support systems or contract
with third parties to replace Morgan Stanley’s systems. We will also need to rapidly establish our own accounting and auditing policies and systems on a stand-alone basis. Morgan Stanley has performed many important corporate functions for our operations, including portions of human resources, information technology,
accounting, office space leasing, corporate services and treasury. We estimate the annual costs associated with replacing these functions and establishing our own infrastructure related thereto, to be in the range of $50 million to $60 million. See
“Unaudited Pro Forma Condensed Combined Financial Statements.” Prior to the distribution, we will enter into agreements with Morgan Stanley under which Morgan Stanley will provide some of these services to us on a transitional basis, for
which we will pay Morgan Stanley. See “Arrangements Between Us and Morgan Stanley” for a description of these arrangements. Upon the occurrence of certain events, including a change of control, Morgan Stanley may terminate these services.
These services may not be sufficient to meet our needs and, after these agreements with Morgan Stanley expire or are terminated, we may not be able to replace these services at all or obtain these services at acceptable prices and terms. Any failure
or significant downturn in our own financial or administrative policies and systems or in Morgan Stanley’s financial or administrative policies and systems during the transitional period could impact our results and could materially harm our
business, financial condition and results of operations. In the United Kingdom, we have shared a brand and bank charter with Morgan
Stanley, and our primary card brand is “Morgan Stanley.” Starting at the time of distribution, we will have a limited right to use the Morgan Stanley brand for three years, following which we will not be able to use this brand. We expect
our primary brand in the United Kingdom to be Goldfish, and we will also utilize other brands. Transitioning to a new brand will result in increased marketing and transitional costs and may result in customer attrition. Risks Related to the Distribution Because
there has not been any public market for our common stock, the market price and trading volume of our common stock may be volatile. Prior to the distribution, there has been no public market for our common stock. Although our common stock has been authorized for listing on the New York Stock Exchange, an active public market for our common stock may not develop. The
market price of our common stock could be subject to significant fluctuations due to factors such as:
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actual or anticipated fluctuations in our financial condition or quarterly or annual results of operations; |
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success of our operating strategies and perceived prospects and the financial services and payment services industries in general; |
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realization of any of the risks described in this section; |
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failure to meet securities analysts’ expectations; |
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the depth and liquidity of the market for our common stock; |
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decline in the stock prices of peer companies; and |
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general economic, industry and market conditions. |
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As a result of these factors, the combined trading prices of Discover common stock and Morgan Stanley
common stock after the distribution may be less than, equal to or greater than the trading price of Morgan Stanley common stock prior to the distribution. Substantial sales of our common stock could occur in connection with the distribution, which could cause our stock price to decline. Based on the distribution ratio and the number of shares of Morgan Stanley common stock outstanding as of March 31, 2007, we expect that immediately following the distribution, there will be approximately 527 million
shares of Discover common stock outstanding which may generally be sold in the public markets. Some Morgan Stanley stockholders who receive shares of Discover common stock in connection with the distribution may sell their Discover shares at any
time following the distribution for a number of reasons, including the preference to concentrate their security holdings in financial services firms such as Morgan Stanley instead of credit card and payment services companies such as Discover. In
addition, index funds tied to the Standard & Poor’s 500 Index and other indices hold shares of Morgan Stanley common stock and will likely be required to sell their Discover shares to the extent Discover is not included in these
indices. The sale of significant amounts of Discover common stock, or the perception that such sales will occur, may cause our stock price to decline. Certain provisions of our charter documents and U.S. Federal and Delaware law may make it difficult for stockholders to change the composition of our board of directors and may discourage hostile takeover attempts that some of our
stockholders may consider to be beneficial. Certain provisions of our amended and restated certificate of incorporation and bylaws
could have the effect of delaying or preventing changes in control if our board of directors determines that such changes in control are not in the best interests of us and our stockholders. These provisions include, among other things, the
following:
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stockholders may not use cumulative voting in the election of directors; |
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our board of directors will have the ability to issue shares of preferred stock and to determine the price and other terms, including preferences and voting rights,
of those shares without stockholder approval; |
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stockholder action may be taken only at a special or regular meeting; |
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stockholders may not call a special meeting of stockholders; |
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advance notice procedures for nominating candidates to our board of directors or presenting matters at stockholder meetings; and |
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any amendment to our bylaws requires the approval of either a majority of our board of directors or holders of at least 80% of the votes entitled to be cast by the
outstanding capital stock in the election of our board of directors. | While these provisions have the effect of
encouraging persons seeking to acquire control of our company to negotiate with our board of directors, they could enable our board of directors to hinder or frustrate a transaction that some, or a majority, of our stockholders might believe to be
in their best interests and, in that case, may prevent or discourage attempts to remove and replace incumbent directors. Moreover, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the General Corporation
Law of the State of Delaware, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess
of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner. These provisions would apply even if the proposed merger or acquisition could be considered beneficial by some stockholders. For more
information, see “Description of Capital Stock—Anti-Takeover Effects of Our Amended and Restated Certificate of Incorporation and Bylaws and Delaware Law.” In addition, certain acquisitions of our stock may be subject to regulatory
approval or notice under U.S. Federal or Delaware law. See “Business—Regulatory Matters—Bank Regulation—Acquisition of Control.”
