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January 12, 2010

Discover loses high-stakes gamble against Morgan Stanley

Discover Financial Services may have hoped to have severed all ties with its former owner Morgan Stanley following Discovers 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

By Verdict Staff

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.

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.

“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.”

Discover financial services

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