Suit alleges misuse of sweep programs

IRVINE, Calif. — Merrill Lynch, Morgan Stanley, Smith Barney and Charles Schwab are being sued for allegedly illegally forcing clients into lower paying deposit accounts, enabling the firms to reap “billions” in extra profits.
The class action was amended in May and filed in U.S. District Court for the Southern District of New York. It alleges a laundry list of violations under New York law, including fraud, breach of contract, breach of fiduciary duty, unjust enrichment and negligent misrepresentation.
It also claims that the sweep programs amount to an illegal “tying” arrangement outlawed by the Sherman Act, a federal antitrust law.
What’s more, Wachovia Securities LLC could be added to the claim.
Last month, officials at parent Wachovia Corp. announced their intention to get more A.G. Edwards customers into deposit accounts.
A.G. Edwards & Sons Inc. of St. Louis, which is being acquired by Charlotte, N.C.-based Wachovia, recently rolled out a deposit sweep program of its own.
“We’ve looked at Wachovia very carefully,” said Joel Laitman, a partner at Schoengold Sporn Laitman & Lometti PC of New York, which filed the case. He declined to say whether he will add Wachovia Securities of Richmond, Va., to the suit.
Mr. Laitman said he has asked the court for permission to amend the complaint during the coming weeks. New defendants could be added then.
A spokesman for Wachovia Securities didn’t respond to questions.
The suit was first filed in January (InvestmentNews, March 26), but details of the claim, which was amended last month, have not previously been reported.
Bank deposit sweep programs put “the broker [who is] on the front line in a very conflicted position,” Mr. Laitman added. “They know this is not what they should be doing as financial advisers.”
The defendant firms deny that they have done anything wrong.
“There is no merit to this lawsuit, and we will contest it,” said James Wiggins, spokesman for Morgan Stanley of New York. “Our disclosures to clients on the bank deposit program were full and fair.”
Charles Schwab & Co. Inc. of San Francisco intends to make a motion for dismissal, said spokeswoman Sarah Bulgatz, adding that the firm doesn’t comment on pending legal matters.
Smith Barney, the retail-brokerage unit of Citigroup Inc. of New York, declined to comment, according to spokesman Alexander Samuelson.
The bank’s broker-dealer, Citigroup Global Capital Markets Inc., is the entity named in the suit.
Merrill gives clients “clear and full disclosures about our cash sweep program,” said spokesman Mark Herr. He called the claim “meritless” and said the firm will ask the court to dismiss it.
The crux of the lawsuit is that at the same time the firms have positioned their brokers as objective financial advisers, they are forcing customers into bank deposits that pay less than market rates, while failing to disclose their large profits from deposit programs, and the attendant conflicts.
Firms do generally disclose payments received directly from banks, and alert clients that bank deposits are more profitable for the firm than money funds. But “there’s no sense of the magnitude” of just how profitable bank sweep programs are, Mr. Laitman said.
Affiliated units
Firms use the low-cost cash from brokerage customers to fund affiliated banking units, which lend those funds out or otherwise invest the money.
Mr. Laitman said Merrill earns a few billion dollars from bank deposits.
That was confirmed by Jon Holtaway, managing director of Danielson Associates Inc., a bank consulting firm in Rockville, Md., who said Merrill’s savings bank earned $2.1 billion last year. The bank holds $55 billion in deposits from Merrill’s customers, plus some other assets, he said.
Merrill’s savings bank earns a net interest margin of 3.6%, Mr. Holtaway said. That contrasts with the 0.5% to 0.6% that firms make in money funds, he said.
The suit claims that all the firms except Morgan Stanley, which rolled out its program in 2005, initially paid deposit account interest rates competitive with those of money market funds. Deposits at Morgan Stanley grew to $16.4 billion as of February 2007, from $449 million in August 2005, according to company reports.
But all the firms eventually went to a tiered rate structure with yields as low as 1% or less for smaller customers.
Mr. Holtaway said Merrill’s savings bank had a cost of funds of 3.45% at yearend — about 0.75 to 1 percentage point less than the average money fund.
Still going strong
Despite the legal challenge, the sweep programs are still being pushed hard.
The latest example occurred last month when Wachovia Corp. officials spoke with analysts about the merger with A.G. Edwards Inc.
The merger “will … allow us to sell considerably more bank products — mortgages, trusts, deposit accounts and that sort of thing — through [A.G. Edwards],” Wachovia chief executive G. Kennedy Thompson said during a May 31 conference call.
“The [bank deposit sweep] will be one of the very first things we work on,” said David Carroll, president of Wachovia’s capital management group.
A.G. Edwards has “room for a lot of improvement,” he said.
But one A.G. Edwards rep, who asked not to be identified, said brokers may keep clients out of the sweep program. “That’s what Wachovia’s own brokers do,” he said.