Item 1 of this Report. Some of our competitors have developed, or may develop, substantially greater financial and other resources than we have, may offer a wider range of programs and services than we offer or may use more effective advertising and marketing strategies to achieve broader brand recognition or merchant acceptance than we have. We may not continue to be able to compete effectively against these threats. In addition, our competitors may be more efficient in introducing innovative programs and services than we are. As a result, our revenue or profitability may decline.
We have repealed our Competitive Programs Policy as a result of a final judgment in our litigation with the U.S. Department of Justice, and our business may suffer as a result.
Based on a final judgment of our litigation with the U.S. Department of Justice, in October 2004 our CPP, which prohibited financial institutions participating in our system from issuing competing proprietary payment cards, became unenforceable and was subsequently repealed. See Note 18 to the Consolidated Financial Statements herein. As a result, our issuers are now permitted to issue general purpose credit or debit cards in the United States on any other general purpose card network (such as American Express or Discover). This may cause our members to issue fewer cards with our brand and to enter into arrangements with our competitors to issue cards, thereby reducing the volume of transactions that we process, decreasing our revenues. A number of our large customers, including Bank of America, Citibank, HSBC, USAA and GE Finance, have begun to issue or have announced that they will issue American Express or Discover-branded cards. Accordingly, the repeal of the CPP may have a material adverse affect on our business, revenue and profitability.
We depend significantly on our relationships with our customers to manage our payment system. If we are unable to maintain those relationships, or if our customers are unable to maintain their relationships with cardholders or merchants that accept our cards for payment, our business may be materially and adversely affected.
We are, and will continue to be, significantly dependent on our relationships with our issuers and acquirers and their further relationships with cardholders and merchants to support our programs and services. We do not issue cards, extend credit to cardholders or determine the interest rates (if applicable) or other fees charged to cardholders using cards that carry our brands. Each issuer determines these and most other competitive card features. In addition, we do not solicit merchants to process transactions or establish the discount rate that merchants are charged for card acceptance, which are responsibilities of our acquirers. As a result, our business significantly depends on the continued success and competitiveness of our issuer and acquirer customers. In turn, our customers’ success depends on a variety of factors over which we have little or no influence. If our customers become financially unstable, we may lose revenue or we may be exposed to settlement risk as described below.
With the exception of the United States and a select number of other jurisdictions, most in-country (as opposed to cross-border) transactions conducted using MasterCard, Maestro and Cirrus cards are authorized, cleared and settled by our customers or other processors without involving our central processing systems. Because we do not provide domestic processing services in these countries and do not, as described above, have direct relationships with cardholders or merchants, we depend on our close working relationships with our customers to effectively manage our brands, together with the perception of our payment system, among
regulators, merchants and consumers in these countries. From time to time, our customers may take actions that we do not believe to be in the best interests of our payment system overall, which may materially and adversely impact our business. In addition, our competitors may process a greater percentage of domestic transactions in jurisdictions outside the United States than we do. As a result, our inability to control the end-to-end processing on cards carrying our brands in many markets may put us at a competitive disadvantage by limiting our ability to introduce value-added programs and services that are dependent upon us processing the underlying transactions.
We rely on the continuing expansion of merchant acceptance of our brands and programs. Although our business strategy is to invest in strengthening our brands and expanding our acceptance network, there can be no guarantee that our efforts in these areas will continue to be successful. If the rate of merchant acceptance growth slows or reverses itself, our business could suffer.
If we are unable to grow our debit business, particularly in the United States, we may fail to maintain and increase our revenue growth.
In recent years, we believe that industry-wide offline and online debit transactions have grown more rapidly than credit or charge transactions. However, in the United States, we believe that transactions involving our brands account for a smaller share of all offline, signature-based debit transactions than they do credit or charge transactions. In addition, many of our competitors process a greater number of online, PIN-based debit transactions at the point of sale than we do, since our Maestro brand has relatively low market penetration in the United States. We may not be able to increase our market penetration for debit transactions in the United States since many of our competitors have long-standing and strong market positions. We may also be impacted adversely by any tendency among U.S. consumers or financial institutions to migrate from offline, signature-based debit transactions to online, PIN-based transactions, because the latter types of transactions are more likely to be processed by other ATM/debit point-of-sale networks. In addition, we generally earn higher revenues on point-of-sale purchase transactions than on cash access transactions, and on domestic credit and offline debit transactions than on comparable online debit transactions.
Furthermore, in June 2003, following the settlement of the U.S. merchant lawsuit, Visa enacted a bylaw requiring its 100 largest issuers of debit cards in the United States to pay a so-called “settlement service fee” if these issuers reduce their debit Visa volume by more than 10%. This bylaw was later modified to clarify that the settlement service fee would only be imposed if an issuer shifted its portfolio of debit cards to MasterCard. See Note 18 to the Consolidated Financial Statements herein for a description of our response to this bylaw provision. If Visa is permitted to impose this settlement service fee on issuers of debit cards according to this bylaw, it would penalize Visa members seeking to do debit business with MasterCard and would effectively prohibit them from converting their debit card programs to our programs.
Any of these factors may inhibit the growth of our debit business, which could materially and adversely affect our revenues and overall prospects for future growth.
The changes to our governance structure in connection with the ownership and governance transactions could have a material adverse effect on our business relationship with our members.
A number of our key customers are currently represented on our board of directors. Upon the consummation of the ownership and governance transactions, the organization and composition of our board of directors will be substantially restructured. In particular, our certificate of incorporation will be amended to provide that, with the exception of the directors to be elected by the holders of our Class M common stock, any person who is or has been during the prior three years a director, officer, employee, agent or representative of, or otherwise has any business relationship that is material to such person with, a member or former member of MasterCard International, or of an operator, member, or licensee of any competing general purpose payment card system, or any affiliate of such person, may not serve as a director of MasterCard. In addition, our members will be able to own only Class B common stock, which has no voting power, and Class M common stock, which is generally
non-voting except that it provides the right to elect up to three directors (but not more than one-quarter of all directors) and approve specified significant corporate actions. If certain of our members are dissatisfied with these changes to our corporate governance structure, this could have a material adverse effect on our business relationship with them and they may elect to instead do business with a competitor with a different governance structure. In addition, our members’ ownership in our company will be reduced substantially in connection with the initial public offering and related transactions. The reduced ownership may reduce their interest in the continued success of our business. A significant loss of revenue or transaction volumes from our members could have a material adverse effect on our business.
Global economic, political and other conditions may adversely affect trends in consumer spending and in cross-border travel, which may materially and adversely impact our revenue and profitability.
The global payments industry depends heavily upon the overall level of consumer, business and government spending. A sustained deterioration in general economic conditions, particularly in the United States or Europe, or increases in interest rates in key countries in which we operate, may adversely affect our financial performance by reducing the number or average purchase amount of transactions involving payment cards carrying our brands. In addition, a significant portion of the volume generated on cards carrying our brands (and a significant portion of the revenue we earn outside the United States) are associated with cross-border business and leisure travel, which may be adversely affected by world geopolitical, economic and other conditions, including the threat of terrorism and outbreak of diseases such as SARS and avian flu. In particular, revenue from processing foreign currency transactions for our customers fluctuates with cross border travel and our customers’ need for transactions to be converted into their base currency.
As a guarantor of certain obligations of principal members and affiliate debit licensees, we are exposed to risk of loss or illiquidity if any of our members default on their MasterCard, Cirrus or Maestro settlement obligations.
We may incur liability in connection with transaction settlements if an issuer or acquirer fails to fund its daily settlement obligations due to technical problems, liquidity shortfall, insolvency or other reasons. If a principal member or affiliate debit licensee is unable to fulfill its settlement obligations to other members, we may bear the loss even if we do not process the transaction. In addition, although we are not contractually obligated to do so, we may elect to keep merchants whole if an acquirer defaults on its merchant payment obligations, in order to maintain the integrity and acceptance of our brands. Our estimated gross legal settlement exposure, which is calculated using the average daily card charges made during the quarter multiplied by the estimated number of days to settle, was approximately $15.6 billion as of December 31, 2005. We have a revolving credit facility in the amount of $2.25 billion to provide liquidity in the event of one or more settlement failures by our members. While we believe that we have sufficient liquidity to cover a settlement failure by any of our largest customers on their peak day, concurrent settlement failures of more than one of our largest customers or of several of our smaller customers may exceed our available resources and could materially and adversely affect our business and financial condition. In addition, even if we have sufficient liquidity to cover a settlement failure, we may not be able to recover the cost of such a payment and may therefore be exposed to significant losses, which could materially and adversely affect our results of operations, cash flow and financial condition. For more information on our settlement exposure as of December 31, 2005, see Note 19 to the Consolidated Financial Statements herein.
Following the ownership and governance transactions, we will no longer have the right to impose special assessments upon the members of MasterCard International, which could leave us exposed to significant losses that could materially and adversely affect our results of operations, cash flow and financial condition, or, in certain circumstances, even cause us to become insolvent.
In connection with the ownership and governance transactions, the certificate of incorporation and the bylaws of MasterCard International will be amended to eliminate the right of MasterCard International to impose special assessments upon its members. This special assessment right currently allows MasterCard International to
recover from its members all or a portion of its expenses and liabilities arising out of extraordinary events, such as settlements or judgments in major litigations and catastrophic occurrences that may cause significant risk or damage to MasterCard. Therefore, following the ownership and governance transactions, we will bear the expenses and liabilities associated with extraordinary events without recourse to our members through a right of assessment. Accordingly, the loss of this special assessment right leaves us exposed to significant risks and losses from these types of extraordinary events, which could materially and adversely affect our results of operations, cash flow and financial condition, or, in certain circumstances, even cause us to become insolvent.
Standard and Poor’s Rating Services has announced that they will downgrade our credit rating upon completion of our initial public offering, which will result in an increase of our interest expense for borrowings under our credit facility. Further downgradings of our credit ratings could materially and adversely affect our future ability to obtain funding or materially increase the cost of any additional funding.
Due to the loss of MasterCard International’s right to impose special assessments upon its members in connection with this offering, Standard & Poor’s Rating Services expects to lower our counterparty credit ratings from A-/A-2 with negative outlook to BBB+/A-2 with stable outlook and our subordinated debt rating from BBB+ with negative outlook to BBB with stable outlook. Until the completion of the ownership and governance transactions, our existing ratings will remain on credit watch with negative outlook. The expected downgrading will result in an increase of our interest expense if borrowings were necessary under our credit facility. In addition, further downgrading of our credit ratings by Standard & Poor’s Rating Services or by any other rating agency could materially and adversely affect our future ability to obtain funding or materially increase the cost of any additional funding.
If our transaction processing systems are disrupted or we are unable to process transactions efficiently or at all, our revenue or profitability would be materially reduced.
Our transaction authorization, clearing and settlement systems may experience service interruptions as a result of fire, natural disasters, power loss, disruptions in long distance or local telecommunications access, fraud, terrorism or accident. Most of our transaction processing systems are controlled by a single facility, supported by a separate smaller co-processing facility. A natural disaster or other problem at our primary and/or back-up facilities or our other owned or leased facilities could interrupt our services. Additionally, we rely on third-party service providers, such as AT&T, for the timely transmission of information across our global data transportation network. If a service provider fails to provide the communications capacity or services we require, as a result of natural disaster, operational disruption, terrorism or any other reason, the failure could interrupt our services, adversely affect the perception of our brands’ reliability and materially reduce our revenue or profitability.
Account data breaches involving card data stored by us or third parties could adversely affect our reputation and revenue.
We, our customers, and other third parties store cardholder account information in connection with our payment cards. In addition, our customers may sponsor third-party processors to process transactions generated by cards carrying our brands. Breach of the systems on which sensitive cardholder data and account information are stored could lead to fraudulent activity involving our cards, damage the reputation of our brands and lead to claims against us. For example, in 2005, a third-party processor that held account information for merchants and acquirers, was subject to a security breach in connection with card and account information for approximately 40 million cards, approximately 10.1 million of which were MasterCard cards. As a result, we have been named in a lawsuit claiming unspecified damages and may be subject to additional lawsuits in connection with data security breaches involving payment cards carrying our brands. If we are unsuccessful in defending lawsuits involving such data security breaches, we may be forced to pay damages, which could materially and adversely affect our profitability. In addition, any damage to our reputation or that of our brands resulting from an account data breach could decrease the use and acceptance of our cards, which could have a material adverse impact on our transaction volumes, revenue and future growth prospects, or increase our costs by leading to additional regulatory burdens being imposed upon us.
An increase in fraudulent activity using our cards could lead to reputational damage to our brands and could reduce the use and acceptance of our cards.
Criminals are using increasingly sophisticated methods to capture cardholder account information to engage in illegal activities such as fraud and identity theft. As outsourcing and specialization become a more acceptable way of doing business in the payments industry, there are more third parties involved in processing transactions using our cards. If fraud levels involving our cards were to rise, it could lead to regulatory intervention (such as mandatory card reissuance) and reputational and financial damage to our brands, which could reduce the use and acceptance of our cards or increase our compliance costs, and thereby have a material adverse impact on our business.
If we are not able to keep pace with the rapid technological developments in our industry to provide customers, merchants and cardholders with new and innovative payment programs and services, the use of our cards could decline, which would reduce our revenue and income.
The payment card industry is subject to rapid and significant technological changes, including continuing developments of technologies in the areas of smart cards, radio frequency and proximity payment devices (such as contactless cards), electronic commerce and mobile commerce, among others. We cannot predict the effect of technological changes on our business. We rely in part on third parties, including some of our competitors and potential competitors, for the development of and access to new technologies. We expect that new services and technologies applicable to the payments industry will continue to emerge, and these new services and technologies may be superior to, or render obsolete, the technologies we currently use in our card programs and services. In addition, our ability to adopt new services and technologies that we develop may be inhibited by a need for industry-wide standards or by resistance from customers or merchants to such changes. Our future success will depend, in part, on our ability to develop or adapt to technological changes and evolving industry standards.
Adverse currency fluctuations and foreign exchange controls could decrease revenue we receive from our international operations.
During 2005 and 2004, approximately 45% and 42% of our revenue, respectively, was generated from activities outside the United States. Some of the revenue we generate outside the United States is subject to unpredictable and indeterminate fluctuations if the values of other currencies change relative to the U.S. dollar. Resulting exchange gains and losses are included in our net income. Our risk management activities provide protection with respect to adverse changes in the value of only a limited number of currencies. Furthermore, we may become subject to exchange control regulations that might restrict or prohibit the conversion of our other revenue currencies into U.S. dollars. The occurrence of any of these factors could decrease revenues we receive from our international operations and have a material adverse impact on our business.
Competing dynamic currency conversion services could reduce the volume of foreign currency transactions we process or force us to change our pricing or practices, which may materially and adversely affect our business.
Some of our members and competitors provide currency conversion services at the point of sale, known as dynamic currency conversion. Dynamic currency conversion services could, if significant numbers of cardholders choose to use them, replace our own currency conversion processing services or could force us to change our pricing or practices for these services. If we process fewer transactions or are forced to change our pricing or practices for our currency conversion processing because of competing dynamic currency conversion services or otherwise, our revenue may be materially and adversely affected.
Our assessment revenues that are based on quarterly GDV are recorded utilizing an estimate of our customers’ performance. Material changes in our customers’ performance compared to estimates could require us to restate our financial statements for prior periods, which could have a material adverse impact on our results of operations and stock price.
Our assessment revenues that are based on quarterly GDV are recorded utilizing an estimate of our customers’ performance. Such estimates are subsequently validated against actual performance as reported by our customers, and differences are ordinarily adjusted in the period in which the customer reports actual results. Rebates and incentives, which are recorded as contra-revenue, are also estimated based on customer performance. Material changes in our customers’ performance compared to estimates, or revisions to performance information subsequently reported by our customers in accordance with the MasterCard rules, could require us to restate our financial statements for prior periods. Any such restatements could have a material adverse impact on our results of operations and on the price of our Class A common stock.
Any acquisitions that we make could disrupt our business and harm our financial condition.
We may evaluate or make strategic acquisitions of complementary businesses, products or technologies. If so, we may not be able to successfully finance or integrate any such businesses, products or technologies. Furthermore, the integration of any acquisition may divert management’s time and resources from our core business and disrupt our operations. We may spend time and money on projects that do not increase our revenue. To the extent we pay the purchase price of any acquisition in cash, it would reduce our cash reserves, and to the extent the purchase price is paid with our stock, it could be dilutive to our stockholders. While we from time to time evaluate potential acquisitions of businesses, products and technologies, and anticipate continuing to make these evaluations, we have no present understandings, commitments or agreements with respect to any material acquisitions.
We expect to record a significant net loss for the second quarter and full year of 2006 as a result of the donation of shares of our Class A common stock and cash to The MasterCard Foundation, and we may make additional cash donations to the MasterCard Foundation to allow it to meet its annual charitable disbursement requirements during the first four years of its operations.
At the time of the ownership and governance transactions, we intend to donate 13,500,047 newly-issued shares of the new Class A common stock, representing approximately 10% of our equity, to The MasterCard Foundation, a private charitable foundation incorporated in Canada. We also expect to donate an estimated $40 million in cash to the Foundation in support of its operating expenses and charitable giving for the first four years of its operations, and we may make additional cash contributions to the Foundation during and after this period. Because the Foundation’s operations are currently being established, the overall size and timing of our expected initial cash donation have not been finally determined.
In connection with the donation of the shares of the Class A common stock, we expect to record an expense that is equal to the value of the shares we are donating. The value of the shares of Class A common stock we donate will be determined based on the initial public offering price per share of Class A common stock in the initial public offering less a marketability discount. This marketability discount and the methodology used to quantify it will be determined by management in consultation with independent valuation consultants retained by MasterCard. As a result of this expected expense, we anticipate recording a significant net loss in the quarter the stock is donated and may record a net loss for the 2006 fiscal year. We also expect to record an expense equal to the value of any cash we donate in the period or periods in which such donation or donations are made. The expense of these donations will not be deductible to MasterCard for tax purposes. As a result of this difference between financial statement and tax treatments of the donations, we expect there to be a significant increase to our effective tax rate in the periods in which the contributions are made.
Changes in the regulatory environment may adversely affect our benefit plans.
We provide certain retirement benefits to our U.S. employees through the MasterCard Accumulation Plan (MAP), a qualified cash balance benefit plan. In 2003, a U.S. federal district court ruled that International Business Machines Corporation’s cash balance pension plan violated the age discrimination provisions of ERISA. If this decision is upheld on appeal and applied to cash balance plans generally, we may be required to amend the MAP and, like other U.S. companies with cash balance plans, may be exposed to claims from plan participants. These developments could have a material adverse impact on our results of operations.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2. Properties
As of December 31, 2005, MasterCard and its subsidiaries owned or leased 57 properties. We own our corporate headquarters, a three-story, 472,600 square foot building located in Purchase, New York. There is no outstanding debt on this building. Our principal technology and operations center is a 528,000 square foot leased facility located in O’Fallon, Missouri, known as “Winghaven”. The term of the lease on this facility is 10 years, which commenced on August 31, 1999. See Note 14 to the Consolidated Financial Statements herein. Our leased properties in the United States are located in 11 states and in the District of Columbia. We also lease properties in 37 other countries. These facilities primarily consist of corporate and regional offices, as well as our operations centers.
We believe that our facilities are suitable and adequate for the business that we currently conduct. However, we periodically review our space requirements and may acquire new space to meet the needs of our business, or consolidate and dispose of facilities that are no longer required.
Item 3. Legal Proceedings
Refer to Notes 16 and 18 to the Consolidated Financial Statements included herein.
Item 4. Submission of Matters to a Vote of Security Holders
A special meeting of stockholders of MasterCard Incorporated was held on November 28, 2005 to consider and approve a new ownership and governance structure for MasterCard. A total of 85,478,318 shares of common stock were represented by proxy at the meeting. The items on the agenda for the special meeting were as follows:
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adoption of the Amended and Restated Certificate of Incorporation of MasterCard Incorporated,
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approval of the proposed initial public offering of the Class A common stock of MasterCard Incorporated,
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approval of the Amended and Restated Certificate of Incorporation of MasterCard International Incorporated,
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approval of the Amended and Restated Bylaws of MasterCard International Incorporated and
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adoption of the MasterCard Incorporated 2006 Long Term Incentive Plan.
Proposal 1-Adopt the Amended and Restated Certificate of Incorporation of MasterCard Incorporated
Proposal 1 received 80,745,803 votes “for,” 610,389 votes “against” and 4,122,126 abstentions and was adopted by stockholders. There were no broker non-votes.
Proposal 2-Approve the proposed initial public offering of the Class A common stock of MasterCard Incorporated
Proposal 2 received 80,749,562 votes “for,” 627,039 votes “against” and 4,101,717 abstentions and was adopted by stockholders. There were no broker non-votes.
Proposal 3-Approve the Amended and Restated Certificate of Incorporation of MasterCard International Incorporated.
Proposal 3 received 80,740,346 votes “for,” 610,389 votes “against” and 4,127,538 abstentions and was adopted by stockholders. There were no broker non-votes.
Proposal 4-Approve the Amended and Restated Bylaws of MasterCard International Incorporated.
Proposal 4 received 80,719,151 votes “for,” 611,952 votes “against” and 4,147,215 abstentions and was adopted by stockholders. There were no broker non-votes.
Proposal 5-Adopt the MasterCard Incorporated 2006 Long Term Incentive Plan
Proposal 5 received 77,878,797 votes “for,” 1,606,952 votes “against” and 5,992,569 abstentions and was adopted by stockholders. There were no broker non-votes.
The amended and restated certificates of incorporation and bylaws of MasterCard Incorporated and MasterCard International and the 2006 Long Term Incentive Plan are expected to be implemented immediately prior to the consummation of the initial public offering.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There is currently no established public trading market for the Class A redeemable common stock of MasterCard Incorporated. There were approximately 1,491 holders of record of the Class A redeemable common stock of MasterCard Incorporated as of March 15, 2006. We have not paid any cash dividends on our Class A redeemable common stock. The Class A redeemable common stock of MasterCard Incorporated is not currently authorized to be issued in connection with any compensation plan.
As previously disclosed in MasterCard Incorporated’s annual and quarterly reports filed with the SEC and as described in Note 20 to the Consolidated Financial Statements contained herein, under MasterCard Incorporated’s organizational documents, its class A redeemable common stock was reallocated among its stockholders and any institutions that became new principal members of its subsidiary, MasterCard International Incorporated, during a three-year transition period following MasterCard’s conversion to a private share company and integration with MasterCard Europe (formerly Europay S.A.) in 2002. The reallocation was undertaken in accordance with a formula based upon such stockholders’ and principal members’ contributions to MasterCard’s business during the twelve months ended June 30, 2005. On July 1, 2005, as part of this reallocation process, MasterCard Incorporated issued an aggregate of 348 shares of its class A redeemable common stock, par value $.01 per share, or one share each, to 348 such new principal members for $.01 per share. On October 21, 2005, a total of 2,218,363 additional shares were delivered to 283 of these new principal members. The issuance and delivery of such shares was not registered under the Securities Act because the shares were offered and sold in a transaction exempt from registration under Section 4(2) of the Securities Act.
