10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended November 30, 2005

Commission File Number 1-11758

Morgan Stanley

(Exact name of Registrant as specified in its charter)

Delaware   36-3145972
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

1585 Broadway

New York, NY 10036

(Address of principal executive offices, including zip code)

 

(212) 761-4000

(Registrant’s telephone number, including area code)

 

Title of each class


  

Name of exchange on

which registered


Securities registered pursuant to Section 12(b) of the Act:

    

Common Stock, $.01 par value

   New York Stock Exchange
Pacific Exchange

Rights to Purchase Series A Junior Participating Preferred Stock

   New York Stock Exchange
Pacific Exchange

8.03% Capital Units

   New York Stock Exchange

7 1/4% Capital Securities of Morgan Stanley Capital Trust II (and Registrant’s guaranty with respect thereto)

   New York Stock Exchange

6 1/4% Capital Securities of Morgan Stanley Capital Trust III (and Registrant’s guaranty with respect thereto)

   New York Stock Exchange

6 1/4% Capital Securities of Morgan Stanley Capital Trust IV (and Registrant’s guaranty with respect thereto)

   New York Stock Exchange

5 3/4% Capital Securities of Morgan Stanley Capital Trust V (and Registrant’s guaranty with respect thereto)

   New York Stock Exchange

6.60% Capital Securities of Morgan Stanley Capital Trust VI (and Registrant’s guaranty with respect thereto)

   New York Stock Exchange

SPARQS® due March 1, 2006; SPARQS due June 1, 2006; SPARQS due August 1, 2006 (2 issuances); SPARQS due September 1, 2006 (2 issuances); SPARQS due October 1, 2006 (2 issuances); SPARQS due November 1, 2006 (2 issuances); SPARQS due December 1, 2006 (2 issuances); SPARQS due January 15, 2007 (2 issuances); SPARQS due February 20, 2007 (2 issuances)

   American Stock Exchange

Exchangeable Notes due June 5, 2006

   New York Stock Exchange

Exchangeable Notes due December 30, 2008 (2 issuances); Exchangeable Notes due December 30, 2010; Exchangeable Notes due April 30, 2011; Exchangeable Notes due June 30, 2011; Exchangeable Notes due December 30, 2011

   American Stock Exchange

Callable Index-Linked Notes due December 30, 2008

   American Stock Exchange

BRIDGESSM due August 30, 2008; BRIDGES due December 30, 2008 (2 issuances); BRIDGES due February 28, 2009; BRIDGES due March 30, 2009; BRIDGES due June 30, 2009; BRIDGES due July 30, 2009; BRIDGES due August 30, 2009; BRIDGES due October 30, 2009; BRIDGES due December 30, 2009; BRIDGES due June 15, 2010

   American Stock Exchange

Capital Protected Notes due June 30, 2008; Capital Protected Notes due September 30, 2008; Capital Protected Notes due December 30, 2008; Capital Protected Notes due December 30, 2009; Capital Protected Notes due August 30, 2010; Capital Protected Notes due October 30, 2010; Capital Protected Notes due January 30, 2011; Capital Protected Notes due March 30, 2011 (2 issuances); Capital Protected Notes due June 30, 2011; Capital Protected Notes due October 30, 2011; Capital Protected Notes due December 30, 2011; Capital Protected Notes due September 30, 2012

   American Stock Exchange

MPSSM due December 30, 2008; MPS due December 30, 2009; MPS due February 1, 2010; MPS due June 15, 2010; MPS due December 30, 2010 (2 issuances); MPS due March 30, 2012

   American Stock Exchange

Stock Participation Notes due September 15, 2010; Stock Participation Notes due December 30, 2010

   American Stock Exchange

PLUSSM due June 30, 2006 (2 issuances); PLUS due July 15, 2006; PLUS due July 30, 2006; PLUS due October 30, 2006; PLUS due November 30, 2006; PLUS due February 20, 2007; PLUS due April 20, 2007; PLUS due April 30, 2007; PLUS due April 30, 2008; PLUS due June 30, 2009

   American Stock Exchange

PROPELSSM due December 30, 2011 (3 issuances)

   American Stock Exchange

Strategic Total Return Securities due December 17, 2009; Strategic Total Return Securities due March 30, 2010; Strategic Total Return Securities due July 30, 2011(2 issuances); Strategic Total Return Securities due January 15, 2012

   American Stock Exchange

BOXES® due October 30, 2031; BOXES due January 30, 2032

   American Stock Exchange
Philadelphia Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

    

PLUS due March 30, 2006 (2 issuances); PLUS due February 20, 2007; PLUS due September 30, 2009

   Nasdaq National Market

MPS due March 30, 2009

   Nasdaq National Market

Capital Protected Notes due September 1, 2010

   Nasdaq National Market

Strategic Total Return Securities due October 30, 2011

   Nasdaq National Market

Indicate by check mark if Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x NO ¨

Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. YES ¨ NO x

Indicate by check mark whether Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Exchange Act Rule 12b-2.    Large accelerated filer x    Accelerated filer ¨    Non-accelerated filer ¨

Indicate by check mark whether Registrant is a shell company (as defined in Exchange Act Rule 12b-2). YES ¨ NO x

As of May 31, 2005, the aggregate market value of the common stock of Registrant held by non-affiliates of Registrant was approximately $52,756,199,948. This calculation does not reflect a determination that persons are affiliates for any other purposes.