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS We have made forward-looking statements in this information
statement, including under “Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere. These forward-looking statements
include statements regarding both us specifically and the industries in which we operate generally. Statements that include words such as “expect,” “intend,” “plan,” “believe,” “project,”
“anticipate,” “seek,” “will” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the U.S. federal securities laws or otherwise. These statements are subject
to risks and uncertainties and include any statements that are not historical factors and statements regarding our financial position, business strategy and other plans and objectives for future operations. Although we believe that these statements
are based on reasonable assumptions, they are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those indicated in such statements. These factors include those listed under “Risk Factors,” and also include, but are not limited to, the following:
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the impact of our separation from Morgan Stanley; |
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our ability to attract and retain employees; |
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the effect of political, economic and market conditions and geopolitical events; |
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changes in economic variables, such as the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and
consumer debt; |
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the level and volatility of equity prices, commodity prices and interest rates, currency values, investments and other market indices; |
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the availability and cost of funding and capital; |
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the actions and initiatives of current and potential competitors; |
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the impact of current, pending and future legislation, regulation and regulatory and legal actions; |
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material security breaches of key systems; |
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unforeseen and catastrophic events; |
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unanticipated developments relating to lawsuits, investigations or similar matters; |
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the potential effects of technological changes. | The foregoing review of important factors should not be construed as exclusive and should be read in conjunction with the other cautionary statements that are included in this information statement. These factors
expressly qualify all subsequent oral and written forward-looking statements attributable to us or persons acting on our behalf. Except for any ongoing obligations to disclose material information as required under U.S. federal securities laws, we
do not have any intention or obligation to update forward-looking statements after we distribute this information statement, whether as a result of new information, future developments or otherwise.
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THE DISTRIBUTION Background and Reasons for the Distribution On December 19, 2006, Morgan Stanley announced that its board of directors had approved the distribution of our common stock to its stockholders in a
tax-free spin-off. Morgan Stanley has received a ruling from the Internal Revenue Service that, based on customary representations and qualifications, the distribution will be tax-free to Morgan Stanley stockholders for U.S. federal income tax
purposes. Morgan Stanley is committed to periodic strategic reviews of its businesses. In December 2006, given record results and significant momentum in both its securities and cards and payments businesses, Morgan Stanley concluded
that the two businesses could best execute their respective growth strategies as two stand-alone, well-capitalized companies with independent boards focused on enhancing stockholder value. Discover delivered record revenues (net
interest income plus other income) and net income in 2006 and since the strategic review in 2005 at which time Morgan Stanley decided not to pursue a spin-off of Discover, it made considerable progress on its critical strategic initiatives
and has begun to lay a strong foundation for future growth. We believe that our separation from Morgan Stanley will enhance stockholder value by creating numerous opportunities and benefits, including the following:
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Fit and focus. Discover and Morgan Stanley management will be able to more clearly focus their efforts on their respective strategic priorities. Discover
will be able to continue building its strong brand adding scale through new products and pursuing opportunities in payments. Morgan Stanley will be able to focus on priorities within its institutional securities, global wealth management group and
asset management segments. |
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Enhancing competitive position. Discover and Morgan Stanley expect that the separation of Discover will eliminate the possibility that Morgan Stanley or
Discover will be placed at a competitive disadvantage relative to their peers because potential clients and strategic partners view Discover or Morgan Stanley, respectively, as a competitor. |
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Increasing our ability to attract and retain employees. We believe that incentive compensation arrangements for key employees, directly related to the market
performance of our common stock, will provide enhanced incentives for performance. The distribution will enable us to offer our key employees equity-based compensation directly linked to the performance of our business, which we expect to enhance
our ability to attract and retain qualified personnel. |
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Improving ability to pursue strategic transactions. We expect that having a more focused equity currency will improve our ability to pursue strategic
initiatives, including acquisitions, joint ventures and investments, subject to certain limitations under the Internal Revenue Code, as described below under “—Effect of Certain Acquisitions of Morgan Stanley Common Stock or Our Common
Stock.” | Manner of Effecting the Distribution The general terms and conditions of the distribution will be set forth in the separation and distribution agreement to be entered into by Morgan Stanley and us. For a description of the expected terms of that
agreement, see “Arrangements Between Us and Morgan Stanley—Separation and Distribution Agreement.” Overview. The
distribution will be accomplished pursuant to the terms and conditions of the separation and distribution agreement, pursuant to which Morgan Stanley will distribute to its stockholders of record all of the outstanding shares of our common stock. As
discussed under “—Trading of Morgan Stanley Common Stock After the Record Date and Prior to the Distribution,” if a holder of record of Morgan Stanley common stock sells those shares in the “regular way” market after the
record date and prior to the distribution, that stockholder will also be selling the right to receive shares of Discover common stock in the distribution. The distribution will be made in book-entry form on the basis of one share of Discover common
stock for every two shares of Morgan Stanley common stock held at the close of business on the record date of June 18, 2007. Morgan Stanley will
30
instruct Mellon Investor Services, as distribution agent, to record the distribution on the distribution date to the holders of record of Morgan Stanley
common stock at the close of business on the record date (or their designated transferees). Book Entry Statements. A book-entry
account statement reflecting your ownership of shares of Discover common stock will be mailed to you during the week of July 2, 2007, or your brokerage account will be credited for the shares on or about July 2, 2007. Treatment of Fractional Shares Fractional shares of
our common stock will not be issued to Morgan Stanley stockholders as part of the distribution nor credited to book-entry accounts. Accordingly, record stockholders of an odd number of shares of Morgan Stanley common stock on the record date will
receive cash in lieu of fractional shares. The distribution agent will aggregate all of the fractional shares and sell them in the open market at then prevailing prices on behalf of these stockholders. These stockholders will receive cash payments
in the amount of their proportionate share of the net sale proceeds from the sale of the aggregated fractional shares, based upon the average gross selling price per share of our common stock after making appropriate deductions for required
withholdings for U.S. federal income tax purposes, if any, and after deducting an amount equal to all brokerage charges, commissions and transfer taxes attributed to the sale of fractional shares. See “—Material U.S. Federal Income Tax
Consequences of the Distribution” for a discussion of the U.S. federal income tax treatment of the proceeds received from the sale of fractional shares. We anticipate that these sales will occur as soon after the distribution date as
practicable as determined by the distribution agent. None of Morgan Stanley, us or the distribution agent will guarantee any minimum sale price for the fractional shares. The distribution agent will have the sole discretion to select the
broker-dealer(s) through which to sell the shares and to determine when, how and at what price to sell the shares. Further, neither the distribution agent nor the selected broker-dealer(s) will be our affiliate or an affiliate of Morgan Stanley.