After the initial public offering, MasterCard intends to list its new Class A common stock on the New York Stock Exchange. In addition, after the consummation of the ownership and governance transactions MasterCard’s board of directors intends to adopt a policy of declaring, subject to legally available funds, quarterly cash dividends on its Class A and Class B common stock. MasterCard also plans to reserve 5,300,000 shares of Class A common stock under a long term equity based incentive plan that was approved by stockholders on November 28, 2005. See “New Ownership and Governance Structure” of Part I, Item 1 - Business for a description of MasterCard’s proposed ownership and governance transactions.
Item 6. Selected Financial Data
On June 28, 2002, we converted from a membership to a stock company through the creation of MasterCard Incorporated, a new holding company. Also on June 28, 2002, MasterCard Incorporated directly and indirectly acquired all of the outstanding stock of Europay International S.A. (“EPI”) in a transaction that we refer to as the “Integration”. On July 16, 2002, EPI was renamed MasterCard Europe S.A. (“MasterCard Europe”). On September 30, 2002, MasterCard Europe was reorganized in Belgium as MasterCard Europe sprl. Note 21 to the Consolidated Financial Statements herein more fully describes these transactions.
The statement of operations data presented below for the years ended December 31, 2005, 2004 and 2003, and the balance sheet data as of December 31, 2005 and 2004, were derived from the audited consolidated financial statements of MasterCard Incorporated included in this Report. The statement of operations data presented below for the years ended December 31, 2002 and 2001, and the balance sheet data as of December 31, 2003, 2002 and 2001, were derived from the audited consolidated financial statements not included in this Report. The results of MasterCard Europe’s operations have been included in our consolidated statements of operations from June 28, 2002 to present. The pro forma net income (loss) per share amounts are not audited. The data set forth below should be read in conjunction with, and are qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and Notes thereto included elsewhere in this Report.
As more fully described in Note 2 to the Consolidated Financial Statements herein, prior to our initial public offering in connection with the ownership and governance transactions, we will reclassify all of our 100,000 outstanding shares of existing Class A redeemable common stock so that our existing stockholders will receive 1.35 shares of our Class B common stock for each share of Class A redeemable common stock that they held prior to the reclassification and a single share of our Class M common stock. Accordingly, shares and per share data will be retroactively restated in the financial statements subsequent to the reclassification to reflect the reclassification as if it were effective at the start of the first period being presented in the financial statements.
Pro forma amounts give effect to the reclassification described above as if it were in place for the periods presented.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements and notes of MasterCard Incorporated and its consolidated subsidiaries, including MasterCard International Incorporated (“MasterCard International”) and MasterCard Europe sprl (“MasterCard Europe”) (together, “MasterCard” or the “Company”) included elsewhere in this Report.
Overview
We are a global payment solutions company that provides a variety of services in support of our customers’ credit, debit and related payment programs. We manage a family of well-known, widely accepted payment card brands including MasterCard®, MasterCard Electronic™, Maestro® and Cirrus®, which we license to our financial institution customers. As part of managing these brands, we also provide our customers with information and transaction processing services and establish and enforce rules and standards surrounding the use of our payment card system by customers and merchants. We generate revenues from the fees that we charge our customers for providing these transaction processing and other payment-related services (operations fees) and by charging assessments to our customers based on the gross dollar volume (GDV) of activity on the cards that carry our brands (assessments). Our pricing for transactions and services is complex. Each category of revenue has numerous fee components depending on the types of transactions or services provided. In addition, standard pricing varies among our regional businesses, and such pricing can be customized further for our customers through incentive and rebate agreements. Operations fees are typically transaction-based and include authorization, settlement and switch, connectivity, currency conversion, warning bulletins, and other fees for a variety of additional services. Assessments are based on GDV for a specific time period and the rates vary depending on the nature of the transactions that generate GDV. GDV includes the aggregated dollar amount of usage (purchases, cash disbursements, balance transfers and convenience checks) on MasterCard-branded cards. Our revenues are based upon transactional information accumulated by our systems or reported by our customers. Our operating expenses are comprised primarily of general and administrative expenses such as personnel, professional fees, data processing, telecommunications, travel and advertising and marketing expenses to promote our brands, including promotions and sponsorships.
We evaluate and monitor our business based on our results from operations, including our percentage of revenue growth and operating expenses as a percentage of total revenue, and our financial position. In addition, we utilize growth in GDV and processed transactions to monitor the strength of our business.
Our liquidity and capital position are strong. We had $1.3 billion in cash, cash equivalents and available-for-sale securities, and $1.2 billion in stockholders’ equity as of December 31, 2005.
We achieved double-digit revenue growth of 13% in 2005. The increase in revenues was due to higher gross usage on cards carrying our brands for goods and services, a larger number of transactions processed by MasterCard, higher cross-border travel by cardholders using our cards and certain pricing changes that went into effect on April 1, 2005. The pricing changes including implementing new fees, increasing existing fees or
modifying our fee calculation methodology accounted for approximately 5% of net revenue growth in 2005. Significant changes in the methodology for calculating fees primarily related to a component of settlement fees being changed from tiered pricing to a flat rate, a component of authorization fees being changed from monthly pricing to weekly pricing which increased utilization, and connectivity fees being expanded to include a charge for the volume of information being transmitted in addition to the fixed fee initially charged. Operating expenses, excluding the impact of the U.S. merchant lawsuit and other legal settlements, increased 11% in 2005. We continued to reduce our operating expenses, excluding the impact of the U.S. merchant lawsuit and other legal settlements, as a percentage of total revenues to 84% in 2005 from 86% in 2004.
In June 2002, we acquired Europay International S.A. (now MasterCard Europe). In 2004, we acquired a research firm and a consulting firm, both of which were immaterial to our operations. The results of operations for these acquisitions are included from their respective acquisition dates.
We successfully complied with Sarbanes-Oxley Section 404 testing three years ahead of the U.S. Securities and Exchange Commission’s deadline for non-accelerated filers. We concluded, based on our assessment, that our internal controls over financial reporting were effective as of December 31, 2005.
We believe the trend within the global payments industry from paper-based forms of payment such as cash and checks toward electronic forms of payment such as cards creates significant opportunities for the continued growth of our business. Our strategy is to drive growth by further penetrating our existing customer base and by expanding our role in targeted geographies and higher-growth segments of the global payments industry (such as corporate payments, prepaid cards and chip based cards), enhancing our merchant relationships, maintaining unsurpassed acceptance and continuing to invest in our brands. We intend to expand our role in targeted geographies by, among other things, pursuing incremental payment processing opportunities in the European Union in connection with the implementation of the Single European Payment Area initiative and in Latin America and Asia/Pacific countries. We are committed to providing our key customers with coordinated services through integrated, dedicated account teams in a manner that allows us to leverage our expertise in payment programs, brand marketing, product development, technology, processing and consulting services for these customers. By investing in strong customer relationships over the long-term, we believe that we can increase our volume of business with key customers over time, and in support of this strategy, we are hiring additional resources and developing sales and other personnel.
There is increased regulatory scrutiny of interchange fees and other aspects of the payments industry which could have an adverse impact on our business. In addition, we face exposure to antitrust and other types of litigation. Competition and pricing pressure within the global payments industry is increasing, due in part to consolidation within the banking sector and the growing power of merchants. Regulatory actions, litigation, and pricing pressure may lead us to change our pricing arrangements and could reduce our overall revenues. See Item 1A
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the potential for economic losses to be incurred on market risk sensitive instruments arising from adverse changes in market factors such as interest rates, foreign currency exchange rates, and equity price risk. We have limited exposure to market risk from changes in interest rates, foreign exchange rates and equity price risk. Management establishes and oversees the implementation of policies, which have been approved by the board of directors, governing our funding, investments, and use of derivative financial instruments. We monitor risk exposures on an ongoing basis. There have been no material changes in our market risk exposures at December 31, 2005 as compared to December 31, 2004.
Foreign Exchange Risk
We enter into forward exchange contracts to minimize risk associated with anticipated receipts and disbursements denominated in foreign currencies. We also enter into contracts to offset possible changes in value due to foreign exchange fluctuations of assets and liabilities denominated in foreign currencies. The objective of this activity is to reduce our exposure to transaction gains and losses resulting from fluctuations of foreign currencies against our functional currencies, principally the U.S. dollar and euro. The terms of the forward currency contracts are generally less than 18 months.
At December 31, 2005 and 2004, forward currency contracts against the U.S. dollar were both purchased (with notional amounts of $78 million and $41 million, respectively) and sold (with notional amounts of $33 million and $20 million, respectively). Based on the year-end 2005 and 2004 foreign exchange positions, the effect of a hypothetical 10 percent strengthening of the U.S. dollar is estimated to create a loss valued at $4 million and $2 million at December 31, 2005 and 2004, respectively.
At December 31, 2005 and 2004, forward currency contracts against the euro were purchased (with notional amounts of $218 million and $128 million, respectively) and sold (with notional amounts of $39 million and no open contracts, respectively). Based on the year-end 2005 and 2004 foreign exchange positions, the effect of a hypothetical 10 percent strengthening of the euro is estimated to create a loss valued at $16 million and $11 million at December 31, 2005 and 2004, respectively.
Our settlement activities are subject to foreign exchange risk resulting from foreign exchange rate fluctuations. This risk is limited to the extent that the timeframe between setting the foreign exchange rates and clearing the financial transactions is typically one business day and by limiting the supported settlement currencies to the U.S. dollar or one of nineteen other stable transaction currencies. The remaining 146 transaction currencies are settled in one of the supported settlement currencies or require local settlement netting arrangements that minimize our foreign exchange exposure.
Interest Rate Risk
Our interest rate sensitive assets are our debt instruments, which we hold as available-for-sale investments. They are rated AA or above and primarily consist of fixed rate short and medium-term instruments. With respect to fixed maturities, our general policy is to invest in high quality securities, while providing adequate liquidity
and maintaining diversification to avoid significant exposure. Based on the net present value of expected future cash flows, a 100 basis point increase in interest rates, assuming a parallel shift of the yield curve, would result in fair value changes and an unrealized loss recorded in other comprehensive income of $19 million and $17 million for 2005 and 2004, respectively. Our held-to-maturity investments are not subject to interest rate movements.
Our interest rate sensitive liabilities consist of subordinated debt securities. A 100 basis point decrease in rates would result in a fair value loss of $5 million and $9 million for December 31, 2005 and 2004, respectively. See Note 13 to the Consolidated Financial Statements herein.
At December 31, 2005 and 2004, we had various credit facilities to provide liquidity in the event of material member settlement failures, settlement service operations and other operational needs. These credit facilities have variable rates, which are applied to the borrowing based on terms and conditions set forth in each agreement. There were 4 million euros and no amounts outstanding at December 31, 2005 and 2004, respectively, under these credit facilities. See Note 13 to the Consolidated Financial Statements herein.
Equity Price Risk
We own trading securities, which are comprised of equity securities selected to offset obligations in connection with an executive compensation plan. The effect of a hypothetical 10 percent decline in market value would result in a loss of $2 million and $3 million in the years ended December 31, 2005 and 2004, respectively. To the extent the executive compensation plan remains in a net appreciation position, an offsetting gain would be recorded in general and administrative expense.
Item 8.
Item 8. Financial Statements and Supplementary Data
MASTERCARD INCORPORATED
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
MasterCard Incorporated
As of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003
Management’s Report on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Cash Flows
Consolidated Statements of Changes in Stockholders’ Equity
Consolidated Statements of Comprehensive Income (Loss)
Notes to Consolidated Financial Statements
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of MasterCard Incorporated is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. As required by Section 404 of the Sarbanes-Oxley Act of 2002, management has assessed the effectiveness of MasterCard’s internal control over financial reporting as of December 31, 2005. In making its assessment management has utilized the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in its report entitled Internal Control-Integrated Framework. Management has concluded that, based on its assessment, MasterCard’s internal control over financial reporting was effective as of December 31, 2005. Our management’s assessment of the effectiveness of MasterCard’s internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears on the next page.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
of MasterCard Incorporated:
We have completed integrated audits of MasterCard Incorporated’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its December 31, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows, of changes in stockholders’ equity and of comprehensive income (loss) present fairly, in all material respects, the financial position of MasterCard Incorporated and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 11 to the consolidated financial statements, the Company changed its method for calculating the market-related value of pension plan assets used in determining the expected return on the assets component of annual pension cost in 2003.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing in this Item, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PRICEWATERHOUSECOOPERS LLP
New York, New York
March 16, 2006
MASTERCARD INCORPORATED
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
MASTERCARD INCORPORATED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
The accompanying notes are an integral part of these consolidated financial statements.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except per share data)
Note 1. Summary of Significant Accounting Policies
Organization-MasterCard Incorporated and its consolidated subsidiaries, including MasterCard International Incorporated (“MasterCard International”), MasterCard Europe sprl (“MasterCard Europe”) (together, “MasterCard” or the “Company”), provide transaction processing and related services to customers principally in support of their credit, deposit access (debit), electronic cash and Automated Teller Machine (“ATM”) payment card programs, and travelers cheque programs. MasterCard enters into transactions with its customers in the normal course of business and operates a system for payment processing among its customers.
The common stock of MasterCard Incorporated is privately owned by certain customers of the Company. As more fully described in Note 2, MasterCard is pursuing a new ownership and governance structure, which will involve a new class of the Company’s common stock being traded on a public exchange. MasterCard enters into transactions with its customers in the normal course of business and operates a system for payment processing among its customers.
Consolidation and basis of presentation-The Company follows accounting principles generally accepted in the United States of America. Certain prior period amounts have been reclassified to conform to the 2005 presentation. The consolidated financial statements include the accounts of MasterCard and its majority-owned subsidiaries. Intercompany transactions are eliminated in consolidation.
The Company consolidates majority-owned and controlled entities, including specific consideration of variable interest entities which are required to be consolidated in accordance with the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46R”). Minority interest is recorded for consolidated entities in which the Company owns less than 100% of the interest. Minority interest represents the equity interest not owned by the Company.
The Company accounts for investments in entities under the equity method of accounting when it holds between 20% and 50% ownership in the entity and when it exercises significant influence. The equity method of accounting is also utilized for limited partnerships and limited liability companies if the investment ownership percentage is greater than 3% of outstanding ownership interests or common stock, respectively, regardless of whether MasterCard has significant influence over the investees. MasterCard’s share of net earnings or losses of entities accounted for under the equity method of accounting is included in other income (expense), net on the consolidated statements of operations.
The Company accounts for investments in affiliates under the historical cost method of accounting when it holds less than 20% ownership in the entity and when it does not exercise significant influence.
Investments in entities for which the equity method and historical cost method of accounting are appropriate are recorded in other assets on the consolidated balance sheets.
Use of estimates-The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Management has established detailed policies and control procedures to ensure the methods used to make estimates are well controlled and applied consistently from period to period. Actual results may differ from these estimates.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Cash and cash equivalents-Cash and cash equivalents include certain highly liquid investments with a maturity of three months or less from the date of purchase. Cash equivalents are recorded at cost, which approximates fair value.
Investment securities-The Company classifies debt securities as held-to-maturity or available-for-sale and classifies equity securities as trading.
Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the debt securities to maturity. Held-to-maturity debt securities are stated at amortized cost. Debt securities that are not held-to-maturity are classified as available-for-sale. Available-for-sale debt securities are carried at fair value, with the unrealized gains and losses, net of applicable taxes, recorded as a separate component of other comprehensive income on the consolidated statements of comprehensive income (loss). Quoted market values, when available, are used to determine the fair value of debt securities. The specific identification method is used to determine gains and losses. Net realized gains and losses on debt securities are recognized in investment income on the consolidated statements of operations.
Equity securities bought and held primarily for sale in the near term are classified as trading and are reported at fair value. Quoted market values are used to determine the fair value of trading securities. The Company’s trading securities are publicly traded and are related to an executive compensation plan. Net realized and unrealized gains and losses on trading securities are recognized in investment income on the consolidated statements of operations. The specific identification method is used to determine realized gains and losses. To the extent these securities appreciate over their original cost, a corresponding offset would be recorded in general and administrative expense in connection with the executive compensation plan.
Held-to-maturity and available-for-sale investments are evaluated for other than temporary impairment on an ongoing basis in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. Available-for-sale securities are available to meet the Company’s current operational needs and accordingly are classified as short-term.
Settlement due from/due to members-The Company operates systems for clearing and settling payment transactions among MasterCard International members. Net settlements are generally cleared daily among members through settlement cash accounts by wire transfer or other bank clearing means. However, some transactions may not settle until subsequent business days, resulting in amounts due from and due to MasterCard International members.
Restricted security deposits held for MasterCard International members-MasterCard requires and holds cash deposits from certain members of MasterCard International in order to maintain collateral for settlement of their transactions. These assets are fully offset by corresponding liabilities included on the consolidated balance sheets. However, the majority of collateral for settlement are typically in the form of letters of credit and bank guarantees.
Property, plant and equipment-Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Depreciation of equipment and furniture and fixtures is computed using the straight-line method over the related estimated useful lives of the assets, generally ranging from two to five years. Amortization of leasehold improvements is computed using the straight-line method over the lesser of the estimated useful lives of the improvements or the terms of the related leases. Capital leases are amortized using the straight-line method over the lives of the leases. Depreciation on buildings is calculated using the straight-line method over an estimated useful life of 30 years. Amortization of leasehold improvements and capital leases is included in depreciation expense.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The Company evaluates the recoverability of all long-lived assets whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. If the carrying value of the asset cannot be recovered from estimated future cash flows, undiscounted and without interest, the fair value of the asset is calculated using the present value of estimated net future cash flows. If the carrying amount of the asset exceeds its fair value, a loss is recorded.
Goodwill-Goodwill represents the excess of cost over net assets acquired in connection with the acquisition of certain businesses. The Company tests its goodwill for impairment at least annually. Goodwill was tested for impairment during each of 2005, 2004 and 2003. In 2004, the company recorded an impairment charge; see Note 8 herein.
Intangible assets-Intangible assets consist of capitalized software costs, franchise rights, trademarks, tradenames and other intangible assets, which have finite lives, and customer relationships, which have indefinite lives. Intangible assets with finite useful lives are amortized over their estimated useful lives under the straight-line method. MasterCard capitalizes average internal costs incurred for payroll and payroll related expenses by department for the employees who directly devote time to the design, development and testing phases of each capitalized software project.
The Company reviews intangible assets with finite lives for impairment when events or changes in circumstances indicate that their carrying amount may not be recoverable. During 2005, 2004 and 2003, the Company recorded impairment charges for finite lived intangible assets; see Note 9 herein. Intangible assets with indefinite lives, customer relationships, are tested for impairment at least annually. No impairment charges were recorded in 2005, 2004 or 2003.
Litigation accrual-The Company is party to certain legal and regulatory proceedings with respect to a variety of matters. Except as described in Notes 16 and 18 herein, MasterCard does not believe that any legal or regulatory proceedings to which it is a party would have a material adverse impact on its business or prospects. The Company evaluates the likelihood of an unfavorable outcome of the legal or regulatory proceedings to which it is a party in accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS No. 5”). These judgments are subjective based on the status of the legal or regulatory proceedings, the merits of its defenses and consultation with in-house and external legal counsel. The actual outcomes of these proceedings may materially differ from the Company’s judgments.
Settlement and travelers cheque risk-MasterCard has global risk management policies and procedures, which include risk standards to provide a framework for managing the Company’s settlement exposure. Settlement risk is the legal exposure due to the difference in timing between the payment transaction date and subsequent settlement. MasterCard International’s rules generally guarantee the payment of MasterCard transactions and certain Cirrus and Maestro transactions between principal members. In the event that MasterCard International effects a payment on behalf of a failed member, MasterCard International may seek an assignment of the underlying receivables. Subject to approval by the Board of Directors, members may be charged for the amount of any settlement losses incurred during the ordinary activities of the Company. MasterCard International’s right to impose special assessments arising out of extraordinary events on its members will be eliminated once the new ownership structure and governance changes are completed, as described in Note 2. MasterCard has also guaranteed the payment of MasterCard-branded travelers cheques in the event of issuer default. The term and amount of these guarantees are unlimited.
Derivative financial instruments-The Company accounts for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). SFAS 133,
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
as amended and interpreted, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS 133 requires that all derivatives, whether designated in hedging relationships or not, be recorded on the balance sheet at fair value in other assets and other liabilities, regardless of the purpose or intent for holding them.
Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a foreign-currency cash flow hedge are recorded in other comprehensive income (loss) until earnings are affected by the variability of cash flows of the hedged transaction (e.g., until periodic settlements of a variable-rate asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative exceeds the variability in the cash flows of the forecasted transaction) is recorded in current-period earnings. Changes in the fair value of derivative instruments which are foreign currency fair value hedges or which do not qualify or are not designated for hedge accounting under SFAS 133 are reported in current-period earnings.
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions for all derivatives that qualify for hedge accounting under SFAS 133. This process includes linking all derivatives that are designated as foreign-currency cash flow hedges to forecasted transactions. The Company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. If and when it is determined that a derivative is no longer expected to be highly effective, hedge accounting is discontinued.
Income taxes-The Company provides for income taxes under the provisions of SFAS No. 109 “Accounting for Income Taxes” (“SFAS 109”). SFAS 109 requires an asset and liability based approach in accounting for income taxes.
Deferred income tax assets and liabilities are recorded to reflect the tax consequences on future years of temporary differences between the financial statement carrying amounts and income tax bases of assets and liabilities. Valuation allowances are provided against assets which are not likely to be realized.
Revenue recognition-The Company’s revenue is comprised principally of operations fees and assessments. Revenues are generated from the fees charged to customers for providing transaction processing and other payment services, and from assessments calculated on the dollar volume of activity on cards carrying our brands. Revenues are generally based upon transactional information accumulated by our systems or reported by our customers. Certain revenues are estimated based upon aggregate transaction information and historical and projected customer performance. Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectibility is reasonably assured.
Operations fees represent fees for authorization, clearing, settlement and other products and services that facilitate transaction and information management among the Company’s customers on a global basis. These fees are recognized as revenue in the same period as the related transactions occur or services are rendered. Other revenues included within operations fees include currency conversion fees, net foreign exchange gains or losses on settlement activities, excessive chargeback violation fees, consulting, sales of holograms, warning bulletins, manuals and publications.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Assessments predominantly represent payments made by members of MasterCard International with respect to their card programs carrying the marks of one or more of the brands within the MasterCard family of brands, principally the MasterCard, Maestro and Cirrus brands. Assessments are based principally upon daily, monthly or quarterly gross dollar volumes (“GDV”), which represent gross usage (purchase and cash disbursements) on MasterCard-branded cards for goods and services, including balance transfers and convenience checks. Assessments are recorded as revenue in the period they are earned, which is when the related GDV is generated on the cards. Assessments are based on management’s estimate of the customers’ performance in a given period, and actual results may differ from these estimates.
