State securities regulators are turning up the heat on Morgan Stanley after discovering it provided false and misleading information about its mutual fund sales practices.
In a complaint filed last Monday, Massachusetts' securities division alleged the New York-based brokerage giant improperly pressured brokers and branch managers to sell proprietary mutual funds to investors, who were unaware that their brokers received additional compensation for pitching in-house funds. Additionally, the firm is accused of failing to provide accurate information to regulators upon request. The claim seeks a cease and desist order on such practices and requests a $1 million fine for its conduct.
As a result, Secretary of the Commonwealth William Galvin and New York Attorney General Eliot Spitzer have launched a joint investigation into compensation practices at Morgan Stanley and other major Wall Street brokerage houses. Spitzer was responsible for spearheading the much-publicized $1.4 billion conflict of interest settlement with 10 big investment banks earlier this year.
The problems at Morgan Stanley's fund unit stemmed from an anonymous tip received in March from a broker in its Boston Back Bay branch who said management put inappropriate pressure on advisers to sell its new Morgan Stanley Allocator Fund. The broker said the tactics used by the branch manager were "nothing short of extortion" and that the manager "made repeated threats" that future syndicate allocations, business development credits and business expense reimbursements would be rescinded if they didn't cooperate.
At first, the company testified it did not pay brokers additional sums for selling its own funds. Morgan Stanley later retracted the statement, telling state officials that brokers receive bonuses for pushing proprietary funds and that customers were not aware of it. However, the firm only corrected the mistake after members of the press exposed it to the public.
"Morgan Stanley has the utmost respect for the Massachusetts securities division and deeply regrets the errors made in one of our communications to the state investigators," a spokeswoman for the firm said.
The company also admitted that it pays brokers more for selling funds from 14 other companies including AIM, American Funds, Fidelity, PIMCO and Franklin Templeton. After conceding that it had misled investors about its compensation practices, Morgan Stanley submitted a spreadsheet to regulators that showed financial advisers from its Back Bay branch sold significantly more shares of the Allocator Fund than was originally disclosed by its testifying attorney. In fact, the initial filing failed to account for the purchasers of A, B, C and D shares of the fund, according to the complaint.
The announcement of a formal inquiry came just two days after Morgan Stanley confirmed that the Securities & Exchange Commission launched a probe into its sale of class B shares, stirring up a controversy over regulatory jurisdiction.
By circling wagons of their own, the states are challenging a bill passed in the House of Representatives earlier this month that, if made into a law, would strip them of their power to curb instances of fraud within the securities industry. The bill, endorsed by the House capital markets subcommittee, would prevent state regulators from working out agreements and settlements with securities firms that would stamp out emerging cases of fraud and sales abuse. That includes rules governing capital and margin requirements, record keeping, financial reporting, disclosure and conflicts of interest.
Spitzer and Galvin cited specific examples of actions by state securities regulators in recent years that would become impossible if the new legislation is passed. Actions against penny stock and micro-cap fraud, day-trading firms, misleading online brokerage advertising and the recent research settlement all were made possible by diligent state regulatory efforts.
"The most important lesson of the last year is the essential role played by state enforcement entities in protecting investors against investment fraud," Spitzer told reporters at a press conference. "It makes no sense to disarm the local cop on the securities beat at a time when we need to strengthen, not weaken, investor protection."
"I am very opposed to the bill," said Mercer Bullard, securities law professor at the University of Mississippi and founder of Fund Democracy, a shareholder advocacy group. "It shows the continued lack of good legislation on the Hill to deal with investor issues." Bullard said that eliminating state authority in the broker/dealer industry would be equivalent to kicking a player off a baseball team after he hit a home run.
Supporters of the bill believe that it would prevent the "Balkanization" of state securities laws and create consistency in the way they are applied. Bullard strongly disagrees, saying that Spitzer has not proposed any new rules but due to the rampant fraud that has pervaded Wall Street the last few years it has the appearance of rulemaking. He said that Spitzer merely identifies fraudsters and uses a full range of settlement options available to resolve what otherwise might have landed CEOs at these companies in jail.
Furthermore, he believes that the National Securities Markets Improvement Act (NSMIA) passed in 1996 effectively addressed the Balkanization of state activities and made regulation more efficient. NSMIA prohibits states from enacting or enforcing any broker/dealer licensing requirement that differs from federal requirements relating to specified areas such as net capital, bonding, and books and record keeping. However, states retain anti-fraud authority and the ability to investigate and institute proceedings for sales practice violations by firms or their sales agents.
The SEC has long exempt mutual funds from disclosing the compensation brokers receive for selling funds on trade confirmation slips, a requirement all other instruments must follow. Even though the SEC has said repeatedly their staff is examining this gap in regulatory structure, they haven't done one thing to change it, Bullard said.
"They believe that having one regulator and the consistency it brings is more important than having effective regulation," he said.
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