Results of the Distribution Following
the distribution, Discover will be an independent, publicly traded company owning and operating what had previously been Morgan Stanley’s Discover segment. We expect to have approximately 115,000 stockholders of record and approximately 527
million shares of our common stock outstanding immediately following the distribution, based on the distribution ratio described above and the number of holders of record of Morgan Stanley shares on March 31, 2007. The actual number of shares to be
distributed will be determined based on the number of shares of Morgan Stanley common stock outstanding on the record date. There will also be employee options to purchase, and restricted stock units convertible into, Discover common stock as
described in “Arrangements Between Us and Morgan Stanley.” The distribution ratio may result in stockholders holding odd lots of Discover shares and this may make it more expensive for Discover stockholders to sell their shares.
You will not be required to make any payment for the shares of Discover common stock you receive, nor will you be required to surrender or
exchange your shares of Morgan Stanley common stock or take any other action in order to receive Discover common stock. The distribution will not affect the number of outstanding Morgan Stanley shares or any rights of Morgan Stanley stockholders,
although it will affect the market value of the outstanding Morgan Stanley common stock. Material U.S. Federal Income Tax Consequences of the
Distribution The following discussion sets forth the material U.S. federal income tax consequences of the distribution. This discussion
is based on the Code, Treasury regulations promulgated under the Code and judicial and administrative interpretations thereof, all as in effect as of the date of this information statement, all of which are subject to change at any time, possibly
with retroactive effect. The discussion assumes that the distribution will be consummated in accordance with the separation and distribution agreement and as further described in this
31
information statement. This is not a complete description of all of the consequences of the distribution and, in particular, may not address U.S. federal
income tax considerations applicable to holders of Morgan Stanley common stock subject to special treatment under U.S. federal income tax law. Holders of Morgan Stanley common stock subject to special treatment include, for example:
| |
• |
|
financial institutions; |
| |
• |
|
traders in securities who elect to apply a mark-to-market method of accounting; |
| |
• |
|
partnerships and other pass-through entities; |
| |
• |
|
holders who acquired their shares pursuant to the exercise of an employee stock option or right or otherwise as compensation; and |
| |
• |
|
holders who hold Morgan Stanley common stock as part of a “hedge,” “straddle,” “conversion” or “constructive sale”
transaction. | In addition, this discussion does not address the U.S. federal income tax consequences to holders of Morgan
Stanley common stock who are not U.S. holders (as defined below) or who do not hold Morgan Stanley common stock as a capital asset. No information is provided in this information statement with respect to the tax consequences of the distribution
under applicable foreign or state or local laws. For purposes of this information statement, a “U.S. holder” means any
beneficial owner of Morgan Stanley common stock, other than an entity or arrangement treated as a partnership for U.S. federal income tax purposes, that for U.S. federal income tax purposes is:
| |
• |
|
an individual who is a citizen or resident of the United States; |
| |
• |
|
a corporation (or other entity taxable as a corporation for U.S. federal income tax purposes) created or organized in or under the laws of the United States or of
any political subdivision thereof; |
| |
• |
|
an estate, the income of which is subject to U.S. federal income taxation regardless of its source; or |
| |
• |
|
a trust if it (i) is subject to the primary supervision of a court within the United States and one or more U.S. persons have the authority to control all
substantial decisions of the trust or (ii) was in existence on August 20, 1996, and has properly elected under applicable Treasury regulations to be treated as a U.S. person. | Holders of Morgan Stanley common stock are urged to consult with their tax advisors regarding the tax consequences of the distribution to them, as
applicable, including the effects of U.S. federal, state and local tax laws, as well as foreign and other tax laws. The Distribution
Morgan Stanley has received a private letter ruling from the IRS to the effect that, among other things, the distribution
(including certain related transactions) will be tax-free to Morgan Stanley stockholders for U.S. federal income tax purposes under sections 355, 368 and related provisions of the Code. Although a private letter ruling from the IRS generally is
binding on the IRS, if the factual assumptions or representations made in the private letter ruling request are untrue or incomplete in any material respect, then Morgan Stanley will not be able to rely on the ruling. In addition, Morgan Stanley
expects to receive an opinion of counsel addressing certain requirements, the satisfaction of which will be assumed in the private letter ruling, that must be met in order for the distribution to qualify under sections 355, 368 and related sections
of the Code.
