(FORTUNE Magazine) – Rene Kim was no neophyte when it came to Wall Street layoffs. She had been through the wars at First Nationwide and Wells Fargo--more than once she had seen blizzards of pink slips dispensed and armies of colleagues shown the door. She never imagined she would have to endure that kind of thing at Charles Schwab Corp. Schwab, she had heard, was a great place to work, filled with nice people you'd choose to spend the day with, and jobs you couldn't wait to begin each morning. As it turned out it would have been a lot less gut-wrenching to stay put at Wells Fargo.

In the past three years Kim has had to be as much an executioner as a brokerage vice president. She has orchestrated four rounds of layoffs. She has doubled up people's workloads. On her darkest day last year, one of her last cuts "was just something I never thought I'd have to do," she recalled recently, fighting tears. She made a call to Joe Eleccion, her closest colleague and good friend. It was a Friday in October that Eleccion remembers well. Kim had learned the awful news but wanted to give him early warning. So she reached him in his car on the way from Benicia to Walnut Creek, Calif., and proceeded to break every HR protocol there is. "Are you driving?" she asked. "Can you pull over?" There, on the side of the road, she told him he would be the next to go.

Eleccion was shocked. But it was he who ended up consoling his boss. The following Monday morning he came in, game face on, and met with his own team to prepare them for the layoffs. "Ninety percent of us will be fine, so don't worry," he told them. "It was hard," he says now, "doing that and knowing that I was going to be part of the 10%."

It is not a scenario that would occur at most companies. But this is not most companies. This is Charles Schwab, which prides itself on treating employees not as headcount but as family. It has long been the anti--Wall Street firm, not just because of the discount trades it offered, but because of the kind of people it attracted. In the brokerage world the jackals migrated to Manhattan and the idealists went to San Francisco. The foundation of Schwab was team play and integrity.

Chuck Schwab launched the company in 1974 both because of an opportunity--commissions were deregulated and discount brokerage became possible--and because of principle. He had had a privileged upbringing but, because of struggles with dyslexia, an outsider's sensibility. He didn't want to mirror East Coast firms. He wanted to be a West Coast alternative, a brokerage that would help real people realize their financial dreams, one that wasn't in business just to make money but to make a difference. He packed Charles Schwab Corp. with energetic renegades (hardly any had MBAs), and he removed the stockbroker's usual fundamental conflict of interest: commission-based pay. According to Schwab, still chairman at age 65, the culture was built on a "sense of fairness toward customer and fairness toward each other. Ethics has always been right dead center in the middle of our thing."

For nearly 30 years Charles Schwab Corp. did very well by being good. The company grew from a ragtag startup where the president sometimes conducted job interviews in his stockinged feet to a brokerage giant with 16,000 employees and $913 billion of client assets. For most of that time Schwab had a bull market at its back as market fever spread through age brackets and pay scales. Most of Schwab's problems were nice ones to have, such as staying ahead of upstarts like E*Trade and hiring enough people to keep up with growth.

Then, three years ago, the bear market took over, and Schwab was mauled. Its annual revenue has plunged 29%, to $4.1 billion last year from $5.8 billion in 2000. Since the huddled masses fled the market, daily average revenue trades, Schwab's barometer of trading activity, have fallen more than 50%, to an average of 145,000 in the latest third quarter. The company's stock price has slumped into the $11 range from an April 1999 peak of $50.16 a share. (In March it hit a low of $6.56 a share.) By the end of this year the company that abhors layoffs will have shed fully 25% of its workforce. It has slashed bonuses, and suspended the 401(k) match to its own employees, even though the firm has been zealous on the importance of saving for retirement. "We were never close to any financial collapse," CEO David Pottruck told his officers recently. "Thanks to the actions that we all took, we maintained a strong balance sheet throughout the ordeal. But the conditions caused us to be concerned about our ability to succeed in all kinds of markets--up or down. The crisis was that deep."

Now, just as the market has turned and Schwab has started to recover, the company has been ensnared in the mutual fund scandal. In November it disclosed that it had found what appeared to be market-timing arrangements with five institutional clients at mutual funds run by its U.S. Trust unit, and about 18 instances of late trading at its Schwab Mutual Fund Marketplace. The firm is conducting an internal inquiry and is cooperating with probes by the Securities and Exchange Commission and the New York State Attorney General's office. It has fired two employees at U.S. Trust who, it said, deleted e-mails relevant to the inquiries.