MasterCard has business agreements with certain customers that provide for fee rebates when the customers meet certain hurdles. Such rebates are calculated on a monthly basis based upon estimated performance and the contracted discount rates for the services provided. MasterCard also enters into agreements with certain customers to provide volume-based and performance support incentives. MasterCard may incur costs directly related to the acquisition of the contract, which are deferred and amortized over the life of the contract. Rebates and incentives are recorded as a reduction of revenue in the same period as the revenue is earned or performance has occurred, in accordance with Emerging Issues Task Force (“EITF”) Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)” (“EITF 01-9”). Rebates and incentives are calculated on a monthly basis based upon estimated performance and the terms of the related business agreements, actual results may differ from these estimates.
In addition, certain rebate and incentive agreements provide for free or discounted services, which are recorded in accordance with EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”. The discount from the fair value of the services is recorded as a reduction of revenue related to other elements of the contract using the residual method.
Pension and other postretirement plans-Compensation cost of an employee’s pension benefit is recognized on the projected unit credit method over the employee’s approximate service period. The unit credit cost method is utilized for funding purposes. Prior to 2003, the expected return on plan assets was based on a calculated asset value. Beginning in 2003, the expected return on plan assets is based on the current fair value of the plan assets; this change in accounting principle is discussed in Note 11 herein.
In May 2004, the FASB issued FASB Staff Position No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”)” (“FSP 106-2”). FSP 106-2 requires companies to account for the effect of the subsidy on benefits attributable to past service as an actuarial experience gain and as a reduction of the service cost component of net postretirement health care costs for amounts attributable to current service, if the benefit provided is at least actuarially equivalent to Medicare Part D. MasterCard determined the effects of the Act were not a significant event requiring an interim remeasurement. Consequently, as permitted by FSP 106-2, net periodic postretirement benefit cost for 2004 does not reflect the effects of the Act. The accumulated postretirement benefit obligation (“APBO”) for the postretirement benefit plan was remeasured at December 31, 2004 to reflect the effects of the Act, which resulted in a reduction in the APBO of $2,680.
Advertising expense-Cost of media advertising is expensed when the advertising takes place. Production costs are expensed as costs are incurred. Promotional items are expensed at the time the promotional event occurs.
Foreign currency translation-The U.S. dollar is the functional currency for the majority of the Company’s businesses except for MasterCard Europe’s operations, for which the functional currency is the euro and
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
MasterCard’s operations in Brazil for which the functional currency is the real. Where the U.S. dollar is considered the functional currency, monetary assets and liabilities are remeasured to U.S. dollars using current exchange rates in effect at the balance sheet date; non-monetary assets and liabilities are remeasured at historical exchange rates; and revenue and expense accounts are remeasured at a weighted average exchange rate for the period. Resulting exchange gains and losses are included in net income (loss). Where local currency is the functional currency, translation from the local currency to U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate for the period. Resulting translation adjustments are reported as a component of other comprehensive income (loss).
Net income (loss) per share-MasterCard computes basic and diluted net income (loss) per share by dividing net income (loss) applicable to common stock by the weighted average number of common shares outstanding for the period.
Note 2. Proposed New Ownership and Governance Structure
MasterCard is pursuing a plan for a new ownership and governance structure that will include the appointment of a new board of directors comprised of a majority of independent directors, the establishment of a charitable foundation and the transition to being a publicly traded company.
Under the proposed ownership and governance structure, MasterCard’s current stockholders are expected to retain a 41% equity interest in the company through ownership of a new non-voting class B common stock that existing stockholders will receive in the reclassification described below. In addition, existing stockholders are expected to receive a new class M common stock that will have no economic rights but will provide them with certain rights, including the right to approve specified significant corporate actions and entitle them to elect up to three of MasterCard’s directors (but not more than one quarter of the total number of directors) and are otherwise non-voting.
MasterCard also intends to issue shares of a new voting class A common stock to public investors through an initial public offering. Upon successful completion of the offering, these public investors are expected to hold shares representing an expected 46% of the Company’s equity and 82% of its general voting power (or 49% of the Company’s equity and 83% of its general voting power if the underwriters exercise their option to purchase additional shares in full). Additional shares of new class A common stock, representing approximately 10% of the Company’s equity and 18% of its voting rights (or 17% of its voting power if the underwriters exercise their option to purchase additional shares in full), are expected to be issued as a donation to The MasterCard Foundation, a charitable foundation incorporated in Canada.
MasterCard intends to use all but $650,000 of the net proceeds from the initial public offering (including any proceeds received pursuant to the underwriters’ option to purchase additional shares) to redeem a number of shares of Class B common stock from the Company’s existing stockholders that is equal to the aggregate number of shares of Class A common stock that we issue to investors in the initial public offering (including any shares sold pursuant to the underwriters’ option to purchase additional shares) and to the Foundation. As a result, the Company’s existing stockholders will own 41% of the Company’s equity. MasterCard intends to use the remaining proceeds to increase its capital, defend itself against legal and regulatory challenges, expand its role in targeted geographics and higher growth segments of the global payments industry and for other general corporate purposes. However, the Company has not determined the amounts of such remaining proceeds that are to be allocated to these purposes. The value of the shares of Class A common stock donated to The MasterCard Foundation will be determined based on the initial public offering price per share of class A common stock less a marketability discount.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Prior to the initial public offering, the Company will reclassify all of the Company’s 100,000 outstanding shares of existing class A redeemable common stock so that the Company’s existing stockholders will receive 1.35 shares of the Company’s new class B common stock for each share of class A redeemable common stock that they hold and a single share of the new class M common stock. Accordingly, shares and per share data will be retroactively restated in the financial statements subsequent to the common stock reclassification to reflect the reclassification as if it was effective at the start of the first period being presented in the financial statements. Pro forma amounts give effect to the reclassification.
Implementation of the new ownership and governance structure is subject to various approvals, including stockholder approval and the requisite regulatory filings. At a special meeting on November 28, 2005, MasterCard’s stockholders approved the new ownership and governance structure.
Note 3. Supplemental Cash Flows
The following table includes supplemental cash flow disclosures for the years ended December 31:
In January 2003, MasterCard purchased a building in Kansas City, Missouri for approximately $23,572. The building is a co-processing data center which replaced the back-up data center in Lake Success, New York. During 2003, MasterCard entered into agreements with the City of Kansas City for (i) the sale-leaseback of the building and related equipment which totaled $36,382 and (ii) the purchase of municipal bonds for the same amount which have been classified as municipal bonds held-to-maturity. The agreements enabled MasterCard to secure state and local financial benefits. No gain or loss was recorded in connection with the agreements. The leaseback has been accounted for as a capital lease as the agreement contains a bargain purchase option at the end of the ten-year lease term on April 1, 2013. The building and related equipment are being depreciated over their estimated economic life in accordance with the Company’s policy. Rent of $1,819 is due annually and is equal to the interest due on the municipal bonds. The future minimum lease payments are $51,238 and are included in the future commitment schedule in Note 15 herein. A portion of the building was subleased to the original building owner for a five-year term with a renewal option. As of December 31, 2005, the future minimum sublease rental income is $1,968.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Note 4. Investment Securities
Available-for-sale investment securities consist of municipal bonds. The amortized cost, gross unrealized gains and losses and fair value of available-for-sale securities are as follows:
Held-to-maturity investment securities also consist of municipal bonds. The carrying value, gross unrecorded gains and losses and fair value of held-to-maturity securities are as follows:
At December 31, 2005, there were no investment securities in continuous significant gross unrealized loss positions for greater than twelve months. Due to the high credit quality of the Company’s investment securities and the intent and ability to hold until maturity, no investment securities are considered to be other-than-temporarily impaired as of December 31, 2005.
The maturity distribution based on contractual terms of investment securities at December 31, 2005 is as follows:
Included in the available-for-sale amounts above are auction rate securities of $194,725 and $273,299 as of December 31, 2005 and 2004, respectively. These securities are reset to current interest rates typically every 35 days and no later than every 90 days, but are included in this table based on their stated maturities. All securities with maturities beyond ten years are auction rate securities.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Components of net investment income are as follows for each of the years ended December 31:
Note 5. Prepaid Expenses
Prepaid expenses consist of the following at December 31:
Prepaid customer and merchant incentives represent payments made to customer and merchants under business agreements.
Note 6. Other Assets
Other assets consist of the following at December 31:
Certain customer and merchant business agreements provide a bonus for agreeing to enter into the agreement. As of December 31, 2005 and 2004, other assets include payments to be made for these bonuses and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
the related liability is included in accrued expenses. The bonus is amortized over the life of the agreement. Once the payment is made the liability is relieved, and the other asset is reclassified as a prepaid expense.
Note 7. Property, Plant and Equipment
Property, plant and equipment consist of the following at December 31:
As of December 31, 2005 and 2004, capital leases of $26,143 and $27,843, respectively, are included in equipment. Accumulated amortization of capital leases was $13,955 and $14,317 as of December 31, 2005 and 2004, respectively.
Depreciation expense for the above property, plant and equipment was $46,304, $51,277 and $52,953 for the years ended December 31, 2005, 2004 and 2003, respectively.
Note 8. Goodwill
The changes in the carrying amount of goodwill for the years ended December 31, 2005, 2004 and 2003 are as follows:
In February 2004, the Company acquired a research and advisory firm focused exclusively on the global financial services industry. In May 2004, the Company acquired a consulting firm specializing in the optimization of customer relationships. For one of the acquisitions noted above, the Company identified certain indicators of potential impairment, including lower than anticipated revenues during 2004 and loss of key
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
customers negatively impacting future revenue growth. Accordingly, the Company recorded impairment losses of $6,560 (goodwill of $5,454 and other intangible assets of $1,106) in 2004, which are reflected within general and administrative expenses on the consolidated statements of operations herein.
Note 9. Other Intangible Assets
The following table sets forth net intangible assets, other than goodwill:
Additions to capitalized software primarily relate to internal projects associated with system enhancements or infrastructure improvements adjusted for the translation of capitalized software denominated in foreign currency.
Amortizable trademarks and tradenames and unamortizable customer relationships include assets which are denominated in foreign currency. As such, a component of the net change in these intangible assets is attributable to foreign currency translation. In particular, customer relationships decreased $26,162 and trademarks decreased $1,965 in 2005 for the portion of these assets assumed in the acquisition of Europay International S.A. on June 28, 2002, as discussed in Note 21 herein.
Amortization and impairment expense on the assets above amounted to the following:
During the years 2005, 2004 and 2003, impairment charges of $1,786, $867 and $3,371, respectively, were recorded primarily in connection with decisions to discontinue the use of various technologies included in capitalized software. The Company performed an impairment analysis on the related technology and concluded that fair value was estimated as zero due to discontinued future use of the underlying technology. Impairment charges are recorded in general and administrative expense on the consolidated statements of operations for each of the years ended December 31, 2005, 2004 and 2003.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The following table sets forth the estimated future amortization expense on amortizable intangible assets for the year ending:
Note 10. Accrued Expenses
Accrued expenses consist of the following at December 31:
Note 11. Pension, Savings Plan and Other Benefits
The Company maintains a noncontributory defined benefit pension plan with a cash balance feature covering substantially all of its U.S. employees. This pension plan credits participants annually with an amount equal to a percentage of eligible pay based on age and service, as well as providing earnings credits based on each participant’s account balance. Additionally, the Company has an unfunded nonqualified supplemental executive retirement plan that provides certain key employees with supplemental retirement benefits in excess of limits imposed on qualified plans by U.S. tax laws.
Effective January 1, 2003, the Company changed its method of calculating the market-related value of plan assets used in determining the expected return on asset component of its annual pension cost. Under the previous method, 80 percent of the gains and losses on plan assets were deferred and recognized in the calculated market-related value over the following four years. Under the new method, the market-related value equals the current fair value of the plan assets. The new method is considered preferable because annual pension expense reflects changes in the market performance of plan assets on a more timely basis.
The cumulative effect of this change in accounting principle related to periods prior to 2003 was a benefit to earnings for the year ended December 31, 2003, in the amount of $7,768, less income taxes of $2,819, for a net benefit of $4,949. The Company’s net periodic pension cost would have been reduced by $1,928 for 2003 if it had not changed its valuation method.
In 2002, in connection with its acquisition of MasterCard Europe, the Company assumed a defined benefit plan (“European Plan”) covering substantially all employees affiliated with MasterCard Europe. On December 31, 2002, the Company settled the benefit obligations and terminated the European Plan. All excess assets have been transferred to a new defined contribution plan.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The following table sets forth the pension plans’ funded status, key assumptions and amounts recognized in the Company’s Consolidated Balance Sheets at December 31, 2005 and 2004. The U.S. plans include both the qualified and the nonqualified pension plans. The Company uses a December 31 measurement date for its pension plans.
The accumulated benefit obligation for the U.S. plans was $157,517 and $142,047 at December 31, 2005 and 2004, respectively.
Information for the Company’s nonqualified pension plan, which has an accumulated benefit obligation in excess of plan assets, is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Net periodic pension cost (benefit) includes the following components for the years ended December 31:
Weighted-average assumptions used to determine net periodic pension cost for the years ended December 31:
The expected return on plan assets is primarily based on long-term historical returns in equity and fixed income markets. Based on estimated returns of 10 percent on equity investments and 6 percent on fixed income investments and the portfolio’s targeted asset allocation range, the weighted average expected return of the qualified pension plan assets is 8.5 percent.
The Company’s qualified pension plan’s weighted-average asset allocations at December 31, 2005 and 2004 by asset category are as follows:
Plan assets are managed with a long-term perspective to ensure that there is an adequate level of assets to support benefit payments to participants over the life of the qualified plan. The Company periodically conducts asset-liability studies to establish the preferred target asset allocation. Plan assets are managed within the asset allocation ranges above, toward targets of 40% large cap U.S. equity, 15% small cap U.S. equity, 15% non-U.S.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
equity and 30% fixed income, with periodic rebalancing to maintain plan assets within the target asset allocation ranges. Plan assets are managed by external investment managers. Investment manager performance is measured against benchmarks for each asset class and peer group on quarterly, one-, three- and five-year periods. An independent consultant assists management with investment manager selections and performance evaluations. The “Other” category includes cash that is available to pay expected benefit payments and expenses.
At December 31, 2005 and 2004, the funded status of the qualified plan exceeded minimum funding requirements and the Company was not required to make contributions. In 2005 and 2004, the Company elected to make voluntary contributions of $40,000 and $15,000, respectively, to its qualified pension plan. In 2006, the Company may make voluntary contributions to its qualified pension plan, up to $30,000. Additionally, the Company does not make any contributions, other than benefit payments, to its nonqualified plan.
The following table summarizes expected benefit payments through 2015 including those payments expected to be paid from the company’s general assets. Since the majority of the benefit payments are made in the form of lump-sum distributions, actual benefit payments may differ from expected benefits payments.
The majority of the Company’s U.S. employees are eligible to participate in a savings and profit sharing plan sponsored by the Company. The plan allows employees to contribute a portion of their base compensation on a pre-tax and after-tax basis in accordance with specified guidelines. The Company matches a percentage of the employee contributions up to certain limits. The Company may also contribute a discretionary profit sharing component linked to its performance each year. In addition, the Company has several defined contribution plans outside of the United States. The Company’s contribution expense related to all of its savings plans was $39,145, $35,517 and $30,626 for 2005, 2004 and 2003, respectively.
The Company has a Value Appreciation Program (“VAP”), which is a frozen incentive compensation plan established in 1995. Annual awards were granted to VAP participants from 1995 through 1998, which entitled participants to the net appreciation on a portfolio of securities of MasterCard members. In 1999, the VAP was replaced by an Executive Incentive Plan (“EIP”) and the Senior Executive Incentive Plan (“SEIP”) (together the “EIP Plans”). Although contributions to the VAP have been discontinued, assets remain and participants are entitled to the net appreciation on the portfolio of securities in accordance with plan provisions. The Company’s liability related to the VAP at December 31, 2005 and 2004 was $9,302 and $10,274 respectively, and the expense was $3,037, $3,145 and $8,497 for the years ending December 31, 2005, 2004 and 2003, respectively.
The Company’s EIP Plans are performance unit plans, in which participants receive grants of units with a value contingent on the achievement of the Company’s long-term performance goals. Employees who are designated Senior Vice President or higher are eligible for participation in any performance period, provided they have met certain performance criteria. The Compensation Committee and/or the President and Chief Executive Officer may also designate other employees as eligible to participate in the plan.
The final value of the units under the EIP Plans is calculated based on the Company’s performance over a three-year period. Upon completion of the three-year performance period, participants receive a cash payment equal to 80 percent of the award earned. The remaining 20 percent of the award is paid upon completion of two additional years of service.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The performance units vest over three and five year periods. Upon termination of employment, excluding retirement, all unvested performance units are forfeited. However, when a participant terminates employment due to retirement, all of the participant’s performance units immediately vest provided that the participant has at least six months of service in the performance period. Eligible retirement is dependent upon age and years of service as follows: age 55 with ten years of service, age 60 with 5 years of service and age 65 with 2 years of service.
In September 2005, MasterCard adjusted its method of recognizing the cost of the EIP Plans to an approach which requires that the cost be recognized over the shorter of the vesting periods stated in the EIP Plans or the date the individual employee becomes eligible to retire. In the event the employee is eligible for retirement on the date the award is made or becomes so within six months of the award date, the cost is recognized over six months. Previously the Company recognized the expense for the EIP Plans using an approach where expense was recognized over the stated vesting periods and in the event an employee actually retired, any unrecognized cost was immediately accelerated. The Company believes this new methodology more appropriately reflects that once reaching retirement eligibility, an employee is not required to provide additional services beyond six months of service in the performance period to vest in the award.
Since the impact to prior quarterly and annual financial statements was not material, the Company recorded a catch-up adjustment of $19,063 ($12,146 after-tax) in 2005 to reflect the change in methodology. This adjustment is included in accrued expenses and general and administrative expenses. The Company’s liability related to the EIP Plans at December 31, 2005 and 2004 was $101,677 and $76,787, respectively, and the expense was $67,353, $42,627 and $27,764 for the years ending December 31, 2005, 2004 and 2003, respectively.
In connection with the Company’s proposed new ownership and governance structure described in Note 2 herein, the Company intends to convert the EIP Plans to an equity based compensation plan. In addition, a one time restricted stock award is intended for non-executive management employees.
Note 12. Postemployment and Postretirement Benefits
The Company maintains a postretirement plan providing health coverage and life insurance benefits for substantially all of its U.S. employees and retirees.
In December 2003, the United States enacted into law the Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”). The Act establishes a prescription drug benefit under Medicare, known as “Medicare Part D”, and a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. The Company believes that benefits provided to certain participants will be at least actuarially equivalent to Medicare Part D, and, accordingly, the Company will be entitled to a subsidy.
In May 2004, the FASB issued FASB Staff Position No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 requires companies to account for the effects of the federal subsidy on benefits attributable to past service as an actuarial experience gain and as a reduction of the service cost component of net postretirement health care costs for amounts attributable to current service, if the benefit provided is at least actuarially equivalent to Medicare Part D.
The Company determined the effects of the Act were not a significant event requiring an interim remeasurement. Consequently, as permitted by FSP 106-2, net periodic postretirement benefit cost for 2004 does not reflect the effects of the Act. The accumulated postretirement benefit obligation (“APBO”) was remeasured at December 31, 2004 to reflect the effects of the Act, which resulted in a reduction in the APBO of $2,680.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The following table presents the status of the Company’s postretirement benefit plan recognized in the Company’s Consolidated Balance Sheets at December 31, 2005 and 2004. The Company uses a December 31 measurement date for its postretirement plan.
Net periodic postretirement benefit cost for the years ended December 31 was:
The weighted-average assumptions used to determine net periodic postretirement benefit cost for years ended December 31 were:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The assumed health care cost trend rates at December 31 were as follows:
The assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage point change in assumed health care cost trend rates would have the following effects:
The Company does not expect to make any contributions, other than benefit payments, to its postretirement plan in 2006. The Company funds its postretirement benefits as payments are required. The following table summarizes expected net benefit payments from the Company’s general assets through 2015.
The Company provides limited postemployment benefits to eligible former employees, primarily severance. The Company accounts for severance expense is accordance with SFAS No. 112, “Employers’ Accounting for Postemployment Benefits” by accruing the expected cost of the severance benefits expected to be provided to former employees after employment over their relevant service periods. During 2005, the Company updated the assumptions in determining the severance accrual. As a result, severance expense increased $20,100 in 2005. The Company has an accrued liability related to severance in the amount of $42,296 and $25,728 at December 31, 2005 and 2004, respectively.
Note 13. Debt
On June 17, 2005, the Company entered into a committed unsecured $2,250,000 revolving credit facility (the “Credit Facility”) with certain financial institutions. The Credit Facility, which expires on June 16, 2006, replaced MasterCard Incorporated’s prior $1,950,000 credit facility which expired on June 17, 2005. Borrowings under the facility are available to provide liquidity in the event of one or more settlement failures by MasterCard International members and, subject to a limit of $300,000, for general corporate purposes. Interest on borrowings under the Credit Facility would be charged at the London Interbank Offered Rate (LIBOR) plus 28 basis points or an alternative base rate. An additional 10 basis points would be applied if the aggregate borrowings under the Credit Facility exceed 33% of the commitments. MasterCard has agreed to pay a facility fee which varies based on MasterCard’s credit rating and is currently equal to 7 basis points on the total commitment, or approximately $1,575 annually. The Company also agreed to pay upfront fees of $675 and administrative fees of $255 for the
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Credit Facility, which are being amortized straight line over one year. Facility and other fees associated with the Credit Facility or prior facilities totaled $2,611, $2,234 and $1,742 for each of the years ended December 31, 2005, 2004, and 2003. MasterCard was in compliance with the Credit Facility covenants as of December 31, 2005. There were no borrowings under the Credit Facility at December 31, 2005 or the previous facility at December 31, 2004. The majority of Credit Facility lenders are members or affiliates of members of MasterCard International.