32
Assuming (i) the continued validity of the private letter ruling from the IRS and of the opinion of
counsel and (ii) that the distribution of our common stock to Morgan Stanley stockholders in connection with the distribution is not otherwise disqualified as tax-free for the reasons set forth under “—Effect of Certain Acquisitions
of Morgan Stanley Common Stock or Our Common Stock” below, the material U.S. federal income tax consequences of the distribution will be as follows:
| |
• |
|
the distribution will not generally result in any taxable income, gain or loss to Morgan Stanley; |
| |
• |
|
no taxable income, gain or loss will be recognized by any U.S. holder solely as the result of the receipt of our common stock in the distribution;
|
| |
• |
|
a U.S. holder will recognize capital gain or loss on any cash received in lieu of a fractional share of our common stock equal to the difference between the amount
of cash received in lieu of the fractional share and the portion of the aggregate tax basis of the Morgan Stanley common stock that is allocable to such fractional share as set forth below; |
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• |
|
the aggregate tax basis of the Morgan Stanley common stock and our common stock, including any fractional share in lieu of which cash is received, in the hands of a
U.S. holder immediately after the distribution will be the same as the aggregate tax basis of the Morgan Stanley common stock held by such holder immediately before the distribution, allocated between the Morgan Stanley common stock and our common
stock in proportion to their relative fair market values on the distribution date; and |
| |
• |
|
the holding period of our common stock received by a U.S. holder will include the holding period of such holder’s Morgan Stanley common stock, provided that
the Morgan Stanley common stock is held as a capital asset on the distribution date. | As described above, the private
letter ruling and the opinion of counsel are based, in part, on certain assumptions and representations as to factual matters. If any of those assumptions or representations is untrue or incomplete as of the effective time of the distribution, the
tax consequences of the distribution could differ materially from those described above. If the distribution were not to qualify for
tax-free treatment under sections 355, 368 and related provisions of the Code, Morgan Stanley would recognize taxable gain equal to the excess of the fair market value of our stock over Morgan Stanley’s tax basis in our stock. Under certain
circumstances, we would be required under the U.S. tax sharing agreement to indemnify Morgan Stanley for all or a portion of this liability. See “Arrangements Between Us and Morgan Stanley—Tax Sharing Agreements.” In addition, each
U.S. holder who receives our common stock in the distribution would be treated as receiving a taxable distribution in an amount equal to the fair market value of our common stock received. Morgan Stanley and Discover may incur some tax cost in connection with the distribution (as a result of certain intercompany transactions or as a result
of certain differences between federal and foreign tax rules), whether or not the distribution qualifies for tax-free treatment under sections 355, 368 and related provisions of the Code. Effect of Certain Acquisitions of Morgan Stanley Common Stock or Our Common Stock Even if the distribution otherwise qualifies as a tax-free distribution under section 355 of the Code, the distribution may result in significant U.S.
federal income tax liabilities to Morgan Stanley if 50% or more of Morgan Stanley stock or our stock (in each case by vote or value) is acquired, directly or indirectly, by one or more persons as part of a plan (or series of related transactions)
that includes the distribution. For purposes of this test, any acquisitions of Morgan Stanley stock or our stock, or any agreement, understanding, arrangement or substantial negotiations regarding an acquisition of Morgan Stanley stock or our stock
within two years before or after the distribution are subject to special scrutiny. The process for determining whether a change in control
prohibited under the foregoing rules has occurred is complex, inherently factual and subject to interpretation of the facts and circumstances of a particular case. If a direct or indirect acquisition of Morgan Stanley stock or our stock resulted in
a change in control prohibited
33
under those rules, Morgan Stanley (but not its stockholders) would recognize taxable gain as described above. Under certain circumstances, we would be
required under the U.S. tax sharing agreement to indemnify Morgan Stanley for this liability. See “Arrangements Between Us and Morgan Stanley—Tax Sharing Agreements.” Information Reporting and Backup Withholding Current Treasury regulations require each holder of
Morgan Stanley common stock (i) who owns immediately prior to the distribution (a) at least five percent of the total outstanding stock of Morgan Stanley or (b) securities of Morgan Stanley with an aggregate tax basis of $1,000,000 or more and
(ii) who receives our common stock in the distribution to attach a statement relating to the distribution to the stockholder’s federal income tax return for the year in which the distribution occurs. Information reporting and backup withholding will apply with respect to cash proceeds received in lieu of a fractional share of our common stock only if
such proceeds equal or exceed $20. The foregoing sets forth the material U.S. federal income tax consequences of the distribution under
current law. This discussion does not address tax consequences that may vary with, or are contingent on, individual circumstances. Moreover, it does not address any non-income tax or any foreign, state or local tax consequences of the distribution.
Each beneficial owner of Morgan Stanley common stock is encouraged to consult his, her or its tax advisor as to the particular consequences of the distribution to the stockholder, including the application of state, local and foreign tax laws, and
as to possible prospective or retroactive changes in tax law that might affect the tax consequences described above. Market for Our Common Stock;
Trading of Our Common Stock Prior to the Distribution There is currently no trading market for our common stock. Our common stock has
been authorized for listing on the New York Stock Exchange under the symbol “DFS.” We expect that a limited market, commonly known as a “when-issued” trading market, for our common stock will begin on or about the week of June
11, 2007. The term “when-issued” means that shares can be traded prior to the time shares are available or issued. We expect that on the first trading day following the distribution date, “when-issued” trading in our common stock
will end and “regular way” trading will begin. “Regular way” trading refers to trading after a security has been issued and typically involves a transaction that settles on the third full business day following the date of a
trade. We have not and will not set the initial price of our common stock; that price will be established by the public markets. We cannot
predict the price at which our common stock will trade before or after the distribution. In fact, the combined trading prices of Discover common stock and Morgan Stanley common stock after the distribution may be less than, equal to or greater than
the trading price of Morgan Stanley common stock prior to the distribution. See “Risk Factors—Risks Related to the Distribution—Because there has not been any public market for our common stock, the market price and trading volume of
our common stock may be volatile.” Shares of our common stock distributed to holders of Morgan Stanley common stock in the
distribution will be transferable under the Securities Act of 1933, as amended (the “Securities Act”), except for shares received by persons who may be deemed to be our affiliates. Persons who may be deemed to be our affiliates after the
distribution generally include individuals or entities that control, are controlled by or are under common control with us and may include certain of our officers, directors or principal stockholders. After we become a publicly traded company,
securities held by our affiliates will be subject to the resale restrictions under the Securities Act. Our affiliates will be permitted to sell shares of our common stock only pursuant to an effective registration statement or an exemption from the
registration requirements of the Securities Act, such as the exemption afforded by Rule 144 under the Securities Act. Trading of Morgan Stanley Common
Stock After the Record Date and Prior to the Distribution Beginning on or shortly before the record date and through the distribution
date, Morgan Stanley expects there will be two concurrent markets in which to trade Morgan Stanley common stock: a “regular way” market and a “when-issued” market. Shares of Morgan Stanley common stock that trade on the
“regular way market” will trade with an entitlement to shares of our common stock distributed in connection with the distribution.
