Taxes and Morgan Stanley Erode Discover’s Settlement Gains

No. 4 payment card network Discover Financial Services will receive $2.75 billion from Visa Inc. and MasterCard Inc. through the settlement of a long-running antitrust lawsuit, Discover and the bank card networks announced yesterday. Discover, however, may actually pocket less than one-third of that amount after paying taxes and a disputed dividend to its former parent company Morgan Stanley, which wants $1.2 billion. And, instead of having all of the funds available to potentially grow its business, Discover will use some of the money to shore up its capital base as the weakening economy takes its toll on cardholder credit quality. Discover also plans to enhance its consumer deposit-gathering operations now that the freeze-up in the asset-backed securities market has reduced its ability to sell bonds backed by cardholder receivables, a key funding source. “It's a shame this wasn't done a year or two ago when the money could have been more productively used to continue to augment Discover's strategy, which I think is enlightened,” says payments consultant and former MasterCard executive Steve Mott of Stamford, Conn.-based BetterBuyDesign. Mott says that strategy includes offering “competitive payment products to banks, particularly smaller banks” that he says get less attention from Visa and MasterCard than big banks. Discover sued Visa and MasterCard in 2004 for lost business during the years that Visa and MasterCard banned their financial-institution members from issuing cards on the Discover or American Express Co. networks. The U.S. Department of Justice successfully challenged those rules, saying they were anticompetitive. That cleared the way for Discover and AmEx to sue the bank card networks. AmEx settled for slightly over $4 billion. Discover's suit had been scheduled for trial earlier this month in U.S. District Court in Manhattan, but the parties settled as trial was about to begin. While not detailing exact amounts, Discover chief financial officer and executive vice president Roy A. Guthrie told analysts Tuesday morning that settlement funds would indeed be used to grow Discover's business with credit and debit card-issuing banks and merchant acquirers. Discover, which owns the Pulse electronic funds network and bought Diners Club International from Citigroup Inc. for $165 million (Digital Transactions News, April 7), already has agreements with acquirers to offer Discover card acceptance to their merchant clients. These acquirers account for 98% of U.S. bank card volume. “First, it'll help us fund our efforts to build out the domestic market acceptance and our international acceptance,” Guthrie said. “Secondly, we'll seek to accelerate our growth in third-party network volumes through signing additional third-party issuers and through cooperative marketing programs with both our domestic third-party issuers and global Diners Club licensee partners.” Discover will receive $862 million in its current fiscal fourth quarter and up to $472 million each quarter next year if it can grow its sales volume by 5%, a target Guthrie said Discover should easily hit. The amounts Visa, the largest network, and No. 2 MasterCard are paying are based on volume. Visa is to pay $1.89 billion subject to approval from its Class B shareholders?the member financial institutions that owned Visa before its March IPO. MasterCard will pay $862.5 million. Under terms of an earlier agreement, Morgan Stanley, which spun off Discover last year, was to receive the first $700 million and potentially up to $1.5 billion of any settlements Discover received in the Visa/MasterCard litigation through a special dividend. But in announcing the settlements late Monday, Discover said, “Morgan Stanley is in breach of the agreement and the amount of Morgan Stanley's special dividend is a matter of dispute.” Guthrie refused to go into detail about what's behind the dispute, which is now the subject of a lawsuit Morgan Stanley filed last week in the New York state court. In its own statement, the investment bank said Discover owes it $1.2 billion on a pre-tax basis. “There is absolutely no basis for Discover's claim that the agreement was breached,” Morgan Stanley said. How much cash Discover actually nets from the settlements thus depends on taxes?its tax rate is 38%?and how much it pays to Morgan Stanley. “The benefit to Discover of this settlement is at least $850 million, and then I would add, could be more, depending on the outcome of the dispute with Morgan Stanley,” Guthrie said in response to an analyst's question. Visa was brief in explaining its rationale for settling. “Resolving this longstanding case on reasonable terms is in the best interest of Visa and our clients, cardholders, and shareholders,” chairman and chief executive Joseph W. Saunders said in Visa's release. MasterCard was more biting. “We believe Discover's lack of success resulted from decisions that created a business model that is not attractive to bank issuers,” General Counsel Noah J. Hanft said in a statement. “Nonetheless, we chose to settle this lawsuit to avoid the uncertainty and distraction of a lengthy jury trial. This result, which is in no way an admission of liability, is in the best interest of our shareholders, our customers, and our company. We will continue to focus on out-competing Discover in the marketplace, where real-world performance is what counts.”