Former Citigroup co-chairman John Reed approached Discover card executives last year with a plan to "get together and jointly buy MasterCard," David Nelms, president and chief operating officer of Discover Financial Services Inc., said in trial testimony Friday.
Mr. Nelms, a witness for the Justice Department in its antitrust case against Visa and MasterCard, said he met at least twice with Mr. Reed in 1999 to pursue this plan, and that it had not been the first time that Citi and Discover had discussed possible collaborations.
Before Mr. Nelms arrived at Discover from MBNA Corp. in 1998, he testified, Citi had proposed "combining volume [with Discover] into a new network" that would be separate from Visa and MasterCard.
By last year, the focus had shifted toward whether Discover - which is owned by Morgan Stanley Dean Witter & Co. - could band with Citi to buy MasterCard, Mr. Nelms said. "They weren't real happy with Visa" at the time, he said. He did not say how or why the negotiations ended.
In a separate revelation, Mr. Nelms said that Richard Vague, the former president of the First USA credit card division of Bank One Corp., had also approached him last year with the idea that Discover cross-sell its cards to people in affinity groups with ties to First USA.
"We negotiated virtually a final contract, and it all fell apart at the end of the summer, when a lot of things fell apart at First USA," Mr. Nelms said. Financial problems at the card unit ultimately led to Mr. Vague's resignation.
The Justice Department elicited the testimony to try to show that the card associations' bylaws prevented Discover from doing what it wanted - that is, forming partnerships with banks - and that Discover suffered as a result.
Mr. Nelms said that if banks were allowed to issue Discover cards, it would drive volume to the Discover/Novus processing network, compel more merchants to accept Discover cards, and spur more consumers to sign up for the cards.
He said that after he got the phone call from Mr. Vague, they met twice in person. "The initial meeting was exploratory - what could we do?" Mr. Nelms said.
According to the testimony, Mr. Vague told Mr. Nelms that First USA's numerous affinity card contracts - with universities and other institutions - came with large guarantees, and First USA could use some extra help selling those products.
The plan that came together was that Discover would buy First USA's affinity mailing lists and try to sell Discover cards to the prospects, with the idea that First USA would ultimately become the issuer - once Visa's prohibition against this type of relationship went away.
Mr. Nelms said it was written into the contract that in the event that Visa dropped rule 2.10(e) - which prohibits Visa issuers from issuing nonbank brands, and is the central rule the Justice Department is fighting - First USA would buy the affinity portfolio.
"What First USA really wanted to do was to issue cards on Discover's network," Mr. Nelms said. "Because of the bylaws, the structure was for us to issue the cards, and it included a clause that they could purchase the accounts" when the climate changed.
M. Laurence Popofsky, a lawyer for Visa, said that if Discover could buy a bank's mailing lists - which are invaluable to credit card issuers - then Visa's bylaw did not seem to be such a terrible impediment. Mr. Nelms countered that it was difficult and expensive to get a bank to agree to such a deal and that First USA "was willing to do it because they thought they would control the customers and get them back."
Mr. Nelms quashed a suggestion by Kenneth Gallo, a MasterCard attorney, that something more was afoot between him and Mr. Vague. "Do you remember that he told you that if things didn't work out at Discover, that he'd like you to join First USA?" Mr. Gallo asked. "No," Mr. Nelms said firmly.
Under friendly questioning from Justice Department lawyer M.J. Moltenbrey, Mr. Nelms described some of the competitive problems his company faces: relatively low merchant acceptance, consumer opinion that the card is not widely accepted, virtually no merchant acceptance outside the United States, and the need to offer bargain-basement prices to get merchants to sign up.
"We have about 3.7 million merchants," Mr. Nelms said. "We think that Visa [U.S.A] has 4.2 million merchants, and obviously Visa has international acceptance as well."
Among Discover customers, "the perception of acceptance is worse than the reality, because they've been rejected so much over the years," he said. It's "an embarrassment when you go to a restaurant" and find that it does not take Discover.
Mr. Nelms said merchants tell him there is "not enough demand" for them to accept Discover and that when customers learn that a merchant does not take Discover, they just pull out a Visa or a MasterCard. "I've personally gotten involved with major retailers to provide such a huge incentive that they wanted to take Discover card," Mr. Nelms said. "Our fraud and chargeback rules are much simpler. We tried to make a big deal that we were a better deal" for merchants.
Despite these problems, Discover is the fourth-largest credit card issuer in the United States in terms of loans outstanding, and the fifth-largest issuer in terms of transaction volume, Mr. Nelms said. But, he added, "only one in 20 times a customer is paying at the point of sale, they use Discover."