34
Shares that trade on the “when-issued” market will trade without an entitlement to shares of our common stock distributed in connection with the
distribution. Therefore, if you own shares of Morgan Stanley common stock at the close of business on the record date and sell those shares on the “regular way” market on or prior to the distribution date, you also will be selling your
right to receive the shares of our common stock that would have been distributed to you in connection with the distribution. If you sell those shares of Morgan Stanley common stock on the “when-issued” market prior to or on the
distribution, you will still receive the shares of our common stock that were to be distributed to you pursuant to your ownership of the shares of Morgan Stanley common stock. If you purchase shares of Morgan Stanley common stock on the
“when-issued” market after the record date or in the “regular way” market after the distribution date, you will not receive an entitlement to shares of our common stock distributed in the distribution. Distribution Conditions and Termination We expect
that the distribution will occur on June 30, 2007, provided that, among other things:
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• |
|
the SEC has declared effective our registration statement on Form 10, of which this information statement is a part, under the Exchange Act and no stop order
relating to our Form 10 registration statement is in effect; |
| |
• |
|
Morgan Stanley has received a tax ruling and/or an opinion of counsel, in each case satisfactory to Morgan Stanley, to the effect that, among other things, the
distribution (and certain related transactions) will be tax-free to Morgan Stanley stockholders for U.S. federal income tax purposes; |
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• |
|
the New York Stock Exchange has approved our common stock for listing, subject to official notice of issuance; |
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• |
|
all material governmental and third-party approvals and consents have been obtained; and |
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• |
|
no event or development has occurred or exists that in the judgment of Morgan Stanley’s board of directors, in its sole discretion, makes it inadvisable to
effect the distribution. | Treatment of Employee Stock Options and Restricted Stock Units Following the distribution, and pursuant to the provisions of the respective plan documents, holders of Morgan Stanley restricted stock units (RSUs) and
options who are active employees of Discover at the time of distribution will have their Morgan Stanley RSUs and options converted into newly-issued Discover RSUs and options pursuant to a conversion formula described below that is intended to
preserve the “intrinsic” value of their pre-distribution RSUs and options. The conversion formula was approved by the Morgan Stanley Compensation, Management Development and Succession Committee, whose members will not receive Discover
RSUs or options in the distribution. The RSUs and options so issued will have substantially the same terms, including expiration date and vesting schedule, as the converted Morgan Stanley RSUs and Options. A conversion ratio will be used to calculate the number of Discover RSUs and the number and exercise price of Discover options that active employees of
Discover at the time of distribution will receive upon the conversion of their Morgan Stanley RSUs and options. This ratio will be calculated by dividing the closing price of Morgan Stanley common stock immediately prior to the distribution by the
opening price of Discover common stock immediately following the distribution, in each case as reported on the New York Stock Exchange. The holder will receive a number of Discover RSUs and options equal to the conversion ratio multiplied by the
number of Morgan Stanley RSUs and options, respectively, held by such holder. The exercise price of each Discover option will be determined by dividing the exercise price of the Morgan Stanley option by the conversion ratio. Set forth below is an example of how the conversion would work. For purposes of this illustration, we assume that the closing price of Morgan Stanley
common stock immediately prior to the distribution is $100.00, and the opening price of Discover common stock immediately following the distribution is $25.00, resulting in a conversion ratio of 4.0 ($100.00/$25.00).
35
Restricted Stock Units
|
|
|
| Number of Morgan Stanley RSUs held immediately prior to the distribution |
|
50 |
| multiplied by |
|
|
| Conversion ratio |
|
4.0 |
|
|
|
| Number of Discover RSUs to be issued upon conversion |
|
200 |
How intrinsic value is preserved:
|
|
|
|
|
|
|
|
|
| |
|
Share Price |
|
# of RSUs |
|
Intrinsic value |
| Morgan Stanley immediately prior to the distribution |
|
$ |
100 |
|
50 |
|
$ |
5,000 |
| Discover immediately following the distribution |
|
$ |
25 |
|
200 |
|
$ |
5,000 |
Options
|
|
|
| Number of Morgan Stanley options held immediately prior to the distribution |
|
50 |
| multiplied by |
|
|
| Conversion ratio |
|
4.0 |
|
|
|
| Number of Discover options to be issued upon conversion |
|
200 |
|
|
|
|
| Exercise price of each Morgan Stanley option immediately prior to the distribution |
|
$ |
50 |
| divided by |
|
|
|
| Conversion Ratio |
|
|
4.0 |
|
|
|
|
| Exercise price of each Discover option to be issued upon conversion |
|
$ |
12.50 |
How intrinsic value is preserved:
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Share Price |
|
Strike Price |
|
# of options |
|
Intrinsic value |
| Morgan Stanley immediately prior to the distribution |
|
$ |
100.00 |
|
$ |
50.00 |
|
50 |
|
$ |
2,500 |
| Discover immediately following the distribution |
|
$ |
25.00 |
|
$ |
12.50 |
|
200 |
|
$ |
2,500 |
All other holders of Morgan Stanley employee stock options and RSUs will have their existing
Morgan Stanley RSUs and options similarly adjusted to preserve the “intrinsic” value of their pre-distribution RSUs and options. Interests of
Morgan Stanley Directors and Executive Officers in the Distribution Following the distribution, none of the directors or executive
officers of Morgan Stanley will be directors or executive officers of Discover. A majority of the directors and executive officers of Morgan Stanley own shares of Morgan Stanley common stock and will receive shares of Discover common stock in the
distribution on the same terms as other Morgan Stanley stockholders. All of the Morgan Stanley directors and executive officers hold Morgan Stanley RSUs and/or options, which will be adjusted following the distribution pursuant to a formula that is
intended to preserve the “intrinsic” value of their pre-distribution RSUs and options. Reason for Furnishing this Information Statement
This information statement is being furnished solely to provide information to Morgan Stanley stockholders who will receive shares of
Discover common stock in connection with the distribution. It is not provided as an inducement or encouragement to buy or sell any of our securities. You should not assume that the information contained in this information statement is accurate as
of any date other than the date set forth on the cover. Changes to the information contained in this information statement may occur after that date, and we undertake no obligation to update the information.
