Dive Brief:

• Discover Financial Services on Wednesday disclosed both a pricing error and that it’s facing a compliance probe from the Federal Deposit Insurance Corp.
• Beginning in 2007, the Riverwoods, Illinois-based card company misclassified certain credit card accounts into its highest merchant and merchant acquirer price tier, according to a filing with the Securities and Exchange Commission. It didn’t affect pricing for cardholders, the company said in the Wednesday filing.
• Separately, the company received a proposed consent order from the FDIC in connection with consumer compliance, Discover said in the filing. The probe “is broadly around our compliance management system,” and could result in additional supervisory actions, CEO Roger Hochschild told analysts Thursday during Discover’s second-quarter earnings conference call.

Dive Insight:

The FDIC probe is unrelated to the misclassification, but that doesn’t mean the pricing error won’t result in further regulatory action, Hochschild said, adding that he didn’t want to speculate.

Hochschild also declined to identify timing related to regulatory actions, but “they can take many forms.” The FDIC’s proposed consent order will be made public once complete, he added.

This time last year, Discover disclosed it was conducting an internal investigation of its student loan servicing practices and related compliance matters, stemming from a Consumer Financial Protection Bureau consent order. That investigation concluded last November, although the company said it may be subject to reviews, probes or other actions related to that segment of its business going forward. 

Since the student loan servicing issue was also related to compliance, “I think there’s a link between that and the broader focus on our compliance management system,” Hochschild told analysts. 

The company is now investing more in compliance: Between 2019 and 2023, it increased spending in that area by about $250 million, Discover CFO John Greene told analysts Thursday.

“As we’ve looked at the work in front of us,” the company is dedicating between $20 million and $50 million more, potentially bringing that to a $300 million increase over the four-year period, he said.

Looking back, Hochschild said he believes the company wasn’t investing enough in compliance. 

“That’s something I take accountability for, but we are very focused on it now,” Hochschild told analysts. “Traditionally, we have been very strong around credit risk management, around liquidity risk management, but have not necessarily made the investments we needed, especially as the complexity of our business increased. As we got into more new products, I think there was a gap there, in terms of our capabilities, and that’s what we’re focused on now.”

Discover’s compliance improvements include simplifying the company’s architecture, automating manual processes and streamlining and standardizing business processes, he said. The company is bringing on new employees, working with outside consultants and investing in technology, he said.

“We as a team know we are not where we want to be, and it is our top priority,” Hochschild said. 

The pricing misclassification also “underscored deficiencies” in the company’s corporate governance and risk management, Hochschild said. The issue was discovered internally, Greene said.

“Incremental revenue resulting from this card product misclassification amounted to less than 1% of our cumulative discount and interchange revenue, gross, since that time,” the company said in the filing. 

Based on information available by the end of the second quarter, Discover deemed the revenue impact of the misclassification immaterial to any of its consolidated financial statements during the affected time period, but made corrections for impacted periods for comparative purposes, the filing noted.

“After adjusting for tax effects, the cumulative impact to beginning retained earnings as of April 1, 2023, was a decrease of $255 million, and the impact to net income for the quarter ended March 31, 2023, was a reduction of $8 million,” according to the filing. 

Discover determined a liability on its balance sheet of $365 million to issue refunds to merchants and merchant acquirers affected by the misclassification. The impact to the first half of the year totaled $22 million, Greene said.

The company is taking actions to correct the misclassification and preparing a program to compensate affected merchants and merchant acquirers, Hochschild said. 

“However, given differences in individual merchant agreements, changes in network terms, and availability of historical data, it is difficult to determine the final amount of potential refunds at this time,” according to the filing.

For the second quarter, Discover reported revenue net of interest expense rose 21%, to $3.9 billion, while net income slipped 18%, to $901 million.