In June 1998, MasterCard International issued ten-year unsecured, subordinated notes (the “Notes”) paying a fixed interest rate of 6.67% per annum. The terms of the Notes require MasterCard to repay the principal amount on June 30, 2008. The Company has the option to prepay the principal amount of the Notes at anytime prior to the repayment date, however an additional “make-whole” amount must also be calculated and paid to investors at that time. The “make-whole” amount represents the discounted value of the remaining principal and interest, less the outstanding principal balance. The interest on the Notes was $5,336 for each of the years ended December 31, 2005, 2004 and 2003. During 2004, MasterCard Incorporated amended certain covenant compliance obligations. The amendment aligns MasterCard’s financial reporting and net worth covenant obligations with similar obligations under its other debt instruments. MasterCard entered into the amendment to better reflect MasterCard’s corporate structure and to reduce the costs and administrative burden of complying with different debt covenants. The Company was in compliance with the covenants of the Notes as of December 31, 2005 and 2004. The principal amount of the Notes outstanding at December 31, 2005 and 2004 was $80,000. The fair value of the Notes was estimated at $82,780 and $86,006 at December 31, 2005 and 2004, respectively.
During 2004, MasterCard Europe and European Payment System Services sprl, a subsidiary of MasterCard, reduced their multi-purpose uncommitted credit facility with a bank from 35,000 euros to a 1,000 euro overdraft facility for MasterCard Europe and European Payment System Services sprl and a 1,000 euro guarantee facility for MasterCard Europe. There were no material borrowings under these facilities at December 31, 2005 and 2004; however at December 31, 2005 and 2004, the facility supported bank-issued guarantees for a total of 842 euros and 692 euros, respectively, which reduced the amount of funds available under the facility. For these bank guarantees, a guarantee fee is paid at a rate of 1.5% per annum.
MasterCard Europe has one additional uncommitted credit agreement totaling 100,000 euros. There were 4,056 euros outstanding under this agreement at December 31, 2005. There were no borrowings under this agreement at December 31, 2004. MasterCard Europe canceled an uncommitted credit agreement totaling 30,000 euros during 2004.
Upon completion of the planned public offering, as described in Note 2, Standard & Poor’s Ratings Services (S&P) has announced that it expects to lower MasterCard’s counterparty credit ratings from A-/A-2 to BBB+/A-2 and MasterCard’s subordinated debt rating from BBB+ to BBB, both with stable outlook. Until such time, the existing ratings will remain on credit watch with negative implications. Once the lower ratings are in effect, the facility fee for our Credit Facility will increase to 8 basis points on the total commitment, or approximately $1,800 annually, and interest on borrowings thereunder will increase to LIBOR plus 37 basis points (or 47 basis points if aggregate borrowings exceed 33% of the commitments) or an alternate base rate.
Note 14. Consolidation of Variable Interest Entity
On August 31, 1999, MasterCard International entered into a ten-year synthetic lease agreement for a global technology and operations center located in O’Fallon, Missouri, called Winghaven. The lessor under the lease agreement is MasterCard International O’Fallon 1999 Trust (the “Trust”). The Trust, which is a variable interest
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
entity was established for a single discrete purpose, is not an operating entity, has a limited life and has no employees. The Trust financed the operations center through a combination of a third party equity investment and the issuance of 7.36 percent Series A Senior Secured Notes (the “Secured Notes”) in the amount of $149,380 due September 1, 2009.
Annual rent of $11,390 is payable by MasterCard International and is equal to interest payments on the Secured Notes and a return to equity-holders. The future minimum lease payments are $45,561 and are included in the future commitment schedule in Note 15. In conjunction with the lease agreement, MasterCard International executed a guarantee of 85.15 percent of the Secured Notes outstanding totaling $127,197. Additionally, upon the occurrence of specific events of default, MasterCard International guarantees repayment of the total outstanding principal and interest on the Secured Notes and would take ownership of the facility. During 2004, MasterCard Incorporated became party to the guarantee and assumed certain covenant compliance obligations, including financial reporting and maintenance of consolidated net worth. The amendment to the guarantee aligns the Company’s financial reporting and net worth covenant obligations under the guarantee with similar obligations under its other debt instruments. The Company entered into the amendment to the guarantee to better reflect the Company’s corporate structure and to reduce the costs and administrative burden of complying with different debt covenants.
The lease agreement permits MasterCard International to purchase the facility after August 31, 2006, upon 180 days notice. The purchase price is equal to the termination value defined in the lease and includes amounts due to the holders of the Secured Notes and the investor equity, along with any accrued and unpaid amounts due to the investor under the lease agreement. The amount due to the holders of the Secured Notes would include the aggregate outstanding principal amount of the Secured Notes, as well as a “make-whole” amount and any accrued and unpaid interest. The “make-whole” amount represents the discounted value of the remaining principal and interest, less the outstanding principal balance.
On January 1, 2003, the Company adopted the provisions of FIN 46R and consolidated the Trust on the Company’s consolidated balance sheets, which resulted in recording $154,000 in municipal bonds held by the Trust, $149,380 in long-term debt and $4,620 of minority interest relating to the equity in the Trust held by a third party. The redemption value of the minority interest approximates its carrying value and will be redeemed by the minority interest holders upon the maturity of the Secured Notes. For the years ended December 31, 2005, 2004 and 2003 the consolidation had no impact on net income (loss). However, interest income and interest expense were each increased by $11,390 in each of the years ended December 31, 2005, 2004 and 2003.
Note 15. Commitments and Contingent Liabilities
The future minimum payments under non-cancelable leases for office buildings and equipment, sponsorships, licensing and other agreements at December 31, 2005 are as follows:
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Included in the table above are capital leases with imputed interest expense of $15,208 and a net present value of minimum lease payments of $42,024. In addition, at December 31, 2005, $32,139 of the future minimum payments in the table above for leases, sponsorship, licensing and other agreements was accrued. Consolidated rental expense for the Company’s office space was approximately $31,096, $32,269 and $28,298 for the years ended December 31, 2005, 2004 and 2003, respectively. Consolidated lease expense for automobiles, computer equipment and office equipment was $9,441, $10,955 and $9,019 for the years ended December 31, 2005, 2004 and 2003, respectively.
MasterCard licenses certain software to its customers. The license agreements contain guarantees under which the Company indemnifies licensees from any adverse judgments arising from claims of intellectual property infringement by third parties. The terms of the guarantees are equal to the terms of the license to which they relate. The amount of the guarantees are limited to damages, losses, costs, expenses or other liabilities incurred by the licensee as a result of any intellectual property rights claims. The Company has historically experienced no intellectual property rights claims relating to the software it licenses to its customers and therefore management believes the probability of future claims is negligible. In addition, the Company does not generate significant revenues from software licenses. However, if circumstances in the future change, the Company may need to reassess whether it would be necessary to assess the fair value of these guarantees.
Note 16. U.S. Merchant Lawsuit and Other Legal Settlements
In 2003, MasterCard settled the U.S. merchant lawsuit described under the caption “U.S. Merchant Opt Out and Consumer Litigations” in Note 18 herein and contract disputes with certain customers. On June 4, 2003, MasterCard International and plaintiffs in the U.S. merchant lawsuit signed a settlement agreement (the “Settlement Agreement”) which required the Company to pay $125,000 in 2003 and $100,000 annually each December from 2004 through 2012. In addition, in 2003, several other lawsuits were initiated by merchants who opted not to participate in the plaintiff class in the U.S. merchant lawsuit. The “opt-out” merchant lawsuits were not covered by the terms of the Settlement Agreement; however have all been individually settled. In 2004, certain other legal matters were settled or resolved with MasterCard’s customers and employees. As more fully described in Note 18 herein, MasterCard is also a party to a number of currency conversion litigations. Based upon litigation developments and settlement negotiations in these currency conversion cases and pursuant to Statement of Financial Standards No. 5, “Accounting for Contingencies”, MasterCard recorded a $75,158 reserve in 2005. This estimate may need to be revised based on future developments. Total liabilities for the U.S. merchant lawsuit and other legal settlements changed as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Note 17. Income Tax
The total income tax provision (benefit) for the years ended December 31 is comprised of the following components:
The domestic and foreign components of earnings (losses) before income taxes for the years ended December 31 are as follows:
MasterCard has not provided for U.S. federal income and foreign withholding taxes on approximately $87,868 of undistributed earnings from non-U.S. subsidiaries as of December 31, 2005 because such earnings are intended to be reinvested indefinitely outside of the United States. If these earnings were distributed, foreign tax credits may become available under current law to reduce the resulting U.S. income tax liability.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The provision (benefit) for income taxes differs from the amount of income tax (benefit) determined by applying the appropriate statutory U.S. federal income tax rate to pretax income (loss) for the years ended December 31, as a result of the following:
The effective income tax rate for the year ended December 31, 2005, 2004 and 2003 was 34.5%, 26.5% and (36.1)%, respectively. The rate in 2004 was lower than 2005 primarily due to the settlement and reassessment of various tax audit matters, the filing and recognition of refund claims and a revaluation of the Company’s deferred state tax assets due to a higher effective state tax rate.
Deferred tax assets and liabilities represent the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The net deferred tax asset at December 31 is comprised of the following:
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The valuation allowance relates to the Company’s ability to recognize tax benefits associated with carry-forward capital losses and state net operating losses. If not utilized, approximately $543 of the Company’s carry-forward capital losses will expire in 2006 and $730 will expire in 2007. Additionally, approximately $11,416 of state carry forward net operating losses will expire commencing in 2009.
Note 18. Legal and Regulatory Proceedings
MasterCard is a party to legal and regulatory proceedings with respect to a variety of matters in the ordinary course of business. Some of these proceedings involve complex claims that are subject to substantial uncertainties and unspecified damages, therefore, the probability of loss and an estimation of damages are not possible to ascertain at present. Accordingly, MasterCard has not established reserves for any of these proceedings other than for the currency conversion litigations. Except for those matters described below, MasterCard does not believe that any legal or regulatory proceedings to which it is a party would have a material impact on its results of operations, financial position, or cash flows. Although MasterCard believes that it has strong defenses for the litigations and regulatory proceedings described below, it could in the future incur judgments or fines or enter into settlements of claims that could have a material adverse effect on its results of operations, financial position or cash flows. Notwithstanding MasterCard’s belief, in the event it may be found liable in a large class-action lawsuit or on the basis of a claim entitling the plaintiff to treble damages or under which it was jointly and severally liable, charges it may be required to record could be significant and could materially and adversely affect its results of operations, cash flow and financial condition, or, in certain circumstances, even cause MasterCard to become insolvent. Moreover, an adverse outcome in a regulatory proceeding could lead to the filing of civil damage claims and possibly result in damage awards in amounts that could be significant and could materially and adversely affect its results of operation, cash flow and financial condition.
Department of Justice Antitrust Litigation and Related Private Litigation
In October 1998, the U.S. Department of Justice (“DOJ”) filed suit against MasterCard International, Visa U.S.A. Inc. and Visa International Corp. in the U.S. District Court for the Southern District of New York alleging that both MasterCard’s and Visa’s governance structure and policies violated U.S. federal antitrust laws. First, the DOJ claimed that “dual governance”-the situation where a financial institution has a representative on the board of directors of MasterCard or Visa while a portion of its card portfolio is issued under the brand of the other association-was anti-competitive and acted to limit innovation within the payment card industry. Second, the DOJ challenged MasterCard’s Competitive Programs Policy (“CPP”) and a Visa bylaw provision that prohibited financial institutions participating in the respective associations from issuing competing proprietary payment cards (such as American Express or Discover). The DOJ alleged that MasterCard’s CPP and Visa’s bylaw provision acted to restrain competition.
On October 9, 2001, the District Court judge issued an opinion upholding the legality and pro-competitive nature of dual governance. However, the judge also held that MasterCard’s CPP and the Visa bylaw constituted unlawful restraints of trade under the federal antitrust laws.
On November 26, 2001, the judge issued a final judgment that ordered MasterCard to repeal the CPP insofar as it applies to issuers and enjoined MasterCard from enacting or enforcing any bylaw, rule, policy or practice that prohibits its issuers from issuing general purpose credit or debit cards in the United States on any other general purpose card network. The final judgment also provides that from the effective date of the final judgment (October 15, 2004) until October 15, 2006, MasterCard is required to permit any issuer with which it entered into
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such an agreement prior to the effective date of the final judgment to terminate that agreement without penalty, provided that the reason for the termination is to permit the issuer to enter into an agreement with American Express or Discover. The final judgment imposes parallel requirements on Visa.
MasterCard appealed the judge’s ruling with respect to the CPP. On September 17, 2003, a three-judge panel of the Second Circuit issued its decision upholding the District Court’s decision. On October 4, 2004, the Supreme Court denied MasterCard’s petition for certiorari, thereby exhausting all avenues for further appeal in this case. Thereafter, the parties agreed that October 15, 2004 would serve as the effective date of the final judgment.
In addition, on September 18, 2003, MasterCard filed a motion before the District Court judge in this case seeking to enjoin Visa, pending completion of the appellate process, from enforcing a newly-enacted bylaw requiring Visa’s 100 largest issuers of debit cards in the United States to pay a so-called “settlement service” fee if they reduce their Visa debit volume by more than 10%. This bylaw was later modified to clarify that the settlement service fee would only be imposed if an issuer shifted its portfolio of debit cards to MasterCard. Visa implemented this bylaw provision following the settlement of the U.S. merchant lawsuit described under the heading “U.S. Merchant Opt Out and Consumer Litigations” below. MasterCard believes that this bylaw is punitive and violates the final judgement in the DOJ litigation, which enjoins Visa and MasterCard from enacting, maintaining, or enforcing any bylaw or policy that prohibits issuers from issuing general purpose cards of debit cards in the United States on any other general purpose card network. On December 8, 2003, the District Court ruled that it lacked jurisdiction to issue an injunction while the appellate process in the DOJ litigation was pending. In light of the Supreme Court’s denial of certiorari on October 4, 2004, jurisdiction was again vested with the District Court. On January 10, 2005, MasterCard renewed its challenge to the bylaw in the District Court, seeking to enjoin Visa from maintaining or enforcing the bylaw and requiring Visa to offer its top 100 offline issuers a right to rescind any debit card agreements entered into with Visa while the settlement service fee was in effect. The motion was fully briefed on June 3, 2005. On August 18, 2005, the Court issued an order appointing a special master to conduct an evidentiary hearing and then issue a report and recommendation as to whether the settlement service fee violates the Court’s final judgment. The hearing on MasterCard’s motion was completed on December 9, 2005 and post-hearing briefing by the parties was completed on February 10, 2006. If MasterCard is unsuccessful and Visa is permitted to impose this settlement service fee on issuers of debit cards according to this bylaw, it could inhibit the growth of our debit business. At this time it is not possible to determine the ultimate resolution of this matter.
On October 4, 2004, Discover Financial Services, Inc. filed a complaint against MasterCard, Visa U.S.A. Inc. and Visa International Incorporated. The complaint was filed in the U.S. District Court for the Southern District of New York and was designated as a related case to the DOJ litigation, and was assigned to the same judge who issued the DOJ decision described above. The complaint alleges that the implementation and enforcement of MasterCard’s CPP and Visa’s bylaw provision as well as MasterCard’s “Honor All Cards” rule (and a similar Visa rule), which require merchants who accept MasterCard cards to accept for payment every validly presented MasterCard card, violated Sections 1 and 2 of the Sherman Act as well as California’s Unfair Competition Act in an alleged market for general purpose card network services and an alleged market for debit card network services. The complaint also challenged MasterCard’s “no surcharge rule” (and a similar Visa rule) under the same statutes. On December 10, 2004, MasterCard moved to dismiss the complaint in its entirety for failure to state a claim. In lieu of filing its opposition papers to MasterCard’s motion, Discover filed an amended complaint on January 7, 2005. In the amended complaint, Discover dropped some of its claims, including its challenge against the no surcharge rule and its claims under California’s Unfair Competition Act, but continued to allege that the implementation and enforcement of MasterCard’s CPP, Visa’s bylaw provision and the Honor All Cards rule violated Sections 1 and 2 of the Sherman Act. Specifically, Discover claimed that MasterCard’s
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CPP unreasonably restrained trade by prohibiting financial institutions who were members of MasterCard from issuing payment cards on the Discover network. Discover requested that the District Court apply collateral estoppel with respect to its final judgment in the DOJ litigation and enter an order that the CPP and Visa’s bylaw provision have injured competition and caused injury to Discover. Discover seeks treble damages in an amount to be proved at trial along with attorneys’ fees and costs. On February 7, 2005, MasterCard moved to dismiss Discover’s amended complaint in its entirety for failure to state a claim. On April 14, 2005, the Court denied, at this stage in the litigation, Discover’s request to give collateral estoppel effect to the findings in the DOJ litigation. However, the Court indicated that Discover may refile a motion for collateral estoppel after discovery. Under the doctrine of collateral estoppel, a court has the discretion to preclude one or more issues from being relitigated in a subsequent action but only if (1) those issues are identical to issues actually litigated and determined in the prior action, (2) proof of those issues were necessary to reach the prior judgment, and (3) the party to be estopped had a full and fair opportunity to litigate those issues in the prior action. Accordingly, if the Court were to give effect to collateral estoppel on one or more issues in the future, then significant elements of plaintiff’s claims would be established, thereby making it more likely that we would be found liable and making the possibility of an award of damages that much more likely. In the event all issues are subsequently decided against MasterCard in dispositive motions during the course of the litigation then there is the possibility that the sole issue remaining will be whether a damage award is appropriate and, if so, what the amount of damages should be. In addition, that same day and in subsequent rulings, with respect to the market for general purpose card network services, the Court denied MasterCard’s motion to dismiss Discover’s Section 1 conspiracy to restrain trade and Section 2 conspiracy to monopolize or maintain a monopoly claims that were based upon the conduct described above. On October 24, 2005, the Court granted MasterCard’s motion to dismiss Discover’s Section 2 monopolization and attempted monopolization claims against MasterCard. On November 9, 2005, the Court denied MasterCard’s motion to dismiss Discover’s claims based upon effects in an alleged debit market. On November 30, 2005, MasterCard filed an answer to the amended complaint. On February 1, 2006, the Court issued a case management order establishing a discovery schedule for this action, which ordered that fact discovery shall be completed by February 1, 2007, and scheduled a status conference for January 4, 2007 to discuss any remaining discovery issues, including expert discovery, as well as the timing of collateral estoppel motions. At this time it is not possible to determine the ultimate resolution of, or estimate the liability related to, the Discover litigation. No provision for losses has been provided in connection with this matter.
On November 15, 2004, American Express filed a complaint against MasterCard, Visa and eight member banks, including JPMorgan Chase & Co., Bank of America Corp., Capital One Financial Corp., U.S. Bancorp, Household International Inc., Wells Fargo & Co., Providian Financial Corp. and USAA Federal Savings Bank. Subsequently, USAA Federal Savings Bank, Bank of America Corp. and Household International Inc. announced settlements with American Express and have been dismissed from the case. The complaint, which was filed in the U.S. District Court for the Southern District of New York, was designated as a related case to the DOJ litigation and was assigned to the same judge. The complaint alleges that the implementation and enforcement of MasterCard’s CPP and Visa’s bylaw provision violated Sections 1 and 2 of the Sherman Act in an alleged market for general purpose card network services and a market for debit card network services. Specifically, American Express claimed that MasterCard’s CPP unreasonably restrained trade by prohibiting financial institutions who were members of MasterCard from issuing payment cards on the American Express network. American Express seeks treble damages in an amount to be proved at trial, along with attorneys’ fees and costs. On January 14, 2005, MasterCard filed a motion to dismiss the complaint for failure to state a claim. American Express also requested that the Court apply collateral estoppel with respect to its final judgement in the DOJ litigation. On April 14, 2005, the District Court denied, at this stage in the litigation, American Express’ request to give collateral estoppel effect to the findings in the DOJ litigation. However, the Court indicated that American Express may refile a motion for collateral estoppel after discovery. As with the lawsuit brought by Discover that
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is described in the preceding paragraph, if the Court were to give effect to collateral estoppel on one or more issues in the future, then significant elements of plaintiff’s claims would be established, thereby making it more likely that we would be found liable and making the possibility of an award of damages that much more likely. In the event all issues are subsequently decided against MasterCard in dispositive motions during the course of the litigation then there is the possibility that the sole issue remaining will be whether a damage award is appropriate and, if so, what the amount of damages should be. In addition, that same day and in subsequent rulings, the Court denied MasterCard’s motion to dismiss American Express’ Section 1 conspiracy to restrain trade claims and Section 2 conspiracy to monopolize claims that were based upon the conduct described above. On November 9, 2005, the Court denied MasterCard’s motion to dismiss American Express’ conspiracy to restrain trade claims in the alleged market for debit card network services. On November 30, 2005, MasterCard filed an answer to the complaint. On February 1, 2006, the Court issued a case management order establishing a discovery schedule for this action, which ordered that fact discovery shall be completed by February 1, 2007, and scheduled a status conference for January 4, 2007 to discuss any remaining discovery issues, including expert discovery, as well as the timing of collateral estoppel motions. At this time it is not possible to determine the ultimate resolution of, or estimate the liability related to, this matter. No provision for losses has been provided in connection with the American Express litigation.
Currency Conversion Litigations
MasterCard International, together with Visa U.S.A., Inc. and Visa International Corp., are defendants in a state court lawsuit in California. The lawsuit alleges that MasterCard and Visa wrongfully imposed an asserted one percent currency conversion “fee” on every credit card transaction by U.S. MasterCard and Visa cardholders involving the purchase of goods or services in a foreign country, and that such alleged “fee” is unlawful. This action, titled Schwartz v. Visa Int’l Corp., et al., was brought in the Superior Court of California in February 2000, purportedly on behalf of the general public. Trial of the Schwartz matter commenced on May 20, 2002 and concluded on November 27, 2002. The Schwartz action claims that the alleged “fee” grossly exceeds any costs the defendants might incur in connection with currency conversions relating to credit card purchase transactions made in foreign countries and is not properly disclosed to cardholders. MasterCard denies these allegations.
On April 8, 2003, the trial court judge issued a final decision in the Schwartz matter. In his decision, the trial judge found that MasterCard’s currency conversion process does not violate the Truth in Lending Act or regulations, nor is it unconscionably priced under California law. However, the judge found that the practice is deceptive under California law, and ordered that MasterCard mandate that members disclose the currency conversion process to cardholders in cardholder agreements, applications, solicitations and monthly billing statements. As to MasterCard, the judge also ordered restitution to California cardholders. The judge issued a decision on restitution on September 19, 2003, which requires a traditional notice and claims process in which consumers have approximately six months to submit their claims. The court issued its final judgment on October 31, 2003. On December 29, 2003, MasterCard appealed the judgment. The final judgment and restitution process have been stayed pending MasterCard’s appeal. On August 6, 2004 the court awarded plaintiff’s attorneys’ fees in the amount of $28,224 to be paid equally by MasterCard and Visa. Accordingly, during the three months ended September 30, 2004, MasterCard accrued amounts totalling $14,112 which are included in U.S. Merchant Lawsuit and Other Legal Settlements in the Consolidated Statements of Operations (see Note 16). MasterCard subsequently filed a notice of appeal on the attorneys’ fee award on October 1, 2004. With respect to restitution, MasterCard believes that it is likely to prevail on appeal. In February 2005, MasterCard filed an appeal regarding the applicability of Proposition 64, which amended sections 17203 and 17204 of the California Business and Professions Code, to this action. On September 28, 2005, the appellate court reversed the trial court, finding that the plaintiff lacked standing to pursue the action in light of Proposition 64. Plaintiff filed a
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petition for review with the California Supreme Court on November 7, 2005, which was granted on December 14, 2005. The California Supreme Court has deferred taking further action pending consideration and disposition of related issues with the court.