The scandal has brought into bold relief a fundamental dilemma for Schwab. With no return in sight of the trading frenzy that marked the end of the bull market, Schwab must find new ways to grow. It can no longer be a simple stock-trading firm. So Pottruck is trying to turn it into a full-service financial services firm for the individual investor, complete with unbiased research, conflict-free advice, even banking services. The question is, Can Schwab do what it needs to do to boost revenue and appease shareholders and remain, as it likes to call itself, the "most ethical" financial services firm? As it acquires firms like U.S. Trust and gets into new territory like managing portfolios, will its workforce be content to be motivated by mission, not by commission? Can it continue to be the kinder, gentler experiment that Chuck Schwab built? And does that make a meaningful difference anyway?

Pottruck believes the answer is emphatically yes. It is critical, he says, that his employees "do more than show up for work and trade their time for money. If that's all they do, we are a commodity company like everybody else in the world. We have to have people who come to work and believe they're on a mission. It's not just a business. It's more than that."

If Schwab had been a Wall Street firm, the response to a market correction would have been a no-brainer: Chop heads. But here workers weren't considered heads--they were friends. Over the years executives had developed a "tool box" filled with all sorts of unorthodox belt-tightening moves designed to buy time till the end of a down cycle without having to resort to what they called the "L-word."

As trading volumes declined through 2000 and into 2001, the company dug one tool after another out of its box. In December of 2000 it eliminated bonuses (which on average amounted to about 50% of compensation.) Then it cut officer pay by 5% to 15%, except for Schwab and Pottruck, who took 20% hits. At the end of the month, Schwab urged employees to take unpaid sabbaticals and days off. It encouraged people to go part-time and job-share. The entire company closed down for a week at Christmas in 2000. In January, it required some employees to take three Fridays off without pay.

In past downturns those steps had always worked. The only layoffs in the company's history were 150 people let go after the crash of 1987. But this correction was more serious, and Schwab was running out of tricks. By early 2001 it was clear that layoffs were inevitable--but it wasn't clear how many. The company started with 2,030 layoffs in April. But it didn't cut deeply enough and had to lay off another 2,050 people in October and November. Altogether, it would pink-slip 4,200 employees in 2001, many of them hired during the boom. They were recent college graduates and people Schwab had lured from other jobs at the height of the boom, and now it had to cut them loose in the bleak San Francisco job market. Chuck Schwab and Pottruck were so remorseful they refused their bonuses. "Most of the decisions that were coming back to haunt us--those were decisions I either made or approved," says Pottruck. "To me, the notion that I would not get a bonus in 2001 and would take a pay cut, frankly, seemed like just reward for a job poorly done."

The layoffs of 2001 felt like a watershed event; the top brass knew the company would be defined by how well they conducted themselves. Should they escort people out? Should they disable employees' e-mail accounts? Wouldn't that look as though they were treating their own employees like criminals? (They didn't do either of those things.) Convinced that this was as bad as it could get, they went overboard with severance packages that included as much as 18 months' pay. Everybody who was fired got new options in lieu of those that wouldn't vest. (As it turned out, the new ones would expire underwater.) Chuck Schwab and his wife, Helen, put $10 million of their own money into a fund to make grants to anyone who wanted to go get an advanced degree until the market picked back up. Everybody who left was promised a $7,000 signing bonus when they came back.

Schwab executives had no idea it was about to get worse. Just when it looked as if the downturn was about to end, the corporate scandals began to unfold. In December 2001, Enron declared bankruptcy. The following June, WorldCom blew up. Pottruck had a fit. "How could this be? Where the hell are the goddamned accountants? How could the board of directors, the auditors let this happen? I just couldn't believe it." This wasn't just a cyclical downturn; it was a disaster. Pottruck saw, in survey after survey, that the individual investor was losing confidence. This was serious. It could be the end of Schwab as everybody had known it.

Now Schwab had too many vice presidents and senior vice presidents and executive vice presidents. It had too many people with 15 to 20 years of experience. The company would have to cut another 2,040 people. For Pottruck, that presented "an incredibly difficult moral dilemma. Do you keep the people who have helped you get to where you are? Or do you keep the people who are going to take you where you want to go?"

To try to be fair, Schwab devised a "skills assessment" system for the first time. In a matter of weeks bosses had to evaluate all their employees, giving them numerical scores and ranking them against one another. Then the executive team spent hours shuffling names like decks of cards, matching them with new jobs in the restructured company. Schwab had always been egalitarian, and the exercise felt painful and counterintuitive, recalls Dawn Lepore, vice chairman of technology, who, after 20 years at the company, knew many of the employees personally. "It was like looking around the dinner table--do we pick the youngest brother or the middle sister? Which ones don't we feed?"

