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Breach of Trust

Recasting itself as a money manager, Charles Schwab is shaking up U.S. Trust. Will the changes attract new assets -- or alienate old clients?

Recasting itself as a money manager, Charles Schwab is shaking up U.S. Trust. Will the changes attract new assets -- or alienate old clients?

By Rich Blake
December 2002
Institutional Investor Magazine

Some companies, like some people, never change. Others, like Charles Schwab Corp., reinvent themselves again and again.

Over the past 31 years, Schwab has transformed itself from discount brokerage to mutual fund supermarket to online trader. Last spring, reeling from the stock market downturn and a precipitous 65 percent falloff in trading commission revenues, Schwab shifted strategies once again: Its new focus will be on asset gathering and money management.

"Our goal is to serve the entire spectrum of wealthy clients," says Schwab co-CEO David Pottruck.

Whether this strategic shift is a bold move or an opportunistic scramble remains to seen, but there's no question that it signals the end of an era at one of the most storied wealth managers in history -- U.S. Trust Corp.

Schwab acquired the 149-year-old high-net-worth money manager back in June 2000 in a high-profile and very pricey $3 billion deal. It subsequently left the bank in the hands of its CEO, Jeffrey Maurer, a 27-year U.S. Trust veteran. Two months ago, as part of its larger strategic shift, Schwab seized control of UST, kicked Maurer upstairs to chairman and replaced him as CEO with Alan Weber, the former CFO at Aetna and a money management neophyte. Maurer's No. 2, president Maribeth Rahe, resigned.

The move represents much more than a changing of the guard. Determined to use UST as its beachhead in money management, Schwab wants to overhaul the bank's business model, imposing changes that Maurer and the old guard had repeatedly resisted. Schwab wants to make up lost trading revenue by casting itself as a trusted financial adviser and money manager, amassing considerably more assets in proprietary products -- beyond the firm's signature money market funds. Eventually, Schwab aims to offer a full range of investment products and services to a wide range of customers, from the emerging affluent, as Schwab dubs households with $250,000 in assets, to the high-end affluent, clients with more than $2 million in assets. UST, whose average account totals $7 million, clearly fits in the top strata. With a new CEO at the helm of UST and a new organizational structure on the ground, Schwab executives are convinced that they can make significant inroads into asset management.

Under Weber's leadership, U.S. Trust will exchange a system that offers only in-house portfolio management for an open architecture arrangement that includes other firms' products; it will push alternative investments such as funds of hedge funds, which UST had only dabbled in; and it will replace the bank's decentralized investment management with a more centralized operation. Says Pottruck, "We want a more scalable business model."

"This is a huge fundamental shift," says Stephen Winks, president of SrConsultant.com in Richmond, Virginia.

The changes are reasonable: Open architecture is the industry norm; alternative investments are a necessity in any money manager's roster; centralizing the investment process often works well. But none of these changes will succeed if clients feel they are losing the personal attention -- and elite reputation -- that has defined UST for decades.

Without UST, Schwab could make only a tentative claim to money management. Of its $144 billion in proprietary assets under management, 85 percent is in money market funds. Separately, U.S. Trust manages about $45 billion in equity and $20 billion in fixed-income portfolios.

"There is no question that Schwab wants to be a full-scale money manager," notes Mark Constant, a financial services analyst at Lehman Brothers. "This is the future of the company, and U.S. Trust is going to be a big part of that effort."

But leading this transformation with U.S. Trust won't be easy. The acquisition, which promised a rush of synergy that never quite appeared, has been a great disappointment. The high-net-worth market has turned out to be less attractive than expected -- funny how a grinding bear market can do that. A recent study of nine private banks, including Citigroup Private Bank, Northern Trust and J.P. Morgan Chase, reports an average asset decline of 3.1 percent during the past two years. At U.S. Trust the drop, to $65 billion, is a sobering 18 percent.

That erosion reflects a host of problems. UST reports mediocre performance and suffers from a reputation as an old-fashioned, slightly stodgy firm. Before Schwab arrived, U.S. Trust also wrestled with subpar technology. After the merger the money manager was slapped with an embarrassing $10 million fine for inadequate reporting of large cash transactions, while a compliance snafu left its marketers without an equity fund performance number to sell for most of the past year.