36
DIVIDEND POLICY Following the distribution, our board of directors intends to consider our policy toward the
payment and amount of dividends. The declaration and amount of future dividends, if any, will be determined by our board of directors and will depend on our financial condition, earnings, capital requirements, legal and regulatory constraints,
industry practice and any other factors that our board of directors believes are relevant.
37
CAPITALIZATION The following table sets forth our capitalization as of February 28, 2007:
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• |
|
on an actual basis; and |
| |
• |
|
on a pro forma basis to give effect to the pro forma adjustments included in our unaudited pro forma condensed combined financial statements.
| The pro forma adjustments are based upon available information and assumptions that management believes are reasonable;
however, such adjustments are subject to change based on the finalization of the terms of the distribution and the agreements which define our relationship with Morgan Stanley after the distribution. In addition, such adjustments are estimates and
may not prove to be accurate. You should read the information in the following table together with “Selected Historical and Pro Forma
Combined Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Unaudited Pro Forma Condensed Combined Financial Statements” and our audited combined financial statements and
the related notes included elsewhere in this information statement.
|
|
|
|
|
|
|
| As of February 28, 2007 |
|
Actual |
|
Pro
Forma |
| |
|
(Unaudited) |
| |
|
(dollars in millions) |
| Cash and cash equivalents |
|
$ |
2,503 |
|
$ |
5,118 |
|
|
|
|
|
|
|
| Long-term borrowings |
|
|
1,506 |
|
|
1,706 |
| Stockholder’s equity: |
|
|
|
|
|
|
| Paid-in capital |
|
|
2,658 |
|
|
2,665 |
| Retained earnings |
|
|
2,742 |
|
|
2,631 |
| Accumulated other comprehensive income |
|
|
129 |
|
|
129 |
|
|
|
|
|
|
|
| Total stockholder’s equity |
|
|
5,529 |
|
|
5,425 |
|
|
|
|
|
|
|
| Total capitalization |
|
$ |
7,035 |
|
$ |
7,131 |
|
|
|
|
|
|
|
38
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS Our unaudited pro forma condensed combined
financial statements presented below have been derived from our audited combined financial statements for the year ended November 30, 2006 and from our unaudited condensed combined financial statements for the three months ended February 28,
2007. The pro forma adjustments and notes to the unaudited pro forma condensed combined financial statements give effect to the distribution of our common stock by Morgan Stanley and the other transactions contemplated by the separation and
distribution agreement. These unaudited pro forma condensed combined financial statements should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited
combined financial statements and the notes to those statements included elsewhere in this information statement. Our unaudited pro forma
condensed combined statement of income for the year ended November 30, 2006 and our unaudited pro forma condensed combined statement of income for the three months ended February 28, 2007 have been prepared as though the distribution had
occurred as of December 1, 2005. The unaudited pro forma condensed combined statement of financial condition has been prepared as though the distribution had occurred on February 28, 2007. The pro forma adjustments are based upon available
information and assumptions that management believes are reasonable, that reflect the expected impacts of events that are directly attributable to the distribution and related transaction agreements, and that are factually supportable and expected
to have a continuing impact on us; however, such adjustments are subject to change based on the finalization of the terms of the distribution and the transaction agreements. See “Arrangements Between Us and Morgan Stanley—Separation and
Distribution Agreement.” In addition, such adjustments are estimates and may not prove to be accurate. Morgan Stanley currently
provides portions of certain corporate functions on our behalf and allocates these costs to us. As a stand-alone public company, and as a direct result of our separation from Morgan Stanley, we will incrementally incur expenses in respect of these
functions. Such functions include but are not limited to corporate communications, community affairs, government relations, human resources and benefit management, company management functions, treasury, investor relations, internal audit, business
technology and corporate legal and compliance. We expect that Morgan Stanley will provide certain of these services to us on a transitional basis, primarily during the first year following the distribution. The annual costs associated with replacing
these functions and establishing our own infrastructure related thereto, which we estimate subject to finalization of our plans to be in the range of $50 million to $60 million, have not been reflected in the unaudited pro forma condensed combined
financial statements presented below. We also incur expenses in the form of corporate allocations from Morgan Stanley for the corporate functions they currently provide to us that will not recur after the distribution. The total amount of these
allocations from Morgan Stanley was approximately $21 million in the three months ended February 28, 2007 and approximately $90 million in 2006. The net reduction in expenses associated with replacing these functions and establishing our own
infrastructure related thereto have not been reflected in the unaudited pro forma condensed combined financial statements presented below. This net reduction in expenses is not expected to be realized until the transition is complete. During the
transition, principally in the remaining quarters of 2007, expenses will be greater than historical levels, reflecting transition related expenses. In connection with the distribution, we expect to replace funding provided through Morgan Stanley intercompany arrangements with alternative sources at market rates available to us. We expect to settle any outstanding intercompany payables,
which amounted to $200 million as of February 28, 2007, we have with Morgan Stanley. In addition, we expect to make a dividend payment to Morgan Stanley in an amount equal to the amount by which our stockholder’s equity exceeds our targeted
stockholder’s equity prior to distribution. Our targeted stockholder’s equity is based upon, among other things, management’s view of underlying business risk, regulatory requirements, and rating agency views. As of February 28,
2007, management determined that $5.4
39
billion of capital was appropriate to support our business. The following table summarizes the anticipated intercompany funding repayments and additional
dividend payments associated with the distribution, with balances as of February 28, 2007.