In addition, MasterCard has been served with complaints in state courts in New York, Arizona, Texas, Florida, Arkansas, Illinois, Tennessee, Michigan, Pennsylvania, Ohio, Minnesota and Missouri seeking to, in effect, extend the judge’s decision in the Schwartz matter to MasterCard cardholders outside of California. Some of these cases have been transferred to the U.S. District Court for the Southern District of New York and combined with the federal complaints in MDL No. 1409 discussed below. In other state court cases, MasterCard has moved to dismiss the claims. On February 1, 2005 a Michigan action was dismissed with prejudice and on April 12, 2005, the plaintiff agreed to withdraw his appeal of that decision. On June 24, 2005, a Minnesota action was dismissed with prejudice; however, plaintiff filed an amended complaint on September 15, 2005. On August 31, 2005, an Illinois action was dismissed with prejudice; plaintiff filed an appeal on February 6, 2006. Briefing is not complete and no date for oral argument has been set. On September 7, 2005, a Texas state court granted MasterCard’s motion to arbitrate, and plaintiff subsequently filed notice that he was withdrawing his lawsuit against MasterCard for all claims. MasterCard has also been served with complaints in state courts in California, Texas and New York alleging it wrongfully imposed an asserted one percent currency conversion “fee” in every debit card transaction by U.S. MasterCard cardholders involving the purchase of goods or services in a foreign country and that such alleged “fee” is unlawful. Visa USA Inc. and Visa International Corp. have been named as co-defendants in the California cases. One such Texas case was dismissed voluntarily by plaintiffs.
MasterCard International, Visa U.S.A., Inc., Visa International Corp., several member banks including Citibank (South Dakota), N.A., Citibank (Nevada), N.A., Chase Manhattan Bank USA, N.A., Bank of America, N.A. (USA), MBNA, and Diners Club are also defendants in a number of federal putative class actions that allege, among other things, violations of federal antitrust laws based on the asserted one percent currency conversion “fee.” Pursuant to an order of the Judicial Panel on Multidistrict Litigation, the federal complaints have been consolidated in MDL No. 1409 before Judge William H. Pauley III in the U.S. District Court for the Southern District of New York. In January 2002, the federal plaintiffs filed a Consolidated Amended Complaint (“MDL Complaint”) adding MBNA Corporation and MBNA America Bank, N.A. as defendants. This pleading asserts two theories of antitrust conspiracy under Section 1 of the Sherman Act: (i) an alleged “inter-association” conspiracy among MasterCard (together with its members), Visa (together with its members) and Diners Club to fix currency conversion “fees” allegedly charged to cardholders of “no less than 1% of the transaction amount and frequently more;” and (ii) two alleged “intra-association” conspiracies, whereby each of Visa and MasterCard is claimed separately to have conspired with its members to fix currency conversion “fees” allegedly charged to cardholders of “no less than 1% of the transaction amount” and “to facilitate and encourage institution-and collection-of second tier currency conversion surcharges.” The MDL Complaint also asserts that the alleged currency conversion “fees” have not been disclosed as required by the Truth in Lending Act and Regulation Z.
Defendants have moved to dismiss the MDL Complaint. On July 3, 2003, Judge Pauley issued a decision granting MasterCard’s motion to dismiss in part. Judge Pauley dismissed the Truth in Lending claims in their entirety as against MasterCard, Visa and several of the member bank defendants. Judge Pauley did not dismiss the antitrust claims. Fact and expert discovery in this matter have closed. On November 12, 2003 plaintiffs filed a motion for class certification, which was granted on October 15, 2004. On March 9, 2005, Judge Pauley issued a decision on defendants’ motion to reconsider the class certification decision. The Judge ruled that the arbitration provisions in the cardholder agreements of member bank defendants, Bank One, MBNA, Providian, Household and Bank of America are valid as to those respective banks and MasterCard and, consequently, cardholders of
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those banks can no longer participate in the class action certified in his earlier decision and must pursue any claims through arbitration. Plaintiffs moved for further reconsideration, which was denied by Judge Pauley on June 16, 2005. In addition, Judge Pauley declined to give effect to the arbitration clauses in the Citibank and Chase cardholder agreements; both banks have appealed that decision. Briefing on the appeal is complete but no date has been set for oral argument. The trial date has been set for May 15, 2006.
Based upon litigation developments, certain of which were favorable to MasterCard, and progress in ongoing settlement discussions in these currency conversion cases that occurred during the third and fourth quarters of 2005 and first quarter of 2006, and pursuant to Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies,” MasterCard recorded an additional $75,158 of legal reserves in 2005. As a result of this additional provision, MasterCard has now established total legal reserves of $89,270 in connection with these currency conversion cases. At this time, it is not possible to determine the ultimate resolutions of these matters.
Merchant Chargeback-Related Litigations
On May 12, 2003, a complaint alleging violations of federal and state antitrust laws, breach of contract, fraud and other theories was filed in the U.S. District Court for the Central District of California (Los Angeles) against MasterCard by a merchant aggregator whose customers include businesses selling adult entertainment content over the Internet. The complaint’s allegations focus on MasterCard’s past and potential future assessments on the plaintiff’s merchant bank (acquirer) for exceeding excessive chargeback standards in connection with the plaintiff’s transaction activity as well as the effect of MasterCard’s chargeback rules and other practices on “card-not-present” merchants. Chargebacks refer to a situation where a transaction is returned, or charged back, to an acquirer by an issuer at the request of cardholders or for other reasons. Prior to MasterCard filing any motion or responsive pleading, the plaintiff filed a voluntary notice of dismissal without prejudice on December 5, 2003. On the same date, the plaintiff filed a complaint in the U.S. District Court for the Eastern District of New York making similar allegations to those made in its initial California complaint. MasterCard moved to dismiss all of the claims in the complaint for failure to state a cause of action. On March 30, 2005 the judge granted MasterCard’s motion and dismissed all of the claims in the complaint. On April 11, 2005, the plaintiff filed a notice of appeal of the district court’s order. The Second Circuit heard oral argument on the appeal on November 22, 2005. The parties are awaiting a decision.
In addition, on June 6, 2003, an action titled California Law Institute v. Visa U.S.A., et al. was initiated against MasterCard and Visa U.S.A., Inc. in the Superior Court of California, purportedly on behalf of the general public. Plaintiff seeks disgorgement, restitution and injunctive relief for unlawful and unfair business practices in violation of California Unfair Trade Practices Act Section 17200, et. seq. Plaintiff purportedly alleges that MasterCard’s (and Visa’s) chargeback fees are unfair and punitive in nature. Plaintiff seeks injunctive relief preventing MasterCard from continuing to engage in its chargeback practices and requiring MasterCard to provide restitution and/or disgorgement for monies improperly obtained by virtue of them. On June 10, 2005, MasterCard filed a motion requesting that the Court bifurcate and decide certain dispositive issues to be tried separately. On December 8, 2005, the court indicated that it would stay the motion and all proceedings indefinitely, pending an opinion from the California Supreme Court in an unrelated case regarding standing requirements under Section 17200 of the California Business and Professions Code that may be dispositive in the instant action.
On September 20, 2004, MasterCard was served with a complaint titled PSW Inc. v. Visa U.S.A. Inc, MasterCard International Incorporated, et. al., No. 04-347, in the District Court of Rhode Island. The plaintiff, as alleged in the complaint, provided credit card billing services primarily for adult content web sites. The plaintiff alleges defendants’ excessive chargeback standards, exclusionary rules, merchant registration programs, cross-
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border acquiring rules and interchange pricing to internet merchants violate federal and state antitrust laws as well as state contract and tort law. The plaintiff seeks $60,000 in compensatory damages as well as $180,000 in punitive damages. On November 24, 2004, MasterCard moved to dismiss the complaint. Prior to the court ruling on MasterCard’s motion to dismiss, plaintiff filed an amended complaint on April 6, 2005. This complaint generally mirrors the original complaint but includes additional causes of action based on the purported deprivation of plaintiff’s rights under the First Amendment of the U.S. Constitution. On May 20, 2005, MasterCard moved to dismiss all of PSW’s claims in the complaint for failure to state a claim and argument on the motion before a magistrate judge was held on November 2, 2005. On February 3, 2006, the magistrate issued a report and recommendation in which he recommended the dismissal of plaintiffs’ antitrust claims, First Amendment claim, and state law claims for conversion, embezzlement, tortious interference with prospective economic advantage, and breach of the implied covenant of good faith and fair dealing. However, the magistrate’s report also recommended that MasterCard’s motion to dismiss plaintiff’s claims for breach of contract and tortious interference with contractual relations be denied. On February 28, 2006, the District Court adopted the magistrate’s report and recommendation. MasterCard’s time to answer those claims that survived the motion to dismiss is currently running.
At this time it is not possible to determine the outcome of, or, except as indicated above in the PSW litigation, estimate the liability related to, the merchant chargeback-related litigations. No provision for losses has been provided in connection with these litigations.
U.S. Merchant Opt Out and Consumer Litigations
Commencing in October 1996, several class action suits were brought by a number of U.S. merchants against MasterCard International and Visa U.S.A., Inc. challenging certain aspects of the payment card industry under U.S. federal antitrust law. Those suits were later consolidated in the U.S. District Court for the Eastern District of New York. The plaintiffs claimed that MasterCard’s “Honor All Cards” rule (and a similar Visa rule), which required merchants who accept MasterCard cards to accept for payment every validly presented MasterCard card, constituted an illegal tying arrangement in violation of Section 1 of the Sherman Act. Plaintiffs claimed that MasterCard and Visa unlawfully tied acceptance of debit cards to acceptance of credit cards. The plaintiffs also claimed that MasterCard and Visa conspired to monopolize what they characterized as the point-of-sale debit card market, thereby suppressing the growth of regional networks such as ATM payment systems. On June 4, 2003, MasterCard International signed a settlement agreement to settle the claims brought by the plaintiffs in this matter, which the Court approved on December 19, 2003. For a description of the settlement agreement, see Note 16. A number of class members have appealed the District Court’s approval of the settlement. These appeals largely focused on the court’s attorneys’ fees award as well on the court’s ruling on the scope of the release set forth in the settlement agreement. On January 4, 2005, the Second Circuit Court of Appeals issued an order affirming the District Court’s approval of the settlement agreement. Accordingly, the settlement is now final.
Several lawsuits were commenced by merchants who opted not to participate in the plaintiff class in the U.S. merchant lawsuit, including Best Buy Stores, CVS, Giant Eagle, Home Depot, Toys “R” Us and Darden Restaurants (collectively, the “Opt Out Plaintiffs”). The majority of these cases were filed in the U.S. District Court for the Eastern District of New York. MasterCard has entered into separate settlement agreements with each of the Opt Out Plaintiffs resolving their claims against MasterCard. The District Court has entered orders dismissing with prejudice each of the Opt Out Plaintiff’s complaints against MasterCard.
In addition, individual or multiple complaints have been brought in 19 different states and the District of Columbia alleging state unfair competition, consumer protection and common law claims against MasterCard
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International (and Visa) on behalf of putative classes of consumers. The claims in these actions largely mirror the allegations made in the U.S. merchant lawsuit and assert that merchants, faced with excessive merchant discount fees, have passed these overcharges to consumers in the form of higher prices on goods and services sold. MasterCard has been successful in the majority of these cases as courts have granted MasterCard’s motions to dismiss for failure to state a claim or plaintiffs have voluntarily dismissed their complaints. Specifically, courts in Arizona, Iowa, New York, Michigan, Minnesota, Nebraska, Maine, North Dakota, Kansas, North Carolina, South Dakota, Vermont, Wisconsin, Florida, Nevada and the District of Columbia have granted MasterCard’s motions and dismissed the complaints with prejudice. Plaintiffs have outstanding appeals of these dismissals in Nebraska and Iowa. In addition, there are outstanding cases in the District of Columbia, New Mexico, Tennessee, California and West Virginia. The parties are awaiting decisions on MasterCard’s motion to dismiss in New Mexico and the District of Columbia. The courts in Tennessee and California have granted MasterCard’s motion to dismiss the respective state unfair competition claims but have denied MasterCard’s motions with respect to unjust enrichment claims in Tennessee and Section 17200 claims for unlawful, unfair, and/or fraudulent business practices in California. Both parties have appealed the Tennessee decisions. The West Virginia Circuit Court denied MasterCard’s motion for summary judgment. On February 14, 2006, MasterCard answered the West Virginia complaint. The parties in West Virginia are currently negotiating a protective order before moving forward with discovery.
On March 14, 2005, MasterCard was served with a complaint that was filed in Ohio state court on behalf of a putative class of consumers under Ohio state unfair competition law. The claims in this action mirror those in the consumer actions described above but also name as co-defendants a purported class of merchants who were class members in the U.S. merchant lawsuit. Plaintiffs allege that Visa, MasterCard and the class members of the U.S. merchant lawsuit conspired to attempt to monopolize the debit card market by tying debit card acceptance to credit card acceptance. On October 7, 2005, plaintiffs filed a voluntary notice of dismissal of their complaint.
On April 29, 2005, a complaint was filed in California state court on behalf of a putative class of consumers under California unfair competition law and the Cartwright Act. The claims in this action seek to piggyback on the portion of the DOJ antitrust litigation in which the United States District Court for the Southern District of New York found that MasterCard’s CPP and Visa’s bylaw constitute unlawful restraints of trade under the federal antitrust laws. See“-Department of Justice Antitrust Litigation and Related Private Litigation.” On July 15, 2005, MasterCard and Visa jointly moved to dismiss plaintiffs’ claims for failure to state a claim. On November 2, 2005, the court dismissed the complaint without prejudice. On December 2, 2005, plaintiffs filed a third amended complaint. On January 24, 2006, MasterCard moved to dismiss the plaintiffs’ claims for failure to state a claim. Plaintiffs have until March 10, 2006 to file an opposition to MasterCard’s motion.
At this time, it is not possible to determine the outcome of, or estimate the liability related to, these consumer cases and no provision for losses has been provided in connection with them. The consumer class actions are not covered by the terms of the settlement agreement in the U.S. merchant lawsuit.
Privasys Litigation
An action was filed against MasterCard International in the U.S. District Court for the Northern District of California on September 12, 2005 by Privasys, Inc. alleging misappropriation of purported trade secrets relating to aspects of the technology used for MasterCard’s PayPass contactless cards. Privasys sought to add a Privasys employee as a co-inventor of a MasterCard patent and injunctive relief against MasterCard’s alleged misappropriation of trade secrets.
On October 3, 2005, MasterCard filed suit against Privasys in the U.S. District Court for the Southern District of New York seeking a declaration that (1) there was no need to correct the inventorship of the
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MasterCard patent, (2) MasterCard has not misappropriated any trade secrets of Privasys, to the extent that any exist, (3) a non-disclosure agreement between Privasys and MasterCard is void and unenforceable and that MasterCard had not breached the non-disclosure agreement or the terms of an exclusive marketing agreement between the parties. MasterCard also alleged breach of the marketing agreement by Privasys.
On October 14, 2005, MasterCard filed a motion to dismiss or transfer the California action on the grounds that the marketing agreement contained a forum selection clause specifying the New York courts as the exclusive venue for all disputes between the parties and that the marketing agreement superseded the non-disclosure agreement. On December 2, 2005, the U.S. District Court granted MasterCard’s motion and dismissed the California action.
On November 14, 2005, Privasys filed counterclaims against MasterCard in the New York action alleging breach of the marketing agreement, fraud and deceit, breach of fiduciary duty, misappropriation of trade secrets, unjust enrichment and monopolization and attempted monopolization under Section 2 of the Sherman Act. In its counterclaims, Privasys included the subject matter of additional patent applications filed by MasterCard allegedly relating to PayPass, and added allegations that MasterCard had fraudulently induced Privasys to enter into the marketing agreement and subsequently frustrated Privasys’ performance under the marketing agreement.
On December 22, 2005 MasterCard filed a motion to dismiss Privasys’ antitrust, fraud and related counterclaims. On January 18, 2006, Privasys amended its counterclaims, omitting the antitrust claim and certain duplicative claims, but retaining other claims against MasterCard, including causes of action for fraud and deceit. MasterCard has replied, denying any wrongdoing. The District Court has scheduled a status conference for May 12, 2006.
The parties are in the early stages of discovery in the Privasys litigation and at this time it is not possible to determine the ultimate resolution of, or estimate the liability related to, this matter. No provision for losses has been provided in connection with the Privasys litigation.
Global Interchange Proceedings
Interchange fees represent a sharing of payment system costs among the financial institutions participating in a four-party payment card system such as MasterCard’s. Typically, interchange fees are paid by the merchant bank (the “acquirer”) to the cardholder bank (the “issuer”) in connection with transactions initiated with the payment system’s cards. These fees reimburse the issuer for a portion of the costs incurred by it in providing services which are of benefit to all participants in the system, including acquirers and merchants. MasterCard or its members establish a default interchange fee (“MIF”) in certain circumstances that applies when there is no other interchange fee arrangement between the issuer and the acquirer. MasterCard establishes a variety of MIF rates depending on such considerations as the location and the type of transaction, and collects the MIF on behalf of the institutions entitled to receive it and remits the MIF to eligible institutions. As described more fully below, MasterCard or its members’ MIFs are subject to regulatory or legal review and/or challenges in a number of jurisdictions. At this time, it is not possible to determine the ultimate resolution of, or estimate the liability related to, any of the interchange proceedings described below. No provision for losses has been provided in connection with them.
United States. In July 2002, a purported class action lawsuit was filed by a group of merchants in the U.S. District Court for the Northern District of California against MasterCard International, Visa U.S.A., Inc., Visa International Corp. and several member banks in California alleging, among other things, that MasterCard’s and Visa’s interchange fees contravene the Sherman Act. The suit seeks treble damages in an unspecified amount,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
attorneys’ fees and injunctive relief. On March 4, 2004, the court dismissed the lawsuit with prejudice in reliance upon the approval of the settlement agreement in the U.S. merchant lawsuit by the U.S. District Court for the Eastern District of New York, which held that the settlement and release in that case extinguished the claims brought by the merchant group in the present case. The plaintiffs have appealed the U.S. District Court for the Eastern District of New York’s approval of the U.S. merchant lawsuit settlement and release to the Second Circuit Court of Appeals and have also appealed the U.S. District Court for the Northern District of California’s dismissal of the present lawsuit to the Ninth Circuit Court of Appeals. On January 4, 2005, the Second Circuit Court of Appeals issued an order affirming the District Court’s approval of the U.S. merchant lawsuit settlement agreement, including the District Court’s finding that the settlement and release extinguished such claims. Plaintiffs did not seek certiorari of the Second Circuit’s decision with the U.S. Supreme Court. The appeal to the Ninth Circuit is currently pending and oral argument was held on December 7, 2005.
On October 8, 2004, a purported class action lawsuit was filed by a group of merchants in the U.S. District Court for the Northern District of California against MasterCard International, Visa U.S.A., Inc., Visa International Corp. and several member banks in California alleging, among other things, that MasterCard’s and Visa’s interchange fees contravene the Sherman Act and the Clayton Act. The complaint contains similar allegations to those brought in the interchange case described in the preceding paragraph, and plaintiffs have designated it as a related case. The plaintiffs seek damages and an injunction against MasterCard (and Visa) setting interchange and engaging in “joint marketing activities,” which plaintiffs allege include the purported negotiation of merchant discount rates with certain merchants. On November 19, 2004, MasterCard filed an answer to the complaint. The plaintiffs filed an amended complaint on April 25, 2005. MasterCard moved to dismiss the claims in the complaint for failure to state a claim and, in the alternative, also moved for summary judgment with respect to certain of the claims. On July 25, 2005, the court issued an order granting MasterCard’s motion to dismiss and dismissed the complaint with prejudice. On August 10, 2005, the plaintiffs filed a notice of appeal. Plaintiffs’ opening appeal brief was filed on November 28, 2005. MasterCard filed its opposition brief to plaintiffs’ appeal on December 26, 2005.
On June 22, 2005, a purported class action lawsuit was filed by a group of merchants in the U.S. District Court of Connecticut against MasterCard International Incorporated, Visa U.S.A., Inc. Visa International Service Association and a number of member banks alleging, among other things, that MasterCard’s and Visa’s purported setting of interchange fees violates Section 1 of the Sherman Act. In addition, the complaint alleges MasterCard’s and Visa’s purported tying and bundling of transaction fees also constitutes a violation of Section 1 of the Sherman Act. The suit seeks treble damages in an unspecified amount, attorneys’ fees and injunctive relief. Since the filing of this complaint, there have been approximately forty similar complaints (the majority styled as class actions although a few complaints are on behalf of individual plaintiffs) filed on behalf of merchants against MasterCard and Visa (and in some cases, certain member banks) in federal courts in California, New York, Wisconsin, Pennsylvania, New Jersey, Ohio, Kentucky and Connecticut. The claims in these complaints are generally brought under Sections 1 and 2 of the Sherman Act. Specifically, the complaints contain some or all of the following claims: (i) that MasterCard’s and Visa’s interchange fees violate Section 1 of the Sherman Act; (ii) that MasterCard and Visa have enacted and enforced various rules, including the no surcharge rule, in violation of Section 1 or 2 of the Sherman Act; (iii) that MasterCard’s and Visa’s purported bundling of the acceptance of premium credit cards to standard credit cards constitutes an unlawful tying arrangement; (iv) that MasterCard’s and Visa’s purported bundling of the acceptance of commercial cards to consumer credit cards constitutes an unlawful tying arrangement; and (v) that MasterCard and Visa have unlawfully tied and bundled transaction fees. In addition to the claims brought under federal antitrust law, some of these complaints contain certain state law consumer protection and common law claims based upon the same conduct described above, and some of the complaints allege that the claims in these actions are not barred by the settlement agreement in the U.S. merchant lawsuit, as described in Note 16. These interchange-related litigations also seek treble
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
damages in an unspecified amount (although several of the complaints allege that the plaintiffs expect that damages will range in the tens of billions of dollars), as well as attorneys’ fees and injunctive relief. On October 19, 2005, the Judicial Panel on Multidistrict Litigation issued an order transferring these cases to Judge Gleeson of the U.S. District Court for the Eastern District of New York for coordination of pre-trial proceedings. Plaintiffs’ amended consolidated class action complaint is due to be filed by April 24, 2006. The Court has indicated that it will allow new discovery to proceed upon the filing of the complaint.