And the anticipated synergy? Schwab's do-it-yourself millionaires were devastated when the market cracked (the firm's client assets under custody plunged from a little more than $1 trillion in August 2000 to $727 billion in October 2002). Many of the Schwab customers whose portfolios remained more or less intact chose not to turn their money over to a conservative bank that offered only its own investment products. And the registered independent financial advisers who were aligned with Schwab and expected to refer some of their upscale clients to U.S. Trust were loath to give up their best accounts.

One Wall Street analyst calculates that the bank's pretax profit margin fell from 24 percent in 2000 to 17 percent in 2001 -- well below the industry median of 29 percent.

Determined to boost those margins, Schwab launched in May a new private wealth management campaign targeting households with assets between $250,000 and $5 million, all told an $11 trillion market. Its current marketing pitch -- Schwab can be a truly objective financial adviser because it is free of investment banking conflicts -- seeks to capitalize on the controversy over Wall Street research. A public face of Schwab's new identity as a money manager: Elizabeth (Liz Ann) Sonders, who takes on the role of chief investment strategist.

Whether UST CEO Weber can execute Schwab's new strategy is an open question. He lacks specific industry experience. A 1970 graduate of the University of Pennsylvania, where Pottruck was a classmate, Weber spent 27 years at Citibank, including a four-year stint as chairman of Citibank International overseeing retail branches in Latin America and Asia. From 1998 until the spring of 2001, Weber, as Aetna CFO, helped engineer the spin-off of the insurer's financial services business to ING Group. Weber resigned in April 2001.

But the new CEO must move carefully in changing U.S. Trust. To the extent that clients perceive Schwab as moving U.S. Trust down market, the brokerage runs the risk of alienating the bank's core customers. "This is a relationship business," says one longtime client of U.S. Trust. "Schwab is rigid and process-oriented. When you introduce that kind of mentality in a relationship business, you can destroy it."

THE SEEDS OF THE SCHWAB­U.S. TRUST DEAL were planted in February 1990, when Marshall Schwarz, heir to the F.A.O. Schwarz fortune, and Maurer, a former tax lawyer, took over, respectively, as U.S. Trust CEO and president. With about 40 percent of the bank's shares held by insiders, most of them nearing retirement and thinking about cashing out, Schwarz and Maurer began to position the bank for a sale, though publicly they insisted that the bank would never be sold.

The first major move of the new management team was to take U.S. Trust out of the corporate lending business and focus on its core competency -- asset management. It opened new offices and made several strategic acquisitions, notably spending $400 million in 1992 for growth equity manager Campbell, Cowperthwait & Co.

Seven years later Maurer stumbled when he failed to re-sign star manager James Cowperthwait in 1999, before the expiration of the lockup contracts that he and his associates had signed. The growth-stock pickers at Campbell Cowperthwait had brought in more than $5 billion in five years. But in 1999 all but two members of Cowperthwait's 26-person team left to form NewBridge Partners. Within a year the start-up had snared former U.S. Trust accounts worth $4 billion. U.S. Trust sued to prevent NewBridge from soliciting clients, and eventually the case was settled with NewBridge making a modest payment to UST.

Not long after the Cowperthwait episode, Schwarz and Maurer focused their attention on a possible sale of the bank. Earlier in the year Schwab's Pottruck had approached Schwarz about a possible acquisition, but the talks remained tentative, in part because of a remaining Glass-Steagall statute that prohibited securities firms from incorporating a bank into their own holding company. Then the November 1999 passage of the Gramm-Leach-Bliley Act enabled banks, securities firms and insurance companies to create a new entity, a financial holding company with dramatically expanded powers. Suddenly, a Schwab­U.S. Trust union looked eminently doable. Schwarz was keen to close a deal, in part because he had recently been diagnosed with prostate cancer. (He subsequently received a successful course of treatment.)

In late November 1999 Maurer called Pottruck to revive merger talks that had begun earlier in the year, at Pottruck's instigation. On January 13, 2000, just a week after AOL and Time Warner joined voices in a New Economy swan song, Schwab announced an agreement to acquire U.S. Trust.