|
|
|
|
| |
|
At February 28, 2007 |
| |
|
(dollars in millions) |
| Morgan Stanley Global Wealth Management Bank Deposit Program |
|
$ |
2,615 |
| Short-term borrowings used to finance cash collateral account |
|
|
886 |
| Short-term borrowings used to finance U.K. card business |
|
|
1,746 |
| Long-term borrowings used to finance fixed assets |
|
|
564 |
| Long-term borrowings used to finance U.K. card business |
|
|
687 |
|
|
|
|
| Total intercompany borrowings |
|
|
6,498 |
| Pro forma dividend payment to Morgan Stanley |
|
|
100 |
|
|
|
|
| Total funding and dividend payments |
|
$ |
6,598 |
|
|
|
|
We also expect to lengthen the maturity profile of borrowings and increase the amount of
stand-alone liquidity held. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” The pro forma adjustments include the following items:
| |
• |
|
The distribution of approximately 527 million shares of our common stock to the stockholders of Morgan Stanley and the payment of a cash dividend to Morgan Stanley
of $100 million for the first quarter of 2007 funded by us through various sources. |
| |
• |
|
Compensation expenses related to equity awards granted under Discover’s Omnibus Incentive and Directors’ Compensation plans. |
| |
• |
|
The replacement of intercompany debt payable to Morgan Stanley with deposits and other funding obtained by us that we intend to have in place on or prior to the
distribution. |
| |
• |
|
The establishment of and costs relating to additional liquidity sources in conjunction with our liquidity and funding policies to replace liquidity previously
sourced by Morgan Stanley. These sources will provide us with liquidity to satisfy the necessary regulatory, rating agency and contingency funding requirements. The liquidity sources include: |
| |
• |
|
A liquidity reserve of approximately $5 billion composed of short-term, highly liquid assets, funded principally through deposits sourced by us. As of March 31,
2007, our liquidity reserve was $5.2 billion. These deposits were sourced through various distribution channels, which include Morgan Stanley and other broker-dealers. None of these deposits were issued to Morgan Stanley.
|
| |
• |
|
An incremental $1.2 billion in unutilized asset-backed commercial paper conduit capacity, in the form of 364-day committed agreements with third-party banks,
increasing total unused capacity to approximately $2.4 billion; and |
| |
• |
|
A multi-year unsecured committed credit facility of at least $1.75 billion, provided by a group of major global banks and available to both Discover Financial
Services as well as our Discover Bank subsidiary. | The unaudited pro forma condensed combined financial statements are
provided for illustrative and informational purposes only and do not reflect what our combined financial condition and results of operations would have been had the distribution occurred at the beginning of all periods presented and are not
necessarily indicative of our future financial condition and future results of operations.
40
Discover Financial Services Unaudited Pro Forma Condensed Combined Statement of Financial Condition
|
|
|
|
|
|
|
|
|
|
|
| As of February 28, 2007 |
|
Historical |
|
Pro Forma
Adjustments |
|
|
Pro
Forma |
| |
|
(in millions) |
| Assets |
|
|
|
|
|
|
|
|
|
|
| Cash and cash equivalents |
|
$ |
2,503 |
|
$ |
(212 |
)(a) |
|
$ |
5,118 |
|
|
|
|
|
|
2,827 |
(b) |
|
|
|
| Investment securities |
|
|
86 |
|
|
— |
|
|
|
86 |
| Net loan receivables |
|
|
21,818 |
|
|
— |
|
|
|
21,818 |
| Accrued interest receivable |
|
|
105 |
|
|
— |
|
|
|
105 |
| Amounts due from asset securitization |
|
|
3,351 |
|
|
— |
|
|
|
3,351 |
| Premises and equipment, net |
|
|
658 |
|
|
— |
|
|
|
658 |
| Goodwill |
|
|
534 |
|
|
— |
|
|
|
534 |
| Intangible assets, net |
|
|
197 |
|
|
— |
|
|
|
197 |
| Other assets |
|
|
512 |
|
|
24 |
(c) |
|
|
536 |
|
|
|
|
|
|
|
|
|
|
|
| Total assets |
|
$ |
29,764 |
|
$ |
2,639 |
|
|
$ |
32,403 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Liabilities |
