Dive Brief:

• Discover Financial Services increased by $799 million the amount it’s setting aside for remediation of a card misclassification issue during the first quarter, the company said in a Wednesday news release. 
• The company decided on that increase after ongoing internal reviews and “extensive discussions” with merchants and regulators, interim CEO Michael Shepherd said Thursday during Discover’s first-quarter earnings call.
• The move, aligned with Discover’s compliance and risk management objectives, “will significantly help advance the resolution of this issue,” CFO John Greene said during the call.

Dive Insight:

Last October, Discover disclosed it was facing a Securities and Exchange Commission probe over the card misclassification issue. Beginning in 2007, the Riverwoods, Illinois-based company misclassified certain credit card accounts into its highest merchant and merchant acquirer price tier, resulting in overcharges.

The issue “underscored deficiencies” in the company’s corporate governance and risk management, former CEO Roger Hochschild said last July, just weeks before he resigned abruptly in August. 

Discover’s experience to date with remediation efforts, regulatory dialogue and the company’s pending merger with Capital One all influenced Discover’s decision to bolster the remediation reserve, Greene noted during Thursday’s call. 

In February, Capital One announced it intended to purchase Discover for $35.3 billion in an all-stock deal; executives have said they expect the deal to close late this year or early next. Capital One CEO Richard Fairbank has said the bank is bracing for a “significant” undertaking in resolving compliance issues at Discover.  

As of the end of last year, Discover’s liability balance related to the card misclassification issue was $375 million, according to the company’s annual filing with the SEC. 

At that point, $12 million of disbursements had been made, as Discover developed its plan to refund merchants and merchant acquirers and discussed those plans with regulators, the filing said.

“Regulators may impose other requirements that may result in additional charges or a remediation amount that differs, possibly materially, from the Company’s current estimate,” the annual filing noted. Additional losses “are probable” due to the SEC probe and the company being named as a defendant in various lawsuits related to the misclassification issue, the filing said. 

Discover executives believe the first-quarter reserve build “will advance the resolution of these issues,” Shepherd said Thursday.

Shepherd, former CEO of BancWest Corp. and its subsidiary, Bank of the West, joined Discover’s board last August, after Hochschild’s resignation and the disclosure of risk and compliance scrutiny the company has faced. Shepherd became interim CEO of Discover last month, when newly appointed CEO Michael Rhodes resigned to take the same role at Ally Financial.

Shepherd on Thursday thanked Rhodes for his leadership “through an important phase.” Rhodes’s new position as Ally’s next CEO “allows him to fulfill his career goal of leading a public company,” Shepherd said. Rhodes, who joins Ally on April 29, was not expected to have a long-term role at Discover following its merger with Capital One, Discover said in a regulatory filing. 

For the first quarter, Discover’s net income plummeted 68%, to $308 million, on a 13% rise in revenue net of interest expense, to $4.2 billion, according to the company’s earnings release. The company’s operating expenses rose 67% in the quarter, to $2.3 billion, largely due to the remediation reserve increase, according to its earnings presentation.