At this time it is not possible to determine the outcome of, or estimate the liability related to, these interchange-related litigations. No provisions for losses have been provided in connection with these litigations.
European Union. In September 2000, the European Commission issued a “Statement of Objections” challenging Visa International’s cross-border MIF under European Community competition rules. On July 24, 2002, the European Commission announced its decision to exempt the Visa MIF from these rules based on certain changes proposed by Visa to its MIF. Among other things, in connection with the exemption order, Visa agreed to adopt a cost-based methodology for calculating its MIF similar to the methodology employed by MasterCard, which considers the costs of certain specified services provided by issuers, and to reduce its MIF rates for debit and credit transactions to amounts at or below certain specified levels.
On September 25, 2003, the European Commission issued a Statement of Objections challenging MasterCard Europe’s cross-border MIF. MasterCard Europe filed its response to this Statement of Objections on January 5, 2004. On June 13, 2005 the European Commission announced a “sector inquiry” into the financial services industry, which MasterCard understands includes an investigation of interchange fees. The sector inquiry is ongoing.
The European Commission has informed MasterCard Europe that it intends to issue a supplemental Statement of Objections in the near future. Following this, the European Commission could issue a prohibition decision ordering MasterCard to change the manner in which it calculates its cross-border MIF. MasterCard Europe could appeal such a decision to the European Court of Justice. Because the cross-border MIF constitutes an essential element of MasterCard Europe’s operations, changes to it could significantly impact MasterCard International’s European members and MasterCard Europe’s business. In addition, a negative decision by the European Commission could lead to the filing of private actions against MasterCard Europe by merchants seeking substantial damages.
United Kingdom Office of Fair Trading. On September 25, 2001, the Office of Fair Trading of the United Kingdom (“OFT”) issued a Rule 14 Notice under the U.K. Competition Act 1998 challenging the MasterCard MIF, the fee paid by acquirers to issuers in connection with point of sale transactions, and multilateral service fee (“MSF”), the fee paid by issuers to acquirers when a customer uses a MasterCard-branded card in the United Kingdom either at an ATM or over the counter to obtain a cash advance. Until November 2004, the MIF and MSF were established by MasterCard U.K. Members Forum Limited (“MMF”) (formerly MasterCard Europay U.K. Ltd. (“MEPUK”)) for domestic credit card transactions in the United Kingdom. The notice contained preliminary conclusions to the effect that the MasterCard U.K. MIF and MSF may infringe U.K. competition law and do not qualify for an exemption in their present forms. On February 11, 2003, the OFT issued a supplemental Rule 14 Notice, which also contained preliminary conclusions challenging MasterCard’s U.K. MIF under the Competition Act. On November 10, 2004, the OFT issued a third notice (now called a Statement of Objections) claiming that the MIF infringes U.K. and European Union competition law.
On November 18, 2004, MasterCard’s board of directors adopted a resolution withdrawing the authority of the U.K. members to set domestic MasterCard MIFs and MSFs and conferring such authority exclusively on MasterCard’s President and Chief Executive Officer.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
On September 6, 2005, the OFT issued its decision, concluding that MasterCard’s U.K. MIFs that were established by MMF prior to November 18, 2004 contravene U.K. and European Union competition law. The OFT decided not to impose penalties on MasterCard or MMF. On November 2 and 4, 2005, respectively, MMF and MasterCard appealed the OFT’s decision to the U.K. Competition Appeals Tribunal. A hearing on the appeals is likely to take place in the second half of September 2006 and a decision is expected by the end of the year. In addition, referencing the November 18, 2004 change described above, the OFT commenced a new investigation of MasterCard’s current U.K. MIFs and, if it determines that they contravene U.K. and European Union competition law, it will issue a new decision and possibly levy fines accruing from the date of its first decision. MasterCard would likely appeal a negative decision by the OFT in any future proceeding to the Competition Appeals Tribunal.
Because the MIF constitutes an essential element of MasterCard’s U.K. operations, the OFT’s decision, if it is upheld on appeal, could have a significant adverse impact on MasterCard’s U.K. members and on MasterCard’s competitive position and overall business in the U.K. In addition, the OFT’s decision could lead to the filing of private actions against MasterCard by merchants and/or consumers which, if its appeal of the OFT’s decision fails, could result in an award or awards of substantial damages.
Germany. On January 19, 2006, a German retailers association filed a complaint with the Federal Cartel Office in Germany concerning MasterCard’s and Visa’s domestic MIFs. The complaint alleges that MasterCard’s and Visa’s MIFs are not transparent to cardholders and include extraneous costs. MasterCard understands that the Federal Cartel Office is reviewing the complaint.
Other Jurisdictions. In Spain, the Competition Tribunal issued a decision in April 2005 denying the interchange fee exemption applications of two of the three domestic credit and debit card processing systems and beginning the process to revoke the exemption it had previously granted to the third such system. The interchange fees set by these three processors apply to MasterCard transactions in Spain and consequently, MasterCard has appealed this decision. In addition, the Tribunal expressed views as to the appropriate manner for setting domestic interchange fees which, if implemented, would result in substantial reductions in credit and debit card interchange fees in Spain. In December 2005, the processors agreed to change the manner in which they set interchange fees, and the new fees are currently being assessed by the Spanish competition authorities to determine if they qualify for an exemption. This could have a material impact on MasterCard’s business in Spain. MasterCard is aware that regulatory authorities and/or central banks in certain other jurisdictions, including Poland, Portugal, Norway, Sweden, New Zealand, Mexico, Colombia, Brazil and Hungary are reviewing MasterCard’s and/or its members’ interchange fees and/or related practices and may seek to regulate the establishment of such fees and/or such practices.
Recent Plaintiff Communication
One of the plaintiffs in MasterCard’s antitrust litigations has asserted in a written communication that the damages it believes it is likely to recover in its lawsuit will exceed MasterCard’s capital and ability to pay, and that MasterCard has failed to adequately disclose to public investors in the proposed initial public offering described in Note 2 the possibility of substantial damages judgments against MasterCard in such lawsuit and the other pending litigations against MasterCard, which the plaintiff has asserted are likely to be in the billions of dollars before trebling. The plaintiff has also requested that MasterCard not relinquish its right to assess its member banks, which the plaintiff alleged would shift the liability to public investors, and increase MasterCard’s litigation reserves to an appropriate (but unspecified) amount. MasterCard has responded to this plaintiff indicating that it disagrees with the plaintiff’s characterization of both its lawsuit and MasterCard’s financial
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
position following the closing of the proposed initial public offering. Contrary to the plaintiff’s claims, MasterCard also believes that its litigation disclosure is materially accurate and complete and in accord with all applicable laws and regulations.
Note 19. Settlement and Travelers Cheque Risk Management
Settlement risk is the legal exposure due to the difference in timing between the payment transaction date and subsequent settlement. Settlement risk is estimated using the average daily card charges during the quarter multiplied by the estimated number of days to settle. The Company has global risk management policies and procedures, which include risk standards to provide a framework for managing the Company’s settlement exposure. MasterCard International’s rules generally guarantee the payment of MasterCard transactions and certain Cirrus and Maestro transactions between principal members. The term and amount of the guarantee are unlimited. Member-reported transaction data and the transaction clearing data underlying the settlement risk exposure calculation may be revised in subsequent reporting periods.
In the event that MasterCard International effects a payment on behalf of a failed member, MasterCard International may seek an assignment of the underlying receivables. Subject to approval by the Board of Directors, members may be charged for the amount of any settlement loss incurred during the ordinary activities of the Company. MasterCard International’s right to impose special assessments arising out of extraordinary events on its members will be eliminated once the new ownership structure and governance changes are completed, as described in Note 2.
MasterCard requires certain members that are not in compliance with the Company’s risk standards in effect at the time of review to post collateral, typically in the form of letters of credit and bank guarantees. This requirement is based on management review of the individual risk circumstances for each member that is out of compliance. In addition to these amounts, MasterCard holds collateral to cover variability and future growth in member programs; the possibility that it may choose to pay merchants to protect brand integrity in the event of merchant bank/acquirer failure, although it is not contractually obligated to do so; and Cirrus and Maestro related risk. MasterCard monitors its credit risk portfolio on a regular basis to estimate potential concentration risks and the adequacy of collateral on hand. Additionally, from time to time, the Company reviews its risk management methodology and standards. As such, the amounts of estimated settlement exposure are revised as necessary.
Estimated settlement exposure, and the portion of the Company’s uncollateralized settlement exposure for MasterCard-branded transactions that relates to members that are deemed not to be in compliance with, or that are under review in connection with, the Company’s risk management standards, at December 31, were as follows:
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Although MasterCard holds collateral at the member level, the Cirrus and Maestro estimated settlement exposures are calculated at the regional level. Therefore, these settlement exposures are reported on a gross basis, rather than net of collateral. During 2005, a significant portion of the increase in Cirrus and Maestro estimated settlement exposures ($505,352) was attributable to the conversion of United Kingdom domestic debit transactions to Maestro transactions.
Of the total estimated settlement exposure under the MasterCard brand, net of collateral, the U.S. generated approximately 49% and 52% at December 31, 2005 and 2004, respectively. The second largest country that accounted for this exposure was the United Kingdom at approximately 10% at December 31, 2005 and 2004. Of the total uncollateralized settlement exposure attributable to non-compliant members, five members represented approximately 75% and 65% at December 31, 2005 and 2004, respectively. The decrease in uncollateralized settlement exposure for non-compliant members during 2005 was mainly attributable to non-compliant members providing collateral or transferring portfolios to compliant members.
MasterCard guarantees the payment of MasterCard-branded travelers cheques in the event of issuer default. The guarantee estimate is based on all outstanding MasterCard-branded travelers cheques, reduced by an actuarial determination of cheques that are not anticipated to be presented for payment. The term and amount of the guarantee are unlimited. MasterCard calculated its MasterCard-branded travelers cheques exposure under this guarantee as $934,124 and $1,172,533 at December 31, 2005 and 2004, respectively.
A significant portion of the Company’s travelers cheque risk is concentrated in one travelers cheque issuer. MasterCard has obtained an unlimited guarantee estimated at $762,579 and $969,593 at December 31, 2005 and 2004, respectively, from a financial institution that is a member, to cover all of the exposure of outstanding travelers cheques with respect to that issuer. In addition, MasterCard has obtained guarantees estimated at $26,457 and $28,592 at December 31, 2005 and 2004, respectively, from financial institutions that are members in order to cover the exposure of outstanding travelers cheques with respect to another issuer. These guarantee amounts have also been reduced by an actuarial determination of cheques that are not anticipated to be presented for payment.
Based on the Company’s ability to assess its members for settlement and travelers cheque losses, the effectiveness of the Company’s global risk management policies and procedures, and the historically low level of losses that the Company has experienced, management believes the probability of future payments for settlement and travelers cheque losses in excess of existing reserves is negligible. As a result of the proposed change in ownership structure and governance, which is described in Note 2, the Company reassessed whether it would be necessary to record an obligation for the fair value of some or all of its settlement and travelers cheque guarantees and has determined that an obligation should not be established.
Note 20. Stockholders’ Equity
MasterCard’s capital stock is privately held by certain of the Company’s customers that are principal members of MasterCard International. Each principal member of MasterCard International has a class A membership interest in MasterCard International, representing that member’s continued rights as a licensee to use MasterCard’s brands, programs, products and services. MasterCard Incorporated owns the sole class B membership interest in MasterCard International, entitling MasterCard Incorporated to exercise all economic rights and substantially all voting rights in MasterCard International. MasterCard International is the Company’s principal operating subsidiary.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
The authorized capital stock of MasterCard Incorporated at December 31, 2005 and 2004 consists of 275,000 shares of class A redeemable common stock, par value $.01 per share (of which 100,000 shares are issued and outstanding); 25,000 shares of class B convertible common stock, par value $.01 per share (of which no shares are issued and outstanding); and 75,000 shares of class C common stock, par value $.01 per share (of which no shares are issued or outstanding). Class C common stock may be issued from time to time with voting powers, designations, preferences and other rights to be determined by the MasterCard board of directors, in compliance with certain limitations, as set forth in the certificate of incorporation of MasterCard.
The shares of class A redeemable and class B convertible common stock were issued on June 28, 2002, pursuant to an Agreement and Plan of Merger dated as of February 13, 2002, in which MasterCard International merged with a subsidiary of MasterCard Incorporated (the “Conversion”), and the Integration Agreement dated as of February 13, 2002, pursuant to which MasterCard Incorporated acquired all of the outstanding shares of Europay International S.A. (now MasterCard Europe) (the “Integration”). In the Conversion and Integration, each principal member of MasterCard International received shares of class A redeemable common stock and class B convertible common stock of MasterCard, representing each member’s existing equity interest in the Company.
Pursuant to the Company’s bylaws (the “bylaws”), on July 1, 2005 all of the Company’s class B convertible common stock converted to class A redeemable common stock. On October 21, 2005, all class A redeemable common stock was reallocated among the Company’s stockholders based on a global proxy calculation set forth in the Company’s bylaws (the “reallocation”). The global proxy calculation is based on the stockholders’ business contribution to MasterCard Incorporated during the twelve months ended June 30, 2005. MasterCard Incorporated redeemed and issued shares as necessary in order to give effect to the reallocation.
The bylaws also provide that customers that became class A members of MasterCard International subsequent to January 1, 2001 would be eligible to participate in the reallocation. To permit this to occur, the Company issued one share to each principal member qualified to participate in the reallocation but that did not receive shares in connection with the initial issuance of shares on June 28, 2002. Accordingly, MasterCard issued .348 shares to principal members on July 1, 2005 in a private placement transaction exempt from registration under the U.S. federal securities laws. The issuance of this common stock was recorded at par in 2005 by reclassifying a portion of retained earnings to common stock. All shares received by these new members, both issued and as a result of the reallocation, will be restricted for resale under applicable U.S. securities laws.
Transfers of shares of common stock and assignment of the right to receive shares were not permitted until July 1, 2005. The global proxy calculation will occur annually after July 1, 2005 based on each stockholder’s business contribution to MasterCard Incorporated during the previous twelve months. After July 1, 2005, no further reallocation of the Company’s shares will occur; however, each stockholder must maintain an ownership percentage of common stock that is no less than 75% and no more than 125% of the shares determined in the most recent global proxy calculation. Stockholders may be required to purchase or sell shares of MasterCard Incorporated, in accordance with procedures established by the Company, in order to satisfy these requirements. After July 1, 2005, MasterCard Incorporated may, at its option, redeem the common stock of a stockholder that ceases to be a principal member of MasterCard International for the book value of the shares, based on MasterCard’s financial statements most recently filed with the Securities and Exchange Commission. If MasterCard Incorporated does not redeem the stockholder’s shares, a stockholder ceasing to be a member of MasterCard International after July 1, 2005 will be required to offer the unredeemed shares to the other stockholders of MasterCard Incorporated in accordance with procedures to be established by the Company. These requirements would not apply if the new ownership and governance structure described in Note 2 herein is implemented.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Note 21. Acquisition of Europay International S.A. (“EPI”) (the “Integration”)
MasterCard acquired, directly and indirectly, 100% of the shares of EPI not previously owned by MasterCard International in the Integration. EPI, now MasterCard Europe, is the Company’s principal operating subsidiary in Europe. MasterCard Europe’s primary business is to license a full range of payment programs and services to financial institutions in the European region and to provide a set of information processing and transaction delivery services to these institutions. The Integration has allowed MasterCard International and MasterCard Europe to form an integrated, global payments company with a single management team and governance structure. The results of EPI’s operations have been included in the consolidated financial statements of the Company from June 28, 2002.
Purchase Price for EPI
MasterCard Incorporated issued 23,760 shares to the shareholders of EPI and MasterCard Europay U.K. Limited (“MEPUK”) in the Integration, in return for directly and indirectly acquiring 100% of the shares of EPI not previously owned by MasterCard International. However, of the 23,760 shares issued, only 17,610 were considered to be issued unconditionally. As discussed more fully below, the purchase price for EPI was based on the estimated value of the unconditional shares only, and this estimated value was determined on the basis of an independent valuation. Considering this valuation and the 17,610 unconditional shares issued, the purchase price of EPI was $267,856, excluding estimated acquisition costs of $10,486 that were incurred by the Company.
In calculating the purchase price of EPI, the Company considered only the unconditional shares issued to the former shareholders of EPI and MEPUK because the Integration Agreement provides that the number of shares allocated to these shareholders would potentially increase or decrease at the end of a three-year transition period as a result of the application of a global proxy formula for the third year of the transition period. Of the 23,760 shares attributable to the exchange of EPI and MEPUK shares, 6,150 shares are conditional shares subject to reallocation at the end of the transition period. EPI and MEPUK shareholders therefore received 17,610 unconditional shares at closing.
In 2005, the Company finalized the calculation of the reallocation of the shares among its stockholders and the shares were reallocated on October 21, 2005. As a result of the performance of the former stockholders of EPI and MEPUK, as measured by the global proxy calculation described in Note 20 herein, approximately 180 conditional shares were retained by these shareholders in the reallocation. In calculating the original purchase price of EPI, the Company considered only the unconditional shares issued to the former stockholders of EPI and MEPUK. Since former EPI and MEPUK stockholders retained 180 conditional shares in the reallocation that were not included in the purchase price initially, these shares constituted a part of the purchase price. Accordingly, based on the estimated fair value of the stock of MasterCard Incorporated as of July 1, 2005, the Company recorded an increase in goodwill and additional paid-in capital of $6,251 with respect to the 180 conditional shares retained by the former EPI and MEPUK shareholders.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Fair Value of EPI Assets Acquired and Liabilities Assumed
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at June 28, 2002, the date of the acquisition of EPI in the Integration, as determined based on an independent appraisal, and also reflects subsequent refinements to the estimated fair values as discussed below. Certain balances for assets acquired and liabilities assumed have been reclassified to conform to MasterCard presentation for consistency:
Subsequent to the acquisition date of EPI, the purchase price allocation was refined and amounts were reallocated among the assets acquired and liabilities assumed. The table above has been adjusted to reflect these refinements, which include a $6,725 increase to the exit cost liability estimate, a $4,722 decrease to the deferred tax estimate, a $4,911 decrease to the value assigned to certain capitalized software technologies and a $6,913 increase to goodwill. Changes to the exit cost liability are discussed below and the changes to goodwill are provided in Note 8.
Pursuant to the Integration, the bylaws of MasterCard International adopted on June 28, 2002 provide that the Company will assume the first $7,000 of losses or liabilities that relate to any breach of EPI’s representations or warranties in the Integration agreement. Any such losses or liabilities in excess of $7,000 could, under MasterCard International’s bylaws, be levied against MasterCard International’s European members as an assessment. MasterCard anticipates that certain former EPI liabilities could trigger this bylaw provision. The $7,000 is included in total liabilities assumed above.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Exit Costs Relating to the Integration
Included in the total liabilities at the time of the EPI acquisition were estimated exit costs relating to the Integration. The exit cost activities were completed in 2005. The changes in the liability for exit costs are summarized as follows:
The following table provides explanations for the Company’s changes in its preliminary estimate of exit costs related to the Integration:
These changes in estimate resulted in a corresponding net increase (decrease) in goodwill, net of taxes.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Note 22. Foreign Exchange Risk Management
The Company enters into foreign currency forward contracts to minimize risk associated with anticipated receipts and disbursements denominated in foreign currencies and the possible changes in value due to foreign exchange fluctuations of assets and liabilities denominated in foreign currencies. MasterCard’s forward contracts are classified by functional currency as summarized below:
U.S. Dollar Functional Currency
Euro Functional Currency
The currencies underlying the foreign currency forward contracts consist primarily of euro, U.K. pounds sterling, Japanese yen, Australian dollars, Swiss francs and Singapore dollars. The fair value of the foreign currency forward contracts generally reflects the estimated amounts that the Company would receive or (pay), on a pre-tax basis, to terminate the contracts at the reporting date based on broker quotes for the same or similar instruments. The terms of the foreign currency forward contracts are generally less than 18 months. The Company has deferred $739 of net gains and $3,497 of net losses, after tax, in accumulated other comprehensive income as of December 31, 2005 and 2004, respectively, all of which is expected to be reclassified to earnings within the next twelve months to provide an economic offset to the earnings impact of the anticipated cash flows hedged.
The Company’s derivative financial instruments are subject to both credit and market risk. Credit risk is the risk of loss due to failure of the counterparty to perform its obligations in accordance with contractual terms. Market risk is the potential change in an investment’s value caused by fluctuations in interest and currency exchange rates, credit spreads or other variables. Credit and market risk related to derivative instruments were not material at December 31, 2005 and 2004.
Generally, the Company does not obtain collateral related to forward contracts because of the high credit ratings of the counterparties that are members. The amount of accounting loss the Company would incur if the counterparties failed to perform according to the terms of the contracts is not considered material.
MASTERCARD INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except per share data)
Note 23. Segment Reporting
In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” MasterCard has one reportable segment, “Payment Services.” All of the Company’s activities are interrelated, and each activity is dependent upon and supportive of the other. Accordingly, all significant operating decisions are based upon analyses of MasterCard as one operating segment. The President and Chief Executive Officer has been identified as the chief operating decision-maker.
Revenue by geographic market is based on the location of our customer that issued the cards which are generating the revenue. Revenue generated in the U.S. was approximately 55%, 58% and 63% of total revenues in 2005, 2004 and 2003, respectively. No individual country, other than the U.S., generated more than 10% of total revenues in those periods. MasterCard does not maintain or measure long-lived assets by geographic location.
Note 24. Other Income
In September 2005, MasterCard recognized $17,500 in other income relating to settlement of a dispute of a customer business agreement. Additionally, in the fourth quarter 2005, the Company recognized approximately $9,000 in other income relating to gains on the sales of two investments in affiliates.
Note 25. Related Party
The common stock of MasterCard Incorporated is privately owned by certain customers of the Company. MasterCard enters into transactions with its customers in the normal course of business and operates a system for payment processing among its customers. During 2005 and 2004, MasterCard had one customer which owned greater than 10% of the Company’s voting stock. This customer generated approximately $319,018, $314,349 and $155,258 of net revenues for the year ended December 31, 2005, 2004 and 2003, respectively. The Company incurred costs of $3,847, $2,669 and $2,678 for treasury and other services provided by this customer for the year ended December 31, 2005, 2004 and 2003, respectively. The Company owed approximately $78,319 and $64,154 to this customer and the customer owed the Company $56,631 and $49,084 as of December 31, 2005 and 2004, respectively.