Optimists viewed the unlikely union of a discount brokerage and blue-blood private bank as a promising alliance for the New Economy. Skeptics suggested that Schwab was wildly overpaying for U.S. Trust, given that the purchase price represented a 60 percent premium over the bank's market value. But the deal only stoked industry appetite for high-net-worth managers.

At Schwab the synergy chatter began almost at once. Soon after the Federal Reserve Board approved the Schwab-UST deal in May 2000, Pottruck publicly proclaimed that "soon the companies would begin referring clients to each other and start working together to develop new research offerings for Schwab's affluent clients." But by the time the deal closed a month later the stock market had already begun its swoon.

Critically, the vast majority of the 5,800 or so registered investment advisers who worked with Schwab -- mainly using the brokerage for back-office and clearing functions -- would not even consider directing their wealthiest clients to U.S. Trust.

Says David Roberts, CEO of National Advisors Trust Co. in Overland Park, Kansas, a group of 80 independent advisers: "The business model of the merger was built around the idea that Schwab's adviser network would transfer significant amounts of assets to U.S. Trust. That was a pretty flawed assumption." While the investment advisers were encouraged to utilize UST's sophisticated tax and estate planning capabilities, many of them were loyal to the local firms they used for these services. By the start of 2002, just $800 million had come into U.S. Trust by way of Schwab referrals.

Schwab, of course, has had other fires to put out. In January it reported that the firm's 2001 net income plunged 72 percent, to $199 million. And this year's results are not much better. Nine-month profits were $188 million, down 11 percent from the first three quarters of 2001.

Once Schwab decided that to recover it had to recast itself as an asset gatherer and money manager, changes at U.S. Trust were inevitable. In addition to shifting to open architecture, Pottruck and Weber are also likely to bring in young, aggressive salespeople who can complement U.S. Trust's current crop of marketers, most of them low-key practitioners of the soft sell. To overhaul the bank's technology, Schwab has already begun an extensive -- and expensive -- program to link the back offices of U.S. Trust and Schwab.

What does Pottruck mean about making U.S. Trust's business model more "scalable"? Sources suggest that will translate into one platform for all the firm's investment offerings, from both Schwab and U.S. Trust. But a U.S. Trust spokeswoman says that products and services will become more scalable "within the U.S. Trust footprint -- not the Schwab footprint."

"The clients will not be affected by these changes," Pottruck told analysts last month. "They will continue to get superior service."

It's never a simple matter to redefine a business model, as Schwab will discover with its new focus on asset management. When the shift threatens an existing subsidiary, as Schwab's move does U.S. Trust, it's even more fraught with danger.


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Image making
Lest anyone doubt the seriousness of Charles Schwab Corp.'s intent to become a full-scale money manager and financial adviser, the firm last month created a new position, chief investment strategist, handing the mantle to Elizabeth (Liz Ann) Sonders, the 37-year-old senior investment strategist at U.S. Trust. In announcing the appointment, Schwab co-CEO David Pottruck declared, "Schwab's advice model has always been about helping investors, not hyping stocks."

In her new role Sonders will provide macroeconomic and investing commentary and she will also serve as a public face of the newly refashioned Schwab. Sonders will draw upon her three years' experience as a member of the investment committee at the U.S. Trust growth equity subsidiary Campbell, Cowperthwait & Co. and her prior 11 years as a portfolio manager at Avatar Associates. "The role will be akin to the traditional strategist, but without the grand forecasts," she says.

Certainly, her own recent performance record is nothing to get hyped up about. The growth fund Sonders currently co-manages is down 35 percent through late November, nearly a full 10 percentage points worse than its Morningstar growth peer group. Over the past three years, the portfolio has returned an average ­26 percent, versus ­16.5 percent for the peer group.

As part of a three-person committee overseeing U.S. Trust's growth portfolios, Sonders has shared investing responsibility with two other managers. Still, a close examination of one those funds, Excelsior Growth (part of U.S. Trust's fund family for its smaller clients), shows it would earn only a C rating from Schwab's grading system, which uses a dozen or so quantitative screens to grade 3,000 publicly traded stocks. To come up with the grade, II looked at the largest 25 of the 28 stocks in her portfolio. Two of the 25 stocks were not rated by Schwab. Of the remaining 23, three were As, seven were Bs, ten were Cs, and three were Ds. The resulting average was a C+.

