A recent U.S. district court ruling in Pennsylvania threatens to inflict significant damage on the banking industry.
The court ruled that a "sweep" fee of 0.5% charged by Mellon Bank for investing trust accounts in interest-bearing deposits was unreasonable. The plaintiffs were awarded $56 million in damages plus 11 years' interest, which their attorneys say could total $100 million.
Although the total may be exaggerated, it has been estimated that 3,000 banks could be exposed to similar liability, resulting in a potentially staggering cost to the banking industry.
Whether the industry can withstand liability on that order of magnitude is a question that should concern banking regulators and Congress.
The Business of Banking
The Mellon decision is disturbing not only because of the costs it inflicts. It also fails to take into account the economic nature of the business of banking.
Our banking system is based on the fundamental notion of banks as profit-making entities. Banks are not publicly owned utilities or charitable enterprises.
They are privately owned businesses. They are chartered with the expectation that they will provide financial services at a sufficient profit to attract shareholders and capital and not be a burden on the federal deposit insurance fund.
Banks are not required by law to offer trust services. And certainly not on a pro bono basis. They do so only after making a carefully considered business decision that they can do so profitably.
Sweep fees are not, as the Mellon court found, the product of a bad motive" by banks. Indeed, other courts have found that bank trustees are required to provide sweep services.
Good Use for Idle Cash
Sweeps provide significant benefits to trust accounts by allowing otherwise idle trust cash to be automatically invested for very short periods of time in interest-bearing vehicles. This cash is eventually reinvested in longer-term instruments.
Prior to the invention of sweeps, trust cash typically was maintained in noninterest-bearing bank deposits.
Sweep fees compensate banks for the performance of a valuable service to trust accounts. They also compensate for the loss of interest.free deposits, which had been a factor in the pricing of bank trust services.
Banks have an undeniable fiduciary duty not to charge excessive fees to trust accounts when making a profit. Trust fees must be reasonable.
But in considering whether a specific fee is reasonable, one needs to look at the trust department's total fee structure.
Were the aggregate trust fees charged by Mellon unreasonable? The court stated that Mellon's annual trust-management fee was reasonable.
If Melon had embedded the sweep fee in its overall trust fee and raised that fee marginally, as some banks legitimately may have done, would the court then have found it unreasonable? It seems unlikely.
And unreasonable compared to what? Surely not when compared to fees charged by nonbank investment service providers.
Encouraging a Feeding Frenzy
The Mellon case is another strike against the banking industry by a litigious law firm that has plagued the industry with a rash of class-action shareholder lawsuits aimed at banks reporting quarterly losses.
In the Mellon case, the firm Put together a class action comprising all persons who are beneficiaries of trust accounts managed by all banks in Pennsylvania that charge sweep fees of more than 0.1%.
The named plaintiffs in the case were beneficiaries of a trust that paid sweep fees of under $50 a year in one case and under $200 a year in the other.
The court's response to this kind of lawsuit not only encourages a feeding frenzy of similar lawsuits against banks but tends to perpetuate the view of banks as public utilities.
As the court's award of damages indicates, this mistaken view can be very costly to banks and their shareholders.
A Challenge to Congress
The court's ruling is symptomatic of a banking industry scraping to find meager profits under an outworn regulatory regime that confines it to a shrinking customer base and deprives it of new profit-making opportunities in other areas of financial activity.
It should not be surprising that banks increasingly look to their trust departments as profit centers.
The challenge posed by the Mellon court's judgment is not only to the banking industry to justify the reasonableness of trust fees, but to Congress to justify the regulatory, straitjacket in which it keeps the industry.
Ms. Fein is a partner in the Washington law firm of Arnold & Porter and author of "Securities Activities of Banks," published in 1991 by Prentice Hall Law and Business.