Discover Financial Services may have
hoped to have severed all ties with its former owner Morgan Stanley
following Discover’s spin-off from the US financial services giant
in 2007. But a protracted legal dispute could now see Discover
having to hand over $800 million to Morgan Stanley.
The case has its roots in 2004, when Discover
initiated an anti-trust lawsuit against its much larger network
rivals Visa and MasterCard, accusing them of blocking access to the
bank-issued card market in the US. The lawsuit was settled in 2008
when Visa and MasterCard agreed to pay Discover $2.75 billion as a
settlement figure.
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As a condition of Discover’s spin-off from
Morgan Stanley, Discover was set to pay its former owner the first
$700 million recovered plus half of any proceeds above $1.5
billion, up to a total consideration of $1.5 billion. But Discover
then accused Morgan Stanley of breaching their agreement by
conducting secret talks with Visa and MasterCard and putting
Discover’s anti-trust lawsuit in jeopardy.
Morgan Stanley countered by filing a lawsuit
of its own claiming that Discover owed it $1.2 billion of the total
$2.75 billion settlement, but this prompted Discover to file its
own countersuit.
It was a high-stakes gamble that Discover
ultimately lost, as New York state Supreme Court Justice Barbara
Kapnick has now ruled that Morgan Stanley’s alleged misdemeanours
do not excuse Discover from paying the amount it has withheld from
Morgan Stanley related to the Visa and MasterCard settlement
proceeds. Although Morgan Stanley’s claim is against the $1.2
billion of the total settlement, after taxes this figure comes to
around $800 million plus interest.
Not surprisingly, Discover is planning to
appeal against the ruling and says that the decision has no effect
on its own damage claims against Morgan Stanley. According to
Sanjay Sakhrani, an equity analyst at Keefe, Bruyette & Woods,
the financial impact of the ruling is likely to be minimal.
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By GlobalData“While clearly not an ideal outcome for
Discover Financial Services, we would point out that Discover can
appeal (which we get the sense that it is likely to do), and that
Discover has already taken the capital hit on its balance sheet
related to Morgan Stanley’s piece of the settlement proceeds and it
resides on the balance sheet of Discover in the form of a liability
(for example, special dividend to Morgan Stanley). The only impact
Discover may feel is about $60 million pre-tax in interest expense
(for example, 6 percent for a little over a year on the $800
million), which is relatively a nominal amount,” he said.
Fourth-quarter earnings
However, Discover’s fourth-quarter
2009 earnings indicate that the network will have to struggle to
maintain momentum during 2010.
Fourth-quarter income from continuing
operations was $371 million, down 16 percent compared to the
year-ago period. After-tax income related to the Visa/MasterCard
anti-trust litigation settlement included in continuing after-tax
earnings was approximately $285 million and $535 million in the
fourth quarters of 2009 and 2008, respectively. Full year income
from continuing operations was $1.3 billion, up 22 percent from
last year.
Managed loans remained relatively flat at $51
billion, with credit card loans decreasing by $670 million compared
to the year-ago period.
Sakhrani told CI: “We believe the
company’s network business offers lucrative economic return
earnings streams and optionality both in terms of growth and/or
merger and acquisition opportunities. However, we do concede the
company’s net interest margin is likely to see some downward
migration from recent levels, offset partially by lower losses
related to a mix shift to loans with a lower risk profile.”