A regular on CNN's Moneyline and Wall Street Week With Louis Rukeyser, Sonders has made many public stock picks. Probably her worst moment as a prognosticator came in a February 2000 New York Times story in which ten stock pickers were asked to identify one stock that "barring an act of God or some unforeseeable geopolitical disaster, they would feel comfortable buying now and holding until January 1, 2010." Sonders gave the nod to JDS Uniphase Corp., then a Nasdaq darling. In February 2000 shares of the fiber-optics company traded at $215. They recently sold for $3.

Sonders acknowledges that the pick was a "nightmare," but jokes, "the decade's not over." -- R.B.


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Glass house?
Charles Schwab Corp. is selling integrity. Assailing the credibility of its Wall Street rivals, the firm has positioned itself through television ads, marketing brochures and a spate of executive speech making as the lone source of truly unconflicted investment advice -- the last defender of the little guy.

But critics contend that the discount - brokerage - pioneer - turned -online-trading -firm-turned-money-manager isn't without its own conflicts of interest -- and that some of its business practices are less than helpful to the small investor.

"For Schwab to be portraying itself as totally conflict-free is somewhat misleading -- they have many of the same conflicts as the big houses," says Douglas Schulz, founder of Westcliff, Colorado­based Investment Securities Consulting. "Schwab had better be careful how far they take this campaign against Wall Street because it could come back to hurt them."

What are Schwab's conflicts? To begin with, though Schwab discounts commissions, small investors pay a hidden price for this when they trade through the firm. Schwab does two things that potentially work against customers: It sells a portion of its orders to electronic market makers like Spear, Leeds & Kellogg and Knight Securities, which execute the transactions without exposing the order to the market for price improvement. In return these firms pay a rebate of a penny or two per share to Schwab. Thus, rather than seeking the best available prices, Schwab effectively shunts some customer orders to a corner of the market where prices may be less than optimal.

Schwab often follows the same process in-house, routing about one third of its orders to subsidiaries. Again, rather than expose those orders to the entire market, where they potentially could be executed at lower prices, Schwab routes many trades to its own over-the-counter market-making arm (for Nasdaq stocks) or to one of its specialist units on a regional exchange (for shares listed on the New York Stock Exchange). By executing orders internally, Schwab captures the difference between the best bid and ask prices for itself. So much for best execution.

Says a Schwab spokesman, "We recognize that the revenues Schwab receives from markets and market makers create a potential conflict of interest, so we constantly track execution quality to ensure our customers are getting competitive executions."

Schwab reports money market fund assets of some $124 billion, much of it swept automatically from client accounts. At most banks and brokerages, money market funds cost no more than 40 basis points. Yet Schwab's biggest money market fund, with $51 billion in assets, carries a fee of 75 basis points -- a staggering expense considering that short-term interest rates yield about 100 basis points for investors. "We believe our money market fund fees are in line with most other brokerages'," says the spokesman.

Schwab may impugn sell-side research as riddled with conflicts of interest, but for the past three years its online offerings for higher-end clients and registered investment advisers have featured equity research from Goldman, Sachs & Co. "It's not inconsistent to raise questions about Wall Street research and also to provide it, because it remains an important factor in the markets," says the Schwab spokesman.

For a company ostensibly looking out for the little guy, Schwab sure makes a lot of margin loans, enabling many small investors to take on the kind of leverage that many investment experts counsel against. Revenue from margin lending is on pace to reach $400 million this year, or 10 percent of total revenues, versus a 5 to 7 percent range for traditional Wall Street brokerages, according to Putnam Lovell Securities. In 2000, 31 percent of Schwab's revenues of $5.8 billion came from margin loans. Last year 19 percent of Schwab's revenues came from such loans. "We have never encouraged margin lending and only make it available as a tool for those who choose to use it," says the company spokesman.

Finally, although it trumpets the fact that it does no investment banking, Schwab can make this claim in part because its own effort to start an investment bank was a flop. In the spring of 2000, Schwab, scrambling to get in on the IPO boom, led a consortium to create an entity called Epoch Capital Partners to do technology IPOs. But the shop, which was funded with $85 million in venture capital, went bust within a year. Schwab sold the business to Goldman Sachs in June 2001. -- R.B.