Perversely, in this environment the company's good intentions often backfired. Schwab has a policy of giving news to employees almost instantaneously, sort of an internal transparency. So it was with the decision to downsize. It occurred at 8:45 of Jody Bilney's very first morning last year. By noon the new marketing executive VP watched incredulously as Pottruck broadcast the news to the entire workforce. "Wow," she recalls thinking, "we are so forthcoming. We absolutely wear it on our sleeves."

But the details would take weeks to work out, and that caused tremendous disruption and fear. "It became very hard for people to focus," says Eleccion, the broker, who is now at another firm. "With each successive layoff, you had to say goodbye to friends. This was a place where the jerks were few and far between." Donna Stapleton, a program manager, packed up her belongings and waited. "There were days when I thought I read signals that I would be laid off, and then days when it was obvious that I would not," she recalls. She did lose her job in October of last year. (This October, though, she became one of the few employees to be hired back.)

Schwab soon found itself trapped in its own largesse. Last year's $97 million in severance costs, along with other charges, wiped out the company's fourth-quarter $86 million operating net, plunging the company into the red. Executives wondered: Should they cut the size of the severance package? The latest round of layoffs affected longer-tenured employees, and while that raised the cost, it made it even more important to treat them fairly. "These were very difficult decisions," says Pottruck, "when you start looking at multi-hundred millions in write-offs." They decided not to cut the package. "The truth of the matter is that how you treat the people who leave is also viewed by all the people who stay," says Pottruck. "Did they do only the minimum or did they show generosity of spirit?"

It was sometimes hard to tell who was better off, those who were fired or those who stayed. Some who were laid off used their severance to spend time with their families, to change careers, to pursue degrees. A few went to Hawaii and improved their golf handicaps. Some, like Eleccion, landed new jobs making just as much money or more.

Meanwhile, their former colleagues continued to slog on at Schwab. It's a tough and wearying assignment to manage this much change, laying off your friends, when you don't know if your own job is safe. Last November, when senior marketing vice president Beth Stelluto had to tell her 40 direct reports that ten of them would lose jobs, she did the only thing she could think of. "I don't know who of us will be here and and who of us won't, but I want every single person here to have a tangible representation of how much you matter," she told them. She made each one take a piece of paper and write his name at the top, and, amid groans, pass it around the room, so that colleagues could complete the sentence: "What I appreciate about you is ..."

At first the gesture elicited a lot of snide remarks, recalls Connie Amador, a single mother and ten-year Schwab veteran. "It was hokey. The old yearbook thing: Hang in there. You fill the world with joy. Yadda yadda yadda." She didn't appreciate the gesture then or for several months after she lost her job. But she reread her colleagues' comments as she began a job search and used them to make a case for why she'd be good in her current position as an account executive at a San Francisco publishing company. Now, the piece of paper has become a treasured memento. It matters to her that one of her colleagues wrote, "I appreciate that you have the courage to voice your beliefs even when they're not the popular view."

Does it matter down in the trenches that Schwab executives have done and said all the right things? That they've anguished over the cuts, relinquished their bonuses, been brutally honest with employees?

It does to Rene Kim, the product management vice president from Wells Fargo. "You felt like Chuck and Dave understood how challenging it's been and whose lives we were affecting. Their words felt genuine and honest and not like they were saying them because they had to." Still, she believes a lot of the anguish and wishful thinking postponed the restructuring, prolonged the agony, and made it worse. "I never thought I would do four years of layoffs in a row," she says. "I should never have to do this again. It's a quota for a lifetime."

All the good deeds and best intentions have not lightened workloads or boosted compensation, even back to normal levels. Bonuses are 40% of what the company considers optimal; there is still no 401(k) match. Options are scarce. The company has budgeted for merit pay raises of 4%, on average, this year. A recent internal survey shows that only a third of the workforce is satisfied, and an equal amount is dissatisfied.

This is heavy lifting--turning a simple stock-trading company into a broad-based financial services firm in the wake of a bear market. All through the restructuring, mid-level managers were devising new products and services aimed at giving advice, managing portfolios, and serving wealthy investors, who are much more sophisticated and demanding than Schwab's traditional clientele. For many Schwab employees, it has been brave new territory. "I felt like I was driving blind," says Martha Deevy, an executive vice president who oversaw efforts to give advice to Schwab's least affluent clients, before she left (voluntarily) a month ago to adopt a baby.