As more fully described in Note 2 herein, MasterCard is pursuing a new ownership and governance structure, which will involve a new class of the Company’s stock being traded on a public exchange. As a result of the new ownership and governance structure, the customer mentioned above will retain only non-voting Class B common stock and Class M common stock that will provide its holders with certain rights, including the right to approve specified significant corporate actions and elect up to three of MasterCard’s directors (but not more than one quarter of all directors) but is otherwise also non-voting.
MASTERCARD INCORPORATED
SUMMARY OF QUARTERLY DATA
(In thousands, except per share data)
Portions of our business are seasonal. Our gross revenue is favorably affected by progressively increased card purchasing volume throughout the year, particularly in the fourth quarter during the holiday shopping period. However, customer and merchant incentives, which are recorded as contra-revenue, and advertising, holiday promotions and incentives also increase correspondingly, generally causing our profitability to decline in the fourth quarter.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
MasterCard Incorporated’s management, including the President and Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Report. Based on that evaluation, the Company’s President and Chief Executive Officer and Chief Financial Officer concluded that MasterCard Incorporated had effective disclosure controls and procedures for (i) recording, processing, summarizing and reporting information that is required to be disclosed in its reports under the Securities Exchange Act of 1934, as amended, within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) ensuring that information required to be disclosed in such reports is accumulated and communicated to MasterCard Incorporated’s management, including its President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
Changes in Internal Control over Financial Reporting
In addition, MasterCard Incorporated’s management assessed the effectiveness of MasterCard’s internal control over financial reporting as of December 31, 2005. In a report included in Item 8 herein, management concluded that based on its assessment, MasterCard’s internal control over financial reporting was effective as of December 31, 2005.
There was no change in MasterCard’s internal control over financial reporting that occurred during the three months ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, MasterCard’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The following table sets forth the names, ages and positions of our current directors and executive officers. Our current directors are officers of, or otherwise affiliated with, our member financial institutions. In connection with the ownership and governance transactions, our certificate of incorporation and bylaws will be amended to, among other things, provide that, with the exception of the directors to be elected by the holders of our Class M common stock, any person who is or has been during the prior three years a director, officer, employee, agent or representative of, or otherwise has any business relationship that is material to such person with, a member or former member of MasterCard International, or an operator, member, or licensee of any competing general purpose payment card system, or any affiliate of such person, may not serve as a director of MasterCard Incorporated. Accordingly, we expect that the majority of our current directors will resign. We intend to reduce the size of our board of directors and otherwise replace these directors with a geographically diverse group of individuals who are independent under the rules of the New York Stock Exchange and the U.S. Securities and Exchange Commission and who have no affiliation with any of our members or any affiliate of a member.
Name
Age
Position
William F. Aldinger
Director (U.S. Representative)
Silvio Barzi
Director (Europe Representative)
Donald L. Boudreau
Director (U.S. Representative)
Augusto M. Escalante
Director (Latin America and the Caribbean Representative)
Richard D. Fairbank
Director (U.S. Representative)
Baldomero Falcones Jaquotot
Chairman of the Board and Director (Europe Representative)
Bernd M. Fieseler
Director (Europe Representative)
Iwao Iijima
Director (Asia/Pacific Representative)
Michel Lucas
Director (Europe Representative)
Norman C. McLuskie
Director (Europe Representative)
Siddharth N. Mehta
Director (U.S. Representative)
Robert W. Pearce
Director (Canada Representative)
Michael T. Pratt
Director (Asia/Pacific Representative)
Robert W. Selander
President and Chief Executive Officer and Director
Tan Teong Hean
Director (Asia/Pacific Representative)
Jac Verhaegen
Director (Europe Representative)
Robert B. Willumstad
Vice Chairman and Director (U.S. Representative)
W. Roy Dunbar
President, Global Technology & Operations
Noah J. Hanft
General Counsel and Secretary
Alan J. Heuer
Chief Operating Officer
Chris A. McWilton
Chief Financial Officer
Michael W. Michl
Chief Administrative Officer
Christopher D. Thom
Chief Risk Officer
All of our officers are appointed by and serve at the discretion of our board of directors. There are no family relationships among any of our directors or executive officers.
Set forth below is a brief description of the business experience of our directors and executive officers. We sometimes refer to the board of directors of MasterCard Incorporated as the “Global Board of Directors” to distinguish it from our regional boards.
William F. Aldinger, age 58, is the former Chairman and Chief Executive Officer of HSBC North America Holdings Inc. Mr. Aldinger has served on the Global Board of Directors since June 2002 and was elected to the MasterCard International board of directors in 1998. He is a former member of MasterCard’s U.S. region board. Mr. Aldinger joined Household International in 1994, and prior to that time served in various positions at Wells Fargo Bank, including Vice Chairman. HSBC Holdings plc acquired Household International Inc. in 2003. Mr. Aldinger is a member of the boards of directors of Illinois Tool Works, Inc., AT&T, Charles Schwab Corporation and KKR Financial. He is a member of the combined boards of directors of Children’s Memorial Medical Center/Children’s Memorial Hospital and the Children’s Memorial Foundation located in Chicago. Mr. Aldinger is also a member of the board of trustees of the J.L. Kellogg Graduate School of Management and the Baruch College Fund.
Silvio Barzi, age 58, is Deputy General Manager of Unicredito Italiano and founder and Chief Executive Officer of Clarima Banca, a bank specializing in credit cards and consumer credit. Mr. Barzi was first elected to the Global Board of Directors in April 2003 and serves on MasterCard’s Europe region board. Prior to joining Unicredito Italiano in 2000, Mr. Barzi was a Vice President at Booz Allen & Hamilton. From 1995 until 1998, he worked for the Credit Suisse-Winterthur Group, where he was responsible for the merger and integration of six Italian-based insurance companies. From 1981 to 1995, Mr. Barzi was a partner in the Italian office and a leader within the European Financial Institutions and Information Technology practices of McKinsey & Company. Mr. Barzi currently serves as a director at CartaSì and SinSys.
Donald L. Boudreau, age 65, is a director of the Company. Mr. Boudreau served as Chairman Emeritus and a non-voting advisory director of MasterCard from June 2002 until November 2004. He served on the MasterCard International board of directors since 1997 and was the Chairman of the MasterCard International board of directors from April 1998 to March 2001. Mr. Boudreau retired from his position as Vice Chairman of The Chase Manhattan Corporation and The Chase Manhattan Bank in December 2000, where he was a member of the Executive Committee. Mr. Boudreau served in a variety of positions during his 40 year career at Chase, and most recently was responsible for all of Chase’s consumer and middle market businesses. Previously, Mr. Boudreau was at various times responsible for Chase’s international businesses, was Chief Administrative Officer of Chase’s corporate business, and was responsible for establishing and managing various risk management and compliance functions at Chase. Earlier in his career, Mr. Boudreau served as chief financial officer of Chase’s consumer business. Mr. Boudreau is a member of the board of trustees of the New York Presbyterian Hospital and of New York Presbyterian Hospital System, Inc and serves as chairman of both of their audit committees.
Augusto M. Escalante, age 56, is Deputy President, Consumer Products and Marketing Areas, Banco Nacional de Mexico, S.A. Mr. Escalante has been a member of the Global Board of Directors since June 2002 and was elected to the MasterCard International board of directors in 2001 after having previously served on the board from April 1998 to March 1999. He is also member of MasterCard’s Latin America and Caribbean region board, for which he formerly served as Chairman. Mr. Escalante joined Banco Nacional de Mexico in 1991 and has served as Deputy President of Banco Nacional de Mexico since January 2000. At Banco Nacional de Mexico, Mr. Escalante is responsible for all consumer products, both deposit and credit, and all marketing and advertising for the Financial Group of Banco Nacional de Mexico. He was previously Deputy President, Bank Card and Electronic Services Area, and Deputy President, Consumer Loans Area of Banco Nacional de Mexico.
Richard D. Fairbank, age 55, is Chairman, Chief Executive Officer and President of Capital One Financial Corporation. Capital One, headquartered in McLean, Virginia, provides credit cards and a variety of other consumer lending and banking products through its subsidiaries in the United States and internationally. Mr. Fairbank founded Capital One in 1988 as part of Virginia-based Signet Bank. He has served as Chairman and Chief Executive Officer of Capital One since it was spun off from Signet as an independent, public company in 1994. In addition, Mr. Fairbank serves as Chairman and Chief Executive Officer of Capital One Bank and Chairman of Capital One F.S.B., two of Capital One’s primary lending subsidiaries. Mr. Fairbank was first elected to the Global Board of Directors in April 2003 and has served on MasterCard’s U.S. region board since 1995. He served as Chairman of MasterCard’s U.S. region board from 2002 to 2004.
Baldomero Falcones Jaquotot, age 59, is Chairman of Europay España, S.A. and Chairman of the Global Board of Directors of MasterCard. He has been a member of the Global Board of Directors since June 2002 and the MasterCard International board of directors since 1997, and is a member of MasterCard’s European regional board. Mr. Falcones joined Banco Urquijo, a predecessor of Banco Santander Central Hispano, in 1979 and has served as Senior Executive Vice President and a member of the Executive Committee of Banco Santander Central Hispano for fifteen years. Mr. Falcones also serves as Chairman of Sociedad Española de Tarjetas Inteligentes and Santander Central Hispano, Seguros y Reaseguros, S.A. He is a director of Sistema 4B.
Bernd M. Fieseler, age 46, is Managing Director and Member of the Executive Board of Deutscher Sparkassen- und Giroverband and is responsible for operating strategy. Mr. Fieseler has been a member of the Global Board of Directors since March 2004 and serves as a member of MasterCard’s Europe Region board and its executive committee. Before joining Deutscher Sparkassen- und Giroverband, he served as Director for Information and Operations for CC-Bank and was a member of the Executive Board of CC-Holding from 1997 until 2001. From 1995 to 1997, Mr. Fieseler was Director and Head of Organisation of BHF-Bank. Mr. Fieseler also serves as Chairman of the Board of EURO Kartensysteme GmbH.
Iwao Iijima, age 61, is Chairman of Orient Corporation. Mr. Iijima has been a member of the Global Board of Directors since March 2004 and serves on MasterCard’s Asia/Pacific region board. From 1998 until 2003, Mr. Iijima served as Executive Vice President of the Orient Corporation. Prior to joining the Orient Corporation, Mr. Iijima served as Board Managing Director of Dai-ichi Kangyo Bank (currently Mizuho Corporate Bank & Mizhuho Bank) from June 1997.
Michel Lucas, age 66, is Général Manager of Banque Federative du Crédit Mutuel, Chairman and Chief Executive Officer of Credit Industriel et Commercial and Vice Chairman of Europay France S.A. Mr. Lucas has been a member of the Global Board of Directors since March 2004 and serves as Vice Chairman of MasterCard’s Europe region board. Mr. Lucas joined Confédération Nationale du Crédit Mutuel in 1971 and has held various positions since that time in political, technical and development areas. He is also a General Manager of Caisse Centrale du Crédit Mutuel and Groupe de Crédit Mutuel Centre Est Europe, and Chairman and General Manager of the Assurances du Crédit Mutuel. Mr. Lucas is a board member of Banque de Tunisie, BMCE, Caisses Dejardins and Banque Transaltantique.
Norman C. McLuskie, age 61, is Chairman, Retail Direct of the Royal Bank of Scotland Group. Mr. McLuskie has been a member of the Global Board of Directors since June 2002 and was first elected to the MasterCard International board of directors in 2000. He also serves on MasterCard’s European regional board. Mr. McLuskie joined Royal Bank of Scotland in 1982. Following the acquisition of Natwest by the Royal Bank of Scotland in March 2000, he was appointed Chief Executive of Retail Direct, a division of the Royal Bank of Scotland Group encompassing its card and consumer finance businesses, among others. Mr. McLuskie’s other directorships include: Deputy Chairman of Tesco Personal Finance, Director of RBS Insurance and a member of the Institute of Chartered Accountants of Scotland. Mr. McLuskie is also a fellow of the Chartered Institute of Bankers in Scotland.
Siddharth N. Mehta, age 47, is Chief Executive Officer of HSBC North America Holdings Inc. and Chairman and Chief Executive Officer of HSBC Finance Corporation, which positions he has held since April 2005. Mr. Mehta was elected to the Global Board of Directors on March 17, 2005. Mr. Mehta oversees HSBC’s North American businesses (Canada and U.S.) and, as Group Managing Director of HSBC Holdings plc, has responsibility for the strategic management of credit cards and the consumer finance customer group throughout the HSBC Group. Prior to April 2005, Mr. Mehta served as Vice Chairman of HSBC Finance Corporation. He joined Household International in 1998, which was acquired by HSBC Holdings plc in 2003. Prior to joining Household, Mr. Mehta served as a Senior Vice President at The Boston Consulting Group. He has served on MasterCard’s U.S. region board since March 2000. Mr. Mehta serves on the board of international advisors for the Monterey, California, Institute of International Studies and is a member of the Financial Services Roundtable. He also serves on the board of advisors for the Myelin Repair Foundation.
Robert W. Pearce, age 51, is President and Chief Executive Officer of the Personal and Commercial Client Group for Bank of Montreal, where he has worked for over twenty years. He has served on the Global Board of Directors since June 2002 and the MasterCard International board of directors since 1999. He previously served as Executive Vice President of North American Electronic Banking Services for Bank of Montreal and was responsible for Bank of Montreal’s MasterCard Cardholder and Merchant Services lines of business, Debit Card business, and Electronic Banking.
Michael T. Pratt, age 52, is Group Executive, Business and Consumer Banking, Westpac Banking Corporation. Mr. Pratt was first elected to the Global Board of Directors in April 2003 and also serves on MasterCard’s Asia/Pacific region board. He is responsible for all of Westpac’s consumer and business banking business in Australia and for all operations of the Bank of Melbourne. Prior to joining Westpac in 2002, Mr. Pratt served as Chief Executive Officer, Australian Financial Services for National Australia Bank, where he was responsible for all retail operations in Australia. From 1998 to 2000, he served as Managing Director and Chief Executive Officer of Bank of New Zealand. He is a Fellow of the Australian Institute of Banking and Finance, a member of the Australian Institute of Company Directors, and a Fellow of the Australian Institute of Management.
Robert W. Selander, age 55, is President and Chief Executive Officer of MasterCard Incorporated. Mr. Selander has served on the Global Board of Directors since June 2002 and the MasterCard International board of directors since 1997. Mr. Selander also serves on the Company’s Policy and Operating Committees. Prior to his election as President and Chief Executive Officer of MasterCard Incorporated in April 1997, Mr. Selander was an Executive Vice President and President of the MasterCard International Europe, Middle East/Africa and Canada regions. Before joining MasterCard in 1994, Mr. Selander spent two decades with Citicorp/Citibank, N.A. He currently serves as a director of Hartford Financial Services Group.
Tan Teong Hean, age 62, is Chief Executive of Southern Bank Berhad in which capacity he has served since 1983. Mr. Tan has been a member of the Global Board of Directors since March 2004. He is Chairman of MasterCard’s Asia/Pacific region board and has been a member of the Asia/Pacific region board since July 1997. Mr. Tan serves as a board member of Cagamas Berhad (the National Mortgage Corporation, Malaysia). He is a Fellow and Council member of the Institute of Bankers Malaysia, a Fellow of the Malaysian Institute of Directors and a Trustee of the Malaysian Institute of Economic Research.
Jac Verhaegen, age 65, formerly a senior executive of Rabobank and a member of its Executive Board, has been a member of the Global Board of Directors since June 2002 and serves on MasterCard’s European regional board. He joined Rabobank in 1979. He served as Deputy General Manager of Retail Banking until 1984 when he was appointed General Manager of the System Development Department. From 1989 to 1993, he was General Manager of Operations for Rabobank International. From 1993 to 1998, Mr. Verhaegen served as General Manager of Payment Services. From 1998 to 2001, Mr. Verhaegen was a member of the Managing Board, Local Banks Division of Rabobank.
Robert B. Willumstad, age 60, is the former President and Chief Operating Officer of Citigroup. Mr. Willumstad retired from his position as President and Chief Operating Officer of Citigroup in September 2005. Mr. Willumstad served as Chairman and Chief Executive Officer of Citigroup’s Global Consumer Group from December 2000 to August 2003 and, as such, led all of Citigroup’s global consumer businesses including Credit Cards, Consumer Finance, and Retail Banking. Mr. Willumstad is Vice Chairman of the Global Board of Directors and has served on the Global Board of Directors and the MasterCard International board of directors since June 2002 and 1999, respectively. Mr. Willumstad was Chairman and CEO of Travelers Group Consumer Finance Services prior to the merger between Citicorp and Travelers Group in 1998. Mr. Willumstad joined Commercial Credit, now CitiFinancial, in 1987. Prior to joining Citigroup’s predecessor companies, Mr. Willumstad served in various positions with Chemical Bank for twenty years, last holding the position of President of Chemical Technologies Corporation.
W. Roy Dunbar, age 44, is President, Global Technology & Operations of MasterCard Incorporated and a member of the Policy and Operating Committees. Before joining the Company in September 2004, Mr. Dunbar served as president of Eli Lilly’s Intercontinental Region, with responsibility for operations in Africa, the Middle East, the Commonwealth of Independent States, Asia, Latin America and the Caribbean. Prior to that time, he was Vice President-Information Technology and Chief Information Officer of Eli Lilly, where he worked since 1990. Mr. Dunbar currently serves as a director of EDS Corporation. Mr. Dunbar also serves as a director of Humana Inc.
Noah J. Hanft, age 53, is General Counsel and Secretary of MasterCard Incorporated and a member of the Policy Committee. Mr. Hanft was appointed as General Counsel and Secretary of the Company in October 2000 and has served in various increasingly senior legal positions at the Company since 1984, except for 1990 to 1993, when Mr. Hanft was Senior Vice President and Assistant General Counsel at AT&T Universal Card Services. Prior to joining MasterCard, Mr. Hanft was associated with the intellectual property law firm of Ladas & Parry in New York. Mr. Hanft serves as a member of the board of directors of the Legal Aid Society.
Alan J. Heuer, age 64, is Chief Operating Officer of MasterCard Incorporated, the Chairman of the Operating Committee and a member of the Policy Committee. Mr. Heuer is responsible for the Company’s Customer Group, which encompasses member relations, global marketing and consulting/cardholder services functions, as well as the Company’s regional activities. Mr. Heuer was appointed head of the Customer Group in February 1999 and as Chief Operating Officer in March 2004. Mr. Heuer joined MasterCard International in 1995. Prior to that time, Mr. Heuer served as Executive Vice President, Retail Banking, for the Bank of New York.
Chris A. McWilton, age 47, is Chief Financial Officer of MasterCard Incorporated and a member of the Policy Committee. Prior to Mr. McWilton’s appointment as Chief Financial Officer in October 2003, he served as Senior Vice President and Controller of the Company. Prior to joining the Company in January 2003, Mr. McWilton was a partner at KPMG LLP, an international accounting and tax firm where he specialized in financial and SEC reporting matters. Mr. McWilton joined KPMG LLP in 1980 and was elected to the partnership in 1992. He is a certified public accountant.
Michael W. Michl, age 60, is Chief Administrative Officer of the Company and a member of the Policy Committee. Prior to becoming Chief Administrative Officer of the Company in 2004, Mr. Michl was Executive Vice President, Central Resources. Mr. Michl is responsible for the Company’s Central Resources unit, encompassing the Company’s global human resources and corporate services functions. Mr. Michl joined MasterCard International in 1998 from Avon Products, where he was Vice President of Human Resources.
Christopher D. Thom, age 57, is the Chief Risk Officer of the Company and a member of the Policy Committee. Mr. Thom is responsible for the Risk Management Group and is accountable for introducing enterprise risk management into the Company. Prior to assuming his position as Chief Risk Officer in October 2004, Mr. Thom served as Senior Executive Vice President, Global Development, from May 2001 until October 2004 and as Senior Executive Vice President, Central Resources from March 1999 until April 2001. Mr. Thom manages franchise management, security and risk management and fraud management functions at the Company. Prior to joining MasterCard International in 1995, Mr. Thom served in a variety of positions at HSBC Group in the United Kingdom, including as general manager, Strategic Development and general manager, Retail.
Committees of the Board of Directors
We have an Audit Committee, a Compensation Committee and a Nominating and Corporate Governance Committee.
Audit. The Audit Committee assists our board of directors in fulfilling its oversight responsibilities. Among other things, it reviews the activities, results and effectiveness of internal and external auditors, and
appoints and confirms the independence of the external auditors. The Audit Committee also reviews the Company’s key risks and controls and its quarterly and annual financial statements. The current members of the Audit Committee are Messrs. McLuskie (Chairman), Falcones, Boudreau, Fieseler, and Pearce.
In 2003 the Global Board of Directors, acting upon the recommendation of the Audit Committee, determined that Mr. Boudreau’s experience and qualifications satisfied the definition of “audit committee financial expert” under the SEC rules. As described more fully below, the Global Board of Directors has not determined Mr. Boudreau to be independent under the rules of the New York Stock Exchange, the American Stock Exchange or NASDAQ.
Compensation. The Compensation Committee establishes the compensation policies and criteria of our President and Chief Executive Officer and other executive officers. The current members of the Compensation Committee are Messrs. Boudreau (Chairman), Falcones, Aldinger and Pearce.
Nominating and Corporate Governance. The Nominating and Corporate Governance Committee considers and nominates individuals for election as directors of the Company and performs the other functions set forth in its charter. The members of the Nominating and Corporate Governance Committee are Messrs. Falcones (Chairman), Boudreau, Tan, Verhaegen and Willumstad.
Our Class A redeemable common stock is not listed on any securities exchange or quoted on any dealer quotation system. Accordingly, neither the Global Board of Directors nor any Committee thereof is currently required to be comprised of a majority of (or in the case of Committees, composed exclusively of) independent directors, as defined in the SEC rules or the rules of the New York Stock Exchange, the American Stock Exchange or NASDAQ. The Global Board of Directors has not determined whether any directors of the Company are independent under these rules. Under the Company’s current bylaws, voting directors other than the President and Chief Executive Officer are representatives of the Company’s stockholders, and generally serve as senior officers of these institutions. In turn, the Company’s stockholders are principal members of MasterCard International and, in this capacity, constitute the Company’s principal customers. Because the Company’s private share structure, as embodied in its current bylaws, provides for extensive representation of the Company’s customers on the Global Board of Directors, the Company has not considered it appropriate to apply the independence standards applicable to public listed companies to its Global Board of Directors. Accordingly, prior to the consummation of the ownership and governance transactions, the Company’s directors (including directors serving on the Audit and Nominating and Corporate Governance Committees) should not be considered to be independent under the rules of the New York Stock Exchange, the American Stock Exchange or NASDAQ.
We have adopted a Supplemental Code of Ethics that applies to our President and Chief Executive Officer, Chief Financial Officer, Controller and other senior officers. Our Supplemental Code of Ethics is posted on our website at www.mastercardintl.com.
Item 11.
