Imagine a business designed specifically to help increase the size of client accounts — but one whose best success stories end in a customer outgrowing the firm and departing for a rival.

This, more or less, was the conundrum facing Charles Schwab & Co. in the mid-1990s — or so reckoned the firm's then CEO David Pottruck. The way he saw it, as some clients matured and amassed sizeable assets, so did their financial planning needs. Tax and estate planning, trust advice, portfolio management, private banking — these were the services that these wealthy customers demanded. But because Schwab could not compete effectively with trust companies and private banks on this account, it had little recourse when a choice customer departed.

Pottruck's frustration with Schwab's status as the industry's high-net-worth client incubator peaked during the dot-com boom years. In the late 1990s, he became convinced that the discount broker needed a way for its wealthiest customers to get the advice services they needed without leaving the Schwab family.

Once Pottruck, an All-American grappler in college, figured out what he wanted, he began to wrestle an action plan into place — one that culminated with the purchase of U.S. Trust in May 2000.

But amid all the calculation and reasoning behind this strategic strike, Pottruck probably did not give enough consideration to the intangibles involved in the deal — things like customer loyalty, corporate culture and historical identity. These forces would give rise to in-house conflict over the best clients, and, ultimately, undermine Schwab's belief in Pottruck's strategic vision.

In Schwab We Trust

In the late 1990s, Pottruck knew what he wanted: a wealth management company to provide investment management and consulting, fiduciary services, financial and estate planning and private banking. He found all of this in U.S. Trust. Founded in 1853, the New York-based firm epitomized Eastern Establishment: Investors without white shoes and a minimum of $10 million to invest need not apply.

The acquisition represented an opportunity for Schwab (based in San Francisco, the capital of the counterculture) to gain instant membership in the New York club to which it was losing so many choice clients.

So it was, then, that fundamentals took a back seat to emotion in the decision to overpay ($2.7 billion) for U.S Trust and make it a wholly owned subsidiary of Charles Schwab. In landing U.S. Trust, Pottruck won a significant psychological battle, but he eventually lost the war. In the face of a devastating business downturn and a failure to realize the synergies Pottruck promised the U.S. Trust acquisition would provide, the Schwab board dismissed Pottruck this past spring.

The Pottruck dismissal is nothing so much as a signal of Schwab's intentions to return to its discount-investing roots. In recent months, the firm divested its Soundview Capital Markets business, dropped trading fees and closed some branches. It also is retrenching and trying to find new ways of profitably serving its sweet spot: investors with $50,000 to $250,000 of assets. There is little room for U.S. Trust, whose average account size is about $7 million, in this emerging strategy.

Not the Retiring Kind

Had he retired in 2000, when his company was riding the crest of the dot-com boom, Chairman Chuck Schwab, now 67, would have been, by most measures, better off. For starters, he would have been a lot richer. But, perhaps more important to him, his status as a financial services visionary would have remained unblemished.

Now, in what feels like an attempt to launder his legacy, Chuck has resumed the duties of CEO and finds himself fighting a logistical battle he has neither the passion nor the aptitude to fight.

On the matters of U.S. Trust, Schwab is firm: It is not for sale.

“We think it's a valuable asset within our corporate portfolio and it serves an important segment of the market that we might not otherwise be ready to reach as a firm,” said a spokesman for Charles Schwab & Co. “We expect it to remain a part of Schwab for the indefinite future.”

Many shareholders are taking this statement at face value.

“Chuck is a stubborn fellow, and if he says something won't be sold, it probably won't be sold, even if it's in the best interest of the shareholders,” says a former Schwab employee and current shareholder who spoke on the condition of anonymity.

More than a few members of the board would support a U.S. Trust divestiture. But none of these seems inclined to oppose the will of the chairman, the man whose name is on every ad and every building, the firm's largest shareholder.