Last year's ranking of employees may have been fair, but it permanently roiled team spirit. Some Schwab employees felt as if they were on an episode of Survivor. Getting a numerical grade changed the zeitgeist from "I'm an individual, and my contribution is unique" to "I'm just a cog in this organization," recalls Amador. Colleagues became more secretive and began to develop alliances. Cynicism crept into conversations; people began to refer to the layoffs as "Schwab's annual fall clearance." Some wondered if Pottruck, who was a confrontational and combative executive until management coach Terry Pearce helped him become more empathetic, was turning out to be a wolf in sheep's clothing. Increasingly, they wanted to know, Where is Chuck?

And if Schwab's culture is so important, then what about the newcomers? (Old-timers call them "atheists.") What about U.S. Trust, Cyber Trader, the State Street unit, employees wondered--do those guys get it? U.S. Trust was considered a haven of old white guys in wingtips, resistant to change. U.S. Trust brokers tended to regard Schwab as the Kmart of the brokerage industry. U.S. was fined $10 million two years ago for allegedly violating anti--money laundering laws and got handed a cease and desist order requiring it to clean up its record-keeping. It is the bank Rush Limbaugh used for the cash withdrawals that he recently denied were money laundering. "I don't think the culture of U.S. Trust is all that different from the culture of Schwab," Pottruck says about the unit's problem mutual-fund trades. "I think this is about the strength of procedures and the clarity of understanding of the zero tolerance of policy failure. We need that to be stronger at Schwab and at U.S. Trust as well."

Some of the new recruits have brought badly needed big-company wisdom, but they have also unintentionally pierced the veil. Jody Bilney, who came from Verizon, where she headed global marketing, has consolidated scores of little marketing departments--the byproducts of Schwab's fast-growth, entrepreneurial days--and is trying to instill focus. "Every time we grow a dollar of revenue, we shouldn't have to grow a dollar of expense," she says. Mary McLeod, executive vice president of HR, who arrived two years ago from Cisco, has tried to speed up meetings and cut down on a hiring process that sometimes required 30 entrance interviews. She's trying carefully not to kill the creative spirit with too many forms and deadlines. GE's Six Sigma would "never work here," she says. Still, the "experts" have made some of the old-timers feel resentful and self-conscious. "They make us feel as if anybody who was here before is a country bumpkin," says one. It's no longer so cool to be mission-driven.

Yet now, more than ever before, it's critical, and Pottruck knows it. If there's a business case to be made for doing right by your employees, it's this: You just might increase the chances that that they too will do the right and ethical thing. Employee behavior is the cornerstone of Schwab's goal to become "the most useful and ethical financial services firm in the world," a place that individual investors trust so much that they will allow Schwab to be their one-stop shop for financial services.

The company ranked head and shoulders above the other big financial services firms in a Wall Street Journal investor confidence survey conducted a year ago. When investors were asked how well "honesty" described each company, Schwab scored 69%, Morgan Stanley (in second place) scored 41%, and J.P. Morgan Chase (in third) 30%. "We've done a really good job of differentiating ourselves in the marketplace," says Bilney. "People understand about objectivity. They understand we aren't burdened with conflicts of interest." Those traits are at the heart of a major repackaging and repositioning of the company's offerings that are due out next year and lie behind its recent acquisition of SoundView Technology Group, a firm noted for its independent stock research.

Which is why the mutual fund scandal may be a severe blow--and the company's biggest wake-up call. The company says it is continuing its own inquiry, and the number of problem trades (18) will probably change. So far, there is no indication either at Schwab or at U.S. Trust of the kind of widespread abuse alleged at other firms, like Putnam or Strong. The company says that net inflows into both Schwab's fund and U.S. Trust's Excelsior Funds have remained strong. Still, this is the company that ran memorable advertisements last year depicting stockbrokers scheming to dress up a lousy stock, saying, "Let's Put Some Lipstick on This Pig." "In a firm where our ethics and our values are a huge reason you work here, no failure rate can be tolerated," Pottruck wrote to his employees after the news broke.

Every day Schwab's drive for growth takes it into uncharted territory. Now that its brokers do far more than execute trades, they want more money. How will it pay them in a way that's conflict-free? Now that Schwab has its own branded mutual funds (which, by the way, are more profitable than steering investors to somebody else's fund), how do you promote them honestly?

Pottruck calls it a slippery slope. Firms like Schwab don't get into trouble because somebody at the top decided one day that conflicts of interest are okay, he sometimes reminds his executives. Firms get into trouble because of an accumulation of "little one-off decisions" and before you know it, your supposedly independent research analysts are recommending the stocks of your investment banking clients. "The good news is that's not the firm that Chuck built," he says. "Our challenge is to make sure we don't screw it up."

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REPORTER ASSOCIATE Patricia Neering