|
|
|
|
|
|
|
|
|
|
| Deposits: |
|
|
|
|
|
|
|
|
|
|
| Interest bearing deposit accounts |
|
$ |
17,576 |
|
$ |
6,081 |
(d) |
|
$ |
21,042 |
|
|
|
|
|
|
(2,615 |
)(d) |
|
|
|
| Non-interest bearing deposit accounts |
|
|
86 |
|
|
— |
|
|
|
86 |
|
|
|
|
|
|
|
|
|
|
|
| Total deposits |
|
|
17,662 |
|
|
3,466 |
|
|
|
21,128 |
|
|
|
|
| Short-term borrowings: |
|
|
|
|
|
|
|
|
|
|
| Short-term borrowings from Morgan Stanley |
|
|
2,632 |
|
|
(2,632 |
)(e) |
|
|
— |
| Other short-term borrowings |
|
|
540 |
|
|
(540 |
)(f) |
|
|
2,433 |
|
|
|
|
|
|
2,433 |
(g) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Total short-term borrowings |
|
|
3,172 |
|
|
(739 |
) |
|
|
2,433 |
|
|
|
|
| Long-term borrowings: |
|
|
|
|
|
|
|
|
|
|
| Long-term debt from Morgan Stanley |
|
|
1,251 |
|
|
(1,251 |
)(h) |
|
|
— |
| Other long-term debt and bank notes |
|
|
255 |
|
|
564 |
(i) |
|
|
1,706 |
|
|
|
|
|
|
887 |
(j) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Total long-term borrowings |
|
|
1,506 |
|
|
200 |
|
|
|
1,706 |
|
|
|
|
| Accrued interest payable |
|
|
151 |
|
|
— |
|
|
|
151 |
| Accrued expenses and other liabilities |
|
|
1,744 |
|
|
16 |
(k) |
|
|
1,560 |
|
|
|
|
|
|
(200 |
)(l) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Total liabilities |
|
|
24,235 |
|
|
2,743 |
|
|
|
26,978 |
|
|
|
|
| Stockholder’s Equity |
|
|
|
|
|
|
|
|
|
|
| Paid-in capital |
|
|
2,658 |
|
|
7 |
(m) |
|
|
2,665 |
| Retained earnings |
|
|
2,742 |
|
|
(111 |
)(n) |
|
|
2,631 |
| Accumulated other comprehensive income |
|
|
129 |
|
|
— |
|
|
|
129 |
|
|
|
|
|
|
|
|
|
|
|
| Total stockholder’s equity |
|
|
5,529 |
|
|
(104 |
) |
|
|
5,425 |
|
|
|
|
|
|
|
|
|
|
|
| Total liabilities and stockholder’s equity |
|
$ |
29,764 |
|
$ |
2,639 |
|
|
$ |
32,403 |
|
|
|
|
|
|
|
|
|
|
|
41
Discover Financial Services Unaudited Pro Forma Condensed Combined Statement of Income
|
|
|
|
|
|
|
|
|
|
|
| For the Three Months Ended February 28, 2007 |
|
Historical |
|
Pro Forma
Adjustments |
|
|
Pro
Forma |
| |
|
(dollars in millions, except
per share amounts) |
| Interest income |
|
$ |
680 |
|
$ |
36 |
(b) |
|
$ |
716 |
| Interest expense: |
|
|
|
|
|
|
|
|
|
|
| Deposits |
|
|
187 |
|
|
(12 |
)(d) |
|
|
270 |
|
|
|
|
|
|
95 |
(d) |
|
|
|
| Short-term borrowings: |
|
|
|
|
|
|
|
|
|
|
| Short-term borrowings from Morgan Stanley |
|
|
70 |
|
|
(70 |
)(e) |
|
|
— |
| Other short-term borrowings |
|
|
7 |
|
|
(7 |
)(f) |
|
|
35 |
|
|
|
|
|
|
35 |
(g) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Total short-term borrowings |
|
|
77 |
|
|
(42 |
) |
|
|
35 |
| Long-term borrowings: |
|
|
|
|
|
|
|
|
|
|
| Long-term borrowings from Morgan Stanley |
|
|
17 |
|
|
(17 |
)(h) |
|
|
— |
| Other long-term debt and bank notes |
|
|
3 |
|
|
9 |
(i) |
|
|
25 |
|
|
|
|
|
|
13 |
(j) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Total long-term borrowings |
|
|
20 |
|
|
5 |
|
|
|
25 |
|
|
|
|
|
|
|
|
|
|
|
| Total interest expense |
|
|
284 |
|
|
46 |
|
|
|
330 |
|
|
|
|
|
|
|
|
|
|
|
| Net interest income |
|
|
396 |
|
|
(10 |
) |
|
|
386 |
| Provision for loan losses |
|
|
195 |
|
|
— |
|
|
|
195 |
|
|
|
|
|
|
|
|
|
|
|
| Net interest income after provision for loan losses |
|
|
201 |
|
|
(10 |
) |
|
|
191 |
| Other income |
|
|
825 |
|
|
— |
|
|
|
825 |
| Other expense |
|
|
655 |
|
|
7 |
(m) |
|
|
663 |
|
|
|
|
|
|
1 |
(o) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Income before income tax expense |
|
|
371 |
|
|
(18 |
) |
|
|
353 |
| Income tax expense |
|
|
137 |
|
|
(7 |
)(p) |
|
|
130 |
|
|
|
|
|
|
|
|
|
|
|
| Net income |
|
$ |
234 |
|
$ |
(11 |
) |
|
$ |
223 |
|
|
|
|
|
|
|
|
|
|
|
| Earnings per share(q) |
|
|
|
|
|
|
|
|
|
|
| Basic |
|
|
|
|
|
|
|
|
$ |
0.44 |
| Diluted |
|
|
|
|
|
|
|
|
$ |
0.42 |
| Weighted average shares outstanding (000s)(q) |
|
|
|
|
|
|
|
|
|
|
| Basic |
|
|
|
|
|
|
|
|
|
504,593 |
| Diluted |
|
|
|
|
|
|
|
|
|
528,956 |
42
|
|
|
|
|
|
|
|
|
|
|
| For the Year Ended November 30, 2006 |
|
| |