“Pottruck paid too much for U.S. Trust, given its contribution,” said one board member who asked not to be identified. “We could have done better putting the investment into a money market. But it's Chuck's call.”

Synergies? What Synergies?

One factor favoring a divestiture is that culture is an important part of any business combination, and the cultures of Schwab and U.S. Trust could not be more antagonistic.

On the one side, there is Schwab, champion of the little guy, the company that democratized the world of financial services by making it accessible to investors of modest means. Conceived as a nonconformist firm, Schwab staffed accordingly, building a tremendously resilient sense of corporate community in the process. The firm was dedicated to helping the little guys help themselves, and its inclusive vibe made it hostile to anything smacking of elitism or of privilege.

On the other side of the corporate spectrum sits U.S. Trust, home to an unapologetically exclusive culture. The elitism is not mere snobbery — it lies at the heart of the company's value proposition. Wealthy families expect such attitude and the extra attentiveness that comes with it. For instance, many consider it a rite of passage when their children have their own U.S. Trust portfolio managers. Said managers often work their entire careers at U.S. Trust, serving generations of the same family. Where Schwab would welcome any and all investors, the accepted way to become a U.S. Trust client is to be recommended by a current client.

Parent and (Privileged) Child
Schwab US Trust
Founded 1974 1853
HQ San Francisco New York
Business Discount brokerage Private-client wealth management
Accounts 7.5 million NA
AUM $976 billion $136 billion
Assets/account $130,000 $7 million
Branches 284 37
Source: Company reports

So it was that culture that set the stage for the intracompany resentment that followed the merger. Some Schwab branch managers had luck referring well-heeled clients, but, for the most part, the U.S. Trust people resented Schwab and frequently sabotaged the migration attempts. U.S. Trust client relationship officers were typically less than excited about referrals from newly minted millionaires in blue jeans whose entrée to wealth was daytrading during the technology boom.

“We were flabbergasted,” one Schwab board member said of the conflict. “Some of the U.S. Trust officers simply refused to accept our referrals.”

When he caught wind of this behavior, Pottruck rolled some heads. In an attempt to impose some Schwab religion, he replaced U.S. Trust CEO Jeffrey Maurer with Alan Weber, a Schwab manager and a veteran of integration-oriented Citigroup. Dozens of portfolio managers also left. Referrals to U.S. Trust from Schwab rose modestly over the ensuing year. Still, U.S. Trust has lagged the asset-growth rate of Schwab since the market rebounded in 2002 and it remains a distant rich cousin within the Schwab family.

Yoke's On Me

Schwab sells for about $9 per share compared with $40-plus when it bought U.S. Trust four years ago.

“Quite frankly, the whole merger has been a disappointment on several levels,” said Matt Snowling, an analyst at Friedman Billings Ramsey & Co. “In 2000, the fear of Schwab was that as their customers made money and their portfolios were headed to the moon, they'd lose those customers to Merrill Lynch or somebody who would give them advice and trust-related services.”

But it turns out that customers chose the discount, self-directed brokerage for a reason. “If you chose Schwab because you liked a $30 trade, does it make sense that you're going to hand over 1 percent in annual fees and hundreds or thousands for other fees or services [to U.S. Trust]?” Snowling asked.

It's true that U.S. Trust will make $55 million or so before taxes, Snowling notes. But in recent years, the company has lost considerable talent, thanks in part to the changes imposed by Pottruck.

Therefore, if Schwab were to sell, “they'd probably only get half — $1.2 billion to $1.5 billion — of what they paid in 2000,” he says.

That means Schwab would have to take a huge writedown on a sale, and it's unlikely that its shareholders have the tolerance for that.

“They just may wait to see if the market can continue to come back and the value of U.S. Trust increases and sell it on a high note,” Snowling says.

For many observers, a sale should be more a matter of when than if.