Discover would be larger if it were not precluded from bidding on bank card portfolios that come up for sale, which forces the company to scrounge for portfolios that do not run on the Visa and MasterCard networks, he said.
Discover tried to bid on the private label portfolio of J.C. Penney, but GE Capital got that. It also unsuccessfully approached Sears, Roebuck and Co. - which created the Discover card in 1985 - about buying the Sears private label card portfolio.
"Do you believe if there were multiple issuers on your network, you would be able to mail to more consumers?" Ms. Moltenbrey asked.
"Sure," Mr. Nelms said. "There's a limit to what a single issuer can do."
A year ago, Discover began issuing MasterCard-branded cards in the United Kingdom, where some of the prohibitions in the United States do not apply. The cards bear the Morgan Stanley Dean Witter brand name - not the Discover name - and run completely on MasterCard's network, as Discover does not have a network abroad.
At the time the product was announced, Discover said it made the strategic decision to use its parent company's brand name because it had more appeal and recognition overseas. In court Friday Mr. Nelms admitted, "We would have liked to have branded it Discover, but we weren't able to."
Discover also wants to issue debit cards, Mr. Nelms said, and "took a very serious look at issuing an ACH debit card that could clear to a checking account." But the company "concluded that without partnering with banks, it was not economical." Banks that issue debit cards have "virtually zero" marketing costs, because the product is an add-on, he said, whereas Discover would be starting from scratch.
Mr. Popofsky of Visa pointed out that Morgan Stanley Dean Witter's brokerage customers have accounts that could be tied to debit cards. Mr. Nelms said those customers "value full domestic acceptance and international acceptance" and thus would be dissatisfied with Discover cards.
Mr. Popofsky tried to compare Mr. Nelms' opinions to those of his boss, Phil Purcell, chief executive officer of Morgan Stanley Dean Witter. Mr. Purcell was dropped from the Justice Department's witness list, perhaps because statements he made at a Senate Banking Committee hearing on May 25, two weeks before the trial began, do not mesh entirely with the government's view.
In his Senate testimony, which Mr. Popofsky introduced as evidence, Mr. Purcell said: "If the Department is successful in obtaining the relief it now seeks with respect to [Visa] Bylaw 2.10(e), it will have created a situation where Discover is the only network that will not be able to build volume by attracting substantial third-party issuers."
Mr. Popofsky tried to get Mr. Nelms to say that if the government succeeded in its central goal of striking down this particular Visa bylaw, banks would gravitate toward American Express - which would enrich them with its classy brand name and higher merchant discount rate - and leave Discover in the dust.
"Do you agree that if the only change is the abolition of 2.10(e), Discover will suffer?" Mr. Popofsky asked. "Do you understand that the sole rule being challenged is 2.10(e)?"
Mr. Nelms said, "I understand there are broad remedies" that the court could apply. "I agree with the position that broad remedies are needed," he said. "Our belief is that we could attract issuers even with a lower [merchant discount] price if other bylaws [besides 2.10(e)] were gone."
Mr. Gallo, who quizzed Mr. Nelms on behalf of MasterCard, tried to coax him to testify that Discover - unlike American Express - had made few if any efforts to reach out to banks and try to make deals about debit or credit cards.
"You never approached MasterCard and asked if there was some way that a bank could issue a card on your network, did you?" Mr. Gallo asked.
"No," Mr. Nelms said, "but maybe I will after this."
Mr. Gallo also reached back to Mr. Nelms' years at MBNA, which he joined in 1991 and left in 1998 as vice chairman of marketing. When he was a bank card executive, Mr. Nelms said, "I perceived that Visa and MasterCard competed for my marketing dollars and my business."
"And you played one off against another?" Mr. Gallo asked.
"Yes," Mr. Nelms said. "They competed vigorously with each other, but the competition was limited to two." He said it would have been better for MBNA and other bank card issuers if there had been four networks from which to choose.
Mr. Gallo was trying to rebut the government's contention that Visa and MasterCard are in cahoots with each other. He also used Mr. Nelms' testimony to try to bolster the associations' position that smart cards are a product whose time has not yet come, rather than a product that got squelched because one association developed it faster than the other.
Mr. Gallo asked Mr. Nelms whether the first thing he did when he took the helm of Discover was to cancel the company's smart card program. Yes, he said. "We moved the people from smart card to Internet," Mr. Nelms said. "I thought the Internet was a much higher priority for us," and it seemed farfetched that Discover would be able to afford rolling out smart card terminals to all its merchants.
This week the Justice Department plans to call what may be its final two witnesses: Bennett Katz, a former general counsel for Visa; and Michael L. Katz, a professor at the University of California at Berkeley.
After that, the trial is expected to break for several days before Visa and MasterCard begin their defense.