Item 11. Executive Compensation
The following table shows the before-tax compensation for the President and Chief Executive Officer and the four next highest paid executive officers (the “Named Executive Officers”) of the Company in respect of the years ended December 31, 2005, 2004 and 2003.
(1) Amounts represent payments in lieu of perquisites (for fiscal years 2005, 2004, and 2003 respectively: Mr. Selander-$56,000, $56,000, $56,000; Mr. Heuer-$45,000, $45,000, $45,000; Mr. Thom-$45,000, $45,000, $45,000; Mr. McWilton-$45,000, $45,000, $0; Mr. Hanft-$45,000, $45,000, $45,000) and reimbursement for tax obligations (for fiscal years 2005, 2004 and 2003, respectively: Mr. Selander- $241,670, $190,804, $224,231; Mr. Heuer-$166,786, $127,307, $144,187; Mr. Thom-$112,735, $109,506, $100,940; Mr. McWilton-$37,917, $32,293, $0; Mr. Hanft-$89,809, $78,390, $73,086).
(2) For fiscal year 2005, includes payments under the Executive Incentive Plan as follows: the final 20% of the award earned for the 2001-2003 performance period, the first 80% of the award earned for the 2003-2005 performance period (the remaining 20% for the 2003-2005 performance period will vest and be released to participants in January 2008) and for Mr. Selander, 100% of a special award earned for 2001-2005.
(3) Includes for fiscal year 2005, payouts under the Company’s discontinued Value Appreciation Plan related to the exercise of vested rights tied to value appreciation of a portfolio of member bank stocks through September 30, 2004 and, beginning October 1, 2004, earnings on investments in third-party investment vehicles (Mr. Selander-$945,215; Mr. Thom-$587,509) and matching contributions under the Company’s Shared Profit and Savings Plan (Mr. Selander-$12,600; Mr. Heuer-$12,600; Mr. Thom-$12,600; Mr. McWilton-$12,600; Mr. Hanft-$12,600), profit sharing contributions under the Company’s Shared Profit and Savings Plan (Mr. Selander-$15,400; Mr. Heuer-$15,400; Mr. Thom-$15,400; Mr. McWilton-$15,400; Mr. Hanft-$15,400); Company contributions to both a non-qualified defined benefit and defined contribution plan - the Annuity Bonus Plan (Mr. Selander-$287,988; Mr. Heuer-$192,341; Mr. Thom-$115,287; Mr. McWilton-$8,629; Mr. Hanft-$69,146): the dollar value of the benefit of premiums paid for a split-dollar life insurance policy projected on an actuarial basis (Mr. Thom-$303,373): the full amount of all premiums paid by the Company for Executive Life Insurance coverage (Mr. Selander-$36,800; Mr.Heuer-$3,120; Mr. Thom-$1,232; Mr. Hanft-$1,024).
Long-Term Incentive Plan-Awards In Fiscal Year 2005(1)
The following table lists grants of performance units in 2005 to the Named Executive Officers under the Senior Executive Incentive Plan. The Compensation Committee of the Board of Directors has determined that these grants will be converted to restricted stock units (RSUs) on a mandatory basis at the time of the initial public offering, at the offering price. See “Business-Proposed New Ownership and Governance Structure” in Part I, Item 1 of this Report. At the time of conversion, a 20% premium will be added to the target amounts set forth in the table below.
(1) The performance units were granted under the Company’s Senior Executive Incentive Plan (SEIP). Each performance unit has a target value equal to $100. The actual value of each unit was to have been calculated based on the Company’s performance over a three-year period based on a combination of qualitative and quantitative measures that include: implementing customer focused strategy; achieving corporate financial targets (including attaining a predetermined level of earnings before interest, taxes, depreciation and amortization, operating expense and return on equity); and enhancing organizational capabilities. The Compensation Committee has determined that the grants of the performance units under the SEIP made in 2005 will be converted to RSUs on a mandatory basis at the time of the ownership and governance transactions, at the offering price. At the time of conversion, a 20% premium will be added to the target amount set forth in the table above.
The performance units under the SEIP described in the preceding table vest in annual increments according to the following schedule, if the participant completes 1,000 hours of service and is employed by the Company on the last day of the respective twelve-month cycle. The RSUs will have an identical vesting and payment schedule to those shown and described below (in accordance with new deferred compensation regulations) and will be paid dividend equivalents on a current basis.
Upon completion of the three-year performance period, participants will receive a payout equal to 80% of the award earned. The remaining 20% of the award will be paid upon completion of two additional years of service, (i.e., five years of service in total). Upon termination of employment, excluding retirement, all unvested performance units will be forfeited. Upon a participant’s termination of employment due to retirement, all of the participant’s performance units will immediately vest provided that the participant has at least six months of service in the performance period. Eligible retirement is dependent upon age and years of service as follows: age 55 with ten years of service, age 60 with five years of service and age 65 with two years of service.
Retirement Benefits
MasterCard Accumulation Plan (“MAP”)
Employees who participate in the MAP earn benefits under the MAP as soon as they become an employee of the Company. Benefits generally vest after four years of service. For each plan year after January 1, 2000, participants are credited with a percentage of their compensation for the plan year in accordance with the table below:
Eligible employees age 50 or older on or prior to December 31, 2000 are eligible for the greater of the pay credit schedule referenced above or the following pay credit schedule:
Compensation is defined as base pay plus annual incentive compensation. These accounts also receive investment credits based on the yield on 30-Year Treasury securities. When a participant terminates employment, the vested amount credited to the participant’s account is paid in a lump sum or converted into an annuity.
Supplemental Retirement Benefits
Supplemental retirement benefits are provided to all Named Executive Officers and certain other participants under various funded and unfunded nonqualified plans such as our Supplemental Executive Retirement Plan and Annuity Bonus Plan described below. These benefits are provided to certain employees whose benefits are limited by compensation or an amount under applicable federal tax laws and regulations.
Supplemental Executive Retirement Plan (“SERP”)
Designated employees, including all Named Executive Officers, may also receive an annual benefit at retirement equal to a designated percentage (100% for Mr. Selander and 80% for each of the other Named Executive Officers) of the participant’s final 48-month average base salary, reduced by a hypothetical prior employer plan benefit and the amount of all benefits received under the MAP, nonqualified arrangements and
social security. The hypothetical prior plan benefit described in the preceding sentence is an offset to SERP benefits that accounts for years of service of a plan participant prior to joining MasterCard. This benefit offset is calculated as a cash balance account that is “earned” on base pay from age 25 until the year prior to the participant being hired by MasterCard. The account continues to receive interest and is offset from the participant’s aggregate SERP benefit. Prior base pay levels are determined by taking the participant’s base pay level upon hiring by MasterCard and reducing the amount by 10% for each prior year. The hypothetical prior benefit plan offset is not intended to represent a SERP participant’s actual prior employment benefit. Pay credits for the hypothetical prior benefit plan are as follows:
The Supplemental Executive Retirement Plan benefits for each Named Executive Officer are in the table below under the caption “Estimated Annual Retirement Benefits Payable to Certain Executive Officers.”
Annuity Bonus Plan
The Annuity Bonus Plan is a non-qualified, after-tax savings plan designed to provide employees with benefits and contributions to the extent amounts under the Company’s qualified plans are capped by IRS limitations. Each year, the Company pays participants a bonus distributed in the form of a payment to a tax-deferred annuity contract. Annual contributions and reimbursement for tax obligations in connection with the plan are reported and separately reflected in the summary compensation table for each of the Named Executive Officers.
Estimated Annual Retirement Benefits Payable to Certain Executive Officers
The following table shows the estimated annual retirement benefits, including supplemental retirement benefits, if any, under the plans applicable to the individuals, which would be payable to each Named Executive Officer assuming retirement at age 60 at his February 1, 2006 base salary with payments made for life:
(1) Assumes MAP account balances increase with interest credits of 4.5% per year.
(2) Information for the Named Executive Officers gives effect to 2006 base salary increases.
(3) Amount will be reduced by Social Security benefits.
MasterCard Shared Profit and Savings Plan
Most Company employees are eligible to participate in the savings (401(k)) component of the MasterCard Shared Profit and Savings Plan. Employees who participate in the plan may contribute from 2% to 6% of base
pay on a tax-deferred basis or after-tax basis. Employees may also contribute supplemental tax-deferred and after-tax amounts from 1% to 5%. Internal Revenue Service limits apply to all tax-deferred contributions. Employees who earn $90,000 or less in base pay can contribute from 2% to 25% of their base pay to the plan, subject to the Internal Revenue Service limits, on a tax-deferred and/or after-tax basis.
The Company matches 100% of employee contributions up to 6% of base pay. Employees must contribute to the savings (401(k)) component of the plan to receive this matching contribution. Matching contributions are 100% vested after four years of service under a graded vesting schedule. Loans and certain types of withdrawals are permitted.
In addition, the Company may make a profit-sharing contribution in the range of 0-10% of base pay. The target contribution is 7%. The 2005 contribution has been determined to be 8.8%.
Compensation of Directors
In the year ended December 31, 2005, directors who were not employees of the Company were paid an annual retainer of $45,000. The Chairman of the Global Board of Directors received an annual retainer of $50,000. Non-employee directors also received an annual retainer of $5,000 for serving as a chairperson of a standing committee; a $1,500 meeting fee for attendance at board meetings; a $1,000 meeting fee for attendance at committee meetings and a $500 meeting fee for telephonic meetings. In addition, customary expenses for attending board and committee meetings were reimbursed.
Under the MasterCard Deferral Plan, up to 100% of non-employee director’s meeting fees and annual retainer may be deferred and invested among several investment return options. In general, deferred amounts are not paid until after the director retires from the board. The amounts are then paid, at the director’s option, either in a lump sum or in five or ten annual installments.
Following the ownership and governance transactions, we expect to establish directors’ compensation practices customary for a publicly traded company.
Compensation Committee Interlocks and Insider Participation
None of the current members of the Compensation Committee has ever served as an officer or employee of the Company. Mr. Boudreau is a former executive officer of Chase Manhattan Bank USA, N.A, an affiliate of one of the Company’s stockholders with which it has a business relationship more fully described below under Item 13 of this Report. For a description of JPMorgan Chase & Co.’s stockholdings in the Company, see Item 12
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth information regarding the beneficial ownership of our voting securities by each person known to us to beneficially own more than five percent of any class of our voting securities as of March 15, 2006. Under our existing bylaws, only principal members of MasterCard International are allowed to own shares of our common stock, and none of our directors or executive officers beneficially owns any equity securities of MasterCard Incorporated or any of its subsidiaries.
(1) Based on an amendment to a statement on Schedule 13G filed on February 10, 2005, JPMorgan Chase & Co. shares voting power with respect to its class A redeemable common stock with its wholly owned subsidiaries, Chase Manhattan Bank USA, National Association, and JPMorgan Chase Bank, National Association.
(2) Based on an amendment to a statement on Schedule 13G filed on February 13, 2006, Citigroup Inc. shares investment and voting power with respect to its class A redeemable common stock with Citicorp Holdings Inc. and Citibank, N.A., its subsidiaries. Citigroup Inc., Citicorp Holdings Inc. and Citibank, N.A. share the same address listed above.
(3) Bank of America Corporation’s Class A redeemable common stock reflects the shares of common stock held by its subsidiaries on a consolidated basis.
(4) HSBC Holdings plc’s class A redeemable common stock reflects the shares of common stock held by its subsidiaries on a consolidated basis.
In connection with the ownership and governance transactions, we will reclassify all of our 100,000,348 outstanding shares of Class A redeemable common stock so that each of our existing stockholders will receive 1.35 shares of new Class B common stock for each share of Class A redeemable common stock that they held prior to the reclassification and a single share of Class M common stock. See Part I, Item 1 - Business-Proposed New Ownership and Governance Structure. While we do not expect that any of our existing stockholders will beneficially own any of our Class A common stock following the ownership and governance transactions, we expect that certain of our existing stockholders will hold five percent or more of the voting power of the Class M common stock.
On November 28, 2005 the stockholders of MasterCard Incorporated adopted the MasterCard Incorporated 2006 Long Term Incentive Plan (the “Incentive Plan”) which provides for a variety of awards for employees including non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock units, performance units and other stock-based awards. The Global Board of Directors has reserved 5,300,000 shares of Class A common stock for issuance under the Incentive Plan.
No awards have been issued under the Incentive Plan and MasterCard does not have any other compensation plan under which equity securities of MasterCard have been authorized for issuance that have not been previously approved by MasterCard’s stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions
Pursuant to a series of agreements, effective as of January 1, 2005, between MasterCard International and JPMorgan Chase Bank, National Association (“JPMorgan Chase”), an affiliate of JPMorgan Chase & Co., JPMorgan Chase and the Company have agreed to certain pricing arrangements for JPMorgan Chase’s use of the Company’s core authorization, clearing and settlement services and certain supplemental user-pay services in the United States. These agreements provide for pricing discounts on our fees and other incentives in exchange for transaction volumes on cards carrying our brands. JPMorgan Chase is a principal member of MasterCard International and owns a portion of the United States franchisee of Mondex International, our wholly-owned subsidiary that operates a prepaid electronic purse program. MasterCard International provides authorization, clearing and settlement services in connection with transactions for which JPMorgan Chase or its affiliates act as issuer or acquirer. In addition, JPMorgan Chase uses several of the Company’s fee-for-service products, including consulting services. A portion of the Company’s $2.25 billion dollar credit facility is syndicated to JPMorgan Chase, for which JPMorgan Chase receives a fee; JPMorgan Chase is the co-administrative agent of that facility and JPMorgan Securities Inc., another affiliate of JPMorgan Chase, is the co-arranger of that facility. Additional amounts are paid by the Company for these services. In addition, JPMorgan Chase and its affiliates receive amounts from the Company for cash management services. JPMorgan Chase acts as issuer of the Company’s corporate cards and provides a variety of banking services for the Company and for its employees pursuant to arrangements entered into with the Company. In addition to the agreements described above, the Company enters into other agreements to provide financial and other incentives to JPMorgan Chase and certain of its affiliates or business partners in connection with payment programs issued by JPMorgan Chase, including co-branded and affinity card programs, from time to time. For the full year ended 2005, net revenues earned from JPMorgan Chase and its affiliates were approximately $319 million, or 11% of total net revenues. For the full year ended 2005, the Company paid JPMorgan Chase approximately $4 million for the treasury and other services described above. Donald L. Boudreau, a director of the Company, is a former executive officer of a predecessor of JPMorgan Chase.
Pursuant to an agreement, dated as of January 1, 2004, among MasterCard International, Citibank, N.A. (“Citibank”), an affiliate of Citigroup Inc., and certain of its affiliates, Citibank and the Company have agreed to certain pricing arrangements with respect to transaction processing services for Citibank affiliates in North America. Citibank and the Company have also agreed to pricing arrangements for transaction processing services for Citibank’s affiliates outside of North America pursuant to an agreement between MasterCard International and Citibank dated January 3, 2005. Both of these agreements provide for pricing discounts on our fees and other incentives in exchange for transaction volumes on cards carrying our brands. Citibank and certain of its affiliates are principal members of MasterCard International and own a portion of the United States franchise of Mondex International, our wholly-owned subsidiary that operates a prepaid electronic purse program. MasterCard International provides authorization, clearing and settlement services in connection with transactions for which Citibank or its affiliates act as issuer or acquirer. In addition, Citibank uses several of the Company’s fee-for-service products, including consulting services. A portion of the Company’s $2.25 billion dollar credit facility is syndicated to Citibank, N.A., for which Citibank and its affiliates receive a fee; Citibank is the co-administrative agent of that facility and Citigroup Global Markets Inc., another affiliate of Citibank, is the lead arranger of that facility. Additional amounts are paid by the Company for these services. Another insurance affiliate of Citibank is a creditor of MasterCard International in connection with a portion of the $149 million lease financing for the Company’s O’Fallon, Missouri operations facility. In addition, Citibank and its affiliates receive fees from the Company for cash management and asset management services. Citibank also acts as issuer of the Company’s corporate purchasing cards. In addition to the agreements described above, the Company enters into other agreements to provide financial and other incentives to Citibank, N.A. and certain of its affiliates or business partners in connection with payment programs issued by Citibank, including co-branded and affinity card programs, from time to time. For the full year ended 2005, net revenues earned from Citibank and its affiliates were approximately $244 million, or 8% of total net revenues. For the full year ended 2005, the Company paid Citibank approximately $1 million for the treasury and other services described above. Robert B. Willumstad, a member of the Global Board of Directors, is the former President and Chief Operating Officer of Citigroup Inc. Another member of the Global Board of Directors, Augusto M. Escalante, is the Deputy President,
Consumer Product and Marketing Areas, of Banco Nacional de Mexico, S.A., another Citibank, N.A. affiliate. Other representatives of Citibank, N.A. or its affiliates may sit on the Company’s regional boards or business committees.
Pursuant to an agreement, effective as of July 1, 2003, between MasterCard International on the one hand and HSBC Bank USA, N.A. and HSBC Bank Nevada, N.A., as successor to Household Bank (SB), N.A., on the other hand (collectively the “HSBC Banks” and both affiliates of HSBC Holdings plc), the HSBC Banks and the Company have agreed to certain pricing arrangements for the HSBC Bank’s use of the Company’s core authorization, clearing and settlement services in the United States. This agreement provides for pricing discounts on our fees and other incentives in exchange for transaction volumes on cards carrying our brands. The HSBC Banks and certain of their affiliates are principal members of MasterCard International and own a portion of the United States franchisee of Mondex International. MasterCard International provides authorization, clearing and settlement services in connection with transactions for which the HSBC Banks act as issuer or acquirer. In addition, the HSBC Banks use several of the Company’s fee-for-service products, including consulting services. A portion of the Company’s $2.25 billion dollar credit facility is syndicated to HSBC Bank USA, N.A., for which HSBC Bank USA, N.A. receives a fee. MasterCard Europe is also party to a 100 million euro uncommitted credit agreement with an affiliate of HSBC. In addition, the HSBC Banks and their affiliates receive amounts from the Company for cash management and investment management services. HSBC Bank USA, N.A. acts as issuer of the Company’s corporate cards and provides a variety of banking services including, but not limited to, foreign exchange for the Company and for its employees pursuant to arrangements entered into with the Company. In addition to the agreements described above, the Company enters into other agreements to provide financial and other incentives to the HSBC Banks and certain of their affiliates or business partners in connection with payment programs issued by the HSBC Banks or their affiliates, including co-branded and affinity card programs, from time to time. For the full year ended 2005, revenues earned from the HSBC Banks and their affiliates were approximately $130 million, representing 4% of total net revenues. For the full year ended 2005, the Company paid the HSBC Banks and their affiliates approximately $1 million for the treasury and other services described above. William F. Aldinger, one of the Company’s current directors, was the Chief Executive Officer of HSBC North America Holdings Inc., an affiliate of the HSBC Banks, until April 2005. Another of the Company’s current directors, Siddharth N. Mehta, is the Chief Executive Officer of HSBC North America Holdings Inc.
Bank of America, National Association (“Bank of America”), an affiliate of Bank of America Corporation, is a principal member of MasterCard International. In January 2006, Bank of America acquired MBNA Corp. (“MBNA”), one of our key customers. MasterCard International provides authorization, clearing and settlement services in connection with transactions for which Bank of America and its affiliates, including MBNA, act as issuers or acquirers. The Company enters into agreements from time to time to provide financial and other incentives to Bank of America, certain of its affiliates or business partners and MBNA in connection with their payment programs. MBNA also has an agreement which provides for pricing discounts on our fees and other incentives in exchange for transaction volumes on cards carrying our brands. The combined net revenues from Bank of America and MBNA for the full year ended 2005 were $200 million, or 7% of total net revenues. For the full year ended 2005 the Company made minimal payments to Bank of America for certain investment services.
Item 14.
Item 14. Principal Accountant Fees and Services
The Audit Committee and the Company have adopted policies and procedures pertaining to the retention of the Company’s independent auditor for any audit or non-audit services. The policies and procedures specifically require Audit Committee pre-approval of all audit and non-audit services. In addition, proposed services of the independent auditor materially exceeding any pre-approved project scope, terms and conditions, or cost levels require specific review and pre-approval by the Audit Committee. The Audit Committee has also delegated power to the Chairman of the Audit Committee to pre-approve in certain circumstances any engagements or changes in engagements by the independent auditor for audit or non-audit services. The Company paid no fees to its independent auditor in fiscal year 2005 in connection with engagements that were not pre-approved by the
Audit Committee or the Audit Committee Chairman. To help ensure the independence of the Company’s independent auditor, the Company has also adopted policies and procedures relating to, among other things, the engagement of the independent auditor and the hiring of employees of the independent auditor.
Set forth below are the audit and non-audit fees billed by PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm, for fiscal year 2005 and fiscal year 2004.
Audit Fees. The aggregate fees billed to the Company by PricewaterhouseCoopers LLP for the audit of the Company’s annual financial statements and review of the Company’s quarterly financial statements were $4,337,738 for fiscal year 2005 and $3,940,623 for fiscal year 2004. Audit fees also include Sarbanes-Oxley Section 404 audit procedures and audit services related to the Company’s proposed initial public offering and associated out-of-pocket expenses.
Audit-Related Fees. The aggregate fees billed to the Company by PricewaterhouseCoopers LLP for assurance and related audit services (but not included in the audit fees set forth above) were $996,730 for fiscal year 2005 and $415,696 for fiscal year 2004. The assurance and related audit services included information technology attestations (e.g. SAS 70), employee benefit plan audits, agreed upon procedures for the attestations, and associated out-of-pocket expenses.
Tax Fees. The aggregate fees billed to the Company by PricewaterhouseCoopers LLP for tax compliance, tax advice and tax planning services were $987,068 for fiscal year 2005 and $1,165,668 for fiscal year 2004. These tax services consisted of tax preparation and examination support, tax accounting advice, tax planning and other tax related services.
All Other Fees. All other fees billed by PricewaterhouseCoopers LLP were $4,300 for fiscal year 2005 and $4,300 for fiscal year 2004. These other fees represent access to PricewaterhouseCoopers LLP’s accounting research and reference tool.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this Report:
1. ConsolidatedFinancial Statements
See Index to Consolidated Financial Statements in Item 8 of this Report.
2. ConsolidatedFinancial Statement Schedules
None.
3. Thefollowing exhibits are filed as part of this Report or, where indicated, were previously filed and are hereby incorporated by reference:
Refer to the Exhibit Index herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
MASTERCARD INCORPORATED
(Registrant)
By:
/S/ ROBERT W. SELANDER
Robert W. Selander
President and Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
EXHIBIT INDEX
* Exhibit omits certain information that has been filed separately with the Securities and Exchange Commission and has been granted confidential treatment.
** The Company has applied for confidential treatment of portions of these exhibits. Accordingly, portions have been omitted and filed separately with the Securities and Exchange Commission.