“I just don't know that U.S. Trust is that good of a fit for Schwab,” said Ross Levin, president of Accredited Investors, a financial planning and investment advisory firm in Minneapolis. “Our own ‘sweet spot’ is clients with assets of $3 million to $7 million. And we ‘custody’ a lot of assets at Schwab. We like Schwab. But we're really competitors with U.S. Trust to the extent that we have CPAs and a lawyer and we do a lot of complex, comprehensive financial planning for clients.”

Keep Enemies Close

The independent investment advisors affiliated with Schwab are of two minds. Some are furious at what they see as U.S. Trust's encroaching on their practices. Others — endorsing Sun Tzu's dictum to “keep your friends close but your enemies closer” — would rather see U.S. Trust remain a Schwab subsidiary than become a rejuvenated, independent competitor. So would many advisors to high-net-worth clients, both with wirehouses and independents. As long as it's a “problem child” hobbled by Schwab's management, it's one less rival to worry about.

Matt Delaney, a principal with the Wharton Business Group outside Philadelphia, a registered independent advisory firm that doesn't do business with Schwab, said buying U.S. Trust upset a lot of advisors who used the Schwab back-shop services but referred clients for legal and other trust services elsewhere.

“Schwab had a really nice low-cost platform for advisors and everyone was pretty happy with Schwab, and then Pottruck started growing Schwab in different directions,”' Delaney said. “Those investment advisors are entrepreneurs, and Pottruck introduced competition to them.”

Schwab Institutional provides custodial, operational and trading support for independent, fee-based investment advisors. The average new Schwab client funds an account at more than $100,000. For a Schwab investment executive to refer a client to one of 325 independent advisors within its affiliated Schwab Advisor Network requires investable assets of $250,000. Schwab advisors refer clients with at least $2 million in assets to U.S. Trust. U.S. Trust's minimum annual fee is $20,000.

The Schwab-U.S. Trust relationship seems to have little effect on those who use Schwab for other services.

“We use Schwab clearing, custody and other services,” said Michael McCabe, vice president of Kohlhepp Investment Advisors, a West Chester, Pa.-based firm that overseas $100 million-plus in individual and small-business client assets. “Schwab is good at that and we'll continue to use them. But our clients are our clients because of the value that we bring to them. Whether we put assets in Schwab or Fidelity, the vast majority of our clients will follow our advice.”

Adrian Moravcsvik, a senior vice president in California for Stein Roe Investment Counsel, also is a user of Schwab institutional services. “We have never been too concerned about U.S. Trust,” Moravcsvik said. “There are differentiating factors between the firms. While some independent advisors may have felt that Schwab was creating a conflict of interest…it has always been our view that firms such as ours and Schwab's need to evolve and change strategically over time, and we have never felt that the Schwab commitment to our group has been betrayed.”

Ironic Billionaires

The ironic thing is that Pottruck's move to acquire U.S. Trust was a right-headed one; Schwab needs a wealth management firm to handle its richest clients. Today, the United States is home to more billionaires — 313, according to the 2004 Forbes survey — than ever before, and wealth is migrating from the east coast to the west. These are forces that favor Schwab, and now is the best time for the U.S. Trust acquisition to be making hay.

But it's not, and for reasons of cultural dissonance, U.S. Trust probably will never pay for itself while it is under the Schwab umbrella. Despite Chuck Schwab's assurances to the contrary, look for the board to quietly search for a buyer, maybe a leveraged buyout by the few U.S. Trust insiders who survived the last few years.

The sale may have to wait until Chuck steps down, but that will be in less than two years. When he does, the firm he founded will realize that its best hope for success is serving the investors of average means, the business that Schwab so spectacularly mined since its founding in 1973.

For better or for worse, Schwab is stuck being the brokerage for the masses. And until Schwab figures out what it wants to be when it grows up, that's not a bad place to be.

ABOUT THE AUTHOR: John Kador is an avid Schwab watcher and author of Charles Schwab: How One Company Beat Wall Street and Reinvented the Brokerage Industry, among nine others.