As of December 31, 2005, there were 1,053,494,099 shares of Registrant’s common stock, $.01 par value, outstanding.

Documents Incorporated By Reference: Portions of Registrant’s definitive proxy statement for its annual stockholders’ meeting to be held on April 4, 2006 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

 



Table of Contents

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Annual Report on Form 10-K

for the fiscal year ended November 30, 2005

 

Table of Contents

 

          Page

     Part I     
Item 1.   

Business

    
    

Overview

   1
    

Available Information

   1
    

Business Segments

   3
    

Institutional Securities

   3
    

Retail Brokerage

   6
    

Asset Management

   7
    

Discover

   8
    

Competition

   9
    

Regulation

   11
    

Executive Officers of Morgan Stanley

   15
Item 1A.   

Risk Factors

   17
Item 1B.   

Unresolved Staff Comments

   22
Item 2.   

Properties

   23
Item 3.   

Legal Proceedings

   24
Item 4.   

Submission of Matters to a Vote of Security Holders

   29
     Part II     
Item 5.   

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   30
Item 6.   

Selected Financial Data

   32
Item 7.   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   34
Item 7A.   

Quantitative and Qualitative Disclosures about Market Risk

   90
Item 8.   

Financial Statements and Supplementary Data

   106
Item 9.   

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   167
Item 9A.   

Controls and Procedures

   167
Item 9B.   

Other Information

   169
     Part III     
Item 10.   

Directors and Executive Officers of the Registrant

   170
Item 11.   

Executive Compensation

   170
Item 12.   

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   171
Item 13.   

Certain Relationships and Related Transactions

   172
Item 14.   

Principal Accountant Fees and Services

   172
     Part IV     
Item 15.   

Exhibits and Financial Statement Schedules

   173
Signatures    174
Index to Financial Statements and Financial Statement Schedules    S-1
Exhibit Index    E-1

 

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Forward-Looking Statements

 

We have included or incorporated by reference into this report, and from time to time may make in our public filings, press releases or other public statements, certain statements, including (without limitation) those under “Legal Proceedings” in Part I, Item 3, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 (“MD&A”), and “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 7A, that may constitute forward-looking statements. In addition, our management may make forward-looking statements to analysts, investors, representatives of the media and others. These forward-looking statements are not historical facts and represent only Morgan Stanley’s beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control.

 

The nature of Morgan Stanley’s business makes predicting the future trends of our revenues, expenses and net income difficult. The risks and uncertainties involved in our businesses could affect the matters referred to in such statements and it is possible that our actual results may differ from the anticipated results indicated in these forward looking statements. Important factors that could cause actual results to differ from those in the forward-looking statements include (without limitation):

 

    the effect of political, economic and market conditions and geopolitical events;

 

    the availability and cost of capital;

 

    the level and volatility of equity prices, commodity prices and interest rates, currency values and other market indices;

 

    the actions and initiatives of current and potential competitors;

 

    the impact of current, pending and future legislation, regulation and regulatory and legal actions in the U.S. and worldwide;

 

    our reputation;

 

    investor sentiment;

 

    the potential effects of technological changes; and

 

    other risks and uncertainties detailed under “Risk Factors” in Part I, Item 1A, “Competition” and “Regulation” in Part I, Item 1 and elsewhere throughout this report.

 

Accordingly, you are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which they are made. Morgan Stanley undertakes no obligation to update publicly or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the dates they are made, whether as a result of new information, future events or otherwise except as required by applicable law. You should, however, consult further disclosures Morgan Stanley may make in future filings of its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments thereto.

 

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Part I

 

Item 1. Business.

 

Overview.

 

Morgan Stanley is a global financial services firm that, through its subsidiaries and affiliates, provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. Morgan Stanley was originally incorporated under the laws of the State of Delaware in 1981, and its predecessor companies date back to 1924. Morgan Stanley conducts its business from its headquarters in and around New York City, its regional offices and branches throughout the U.S. and its principal offices in London, Tokyo, Hong Kong and other world financial centers. At November 30, 2005, Morgan Stanley had 53,218 employees worldwide. Unless the context otherwise requires, the terms “Morgan Stanley,” the “Company,” “we” and “our” mean Morgan Stanley and its consolidated subsidiaries.

 

Financial information concerning Morgan Stanley, our business segments and geographic regions for each of the fiscal years ended November 30, 2005, November 30, 2004 and November 30, 2003 is included in the consolidated financial statements and the notes thereto in “Financial Statements and Supplementary Data” in Part II, Item 8. See also “Results of Operations—Executive Summary” in Part II, Item 7 for an overview of Morgan Stanley’s fiscal 2005 performance.

 

Available Information.

 

Morgan Stanley files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Morgan Stanley) file electronically with the SEC. Morgan Stanley’s electronic SEC filings are available to the public at the SEC’s internet site, www.sec.gov.

 

Morgan Stanley’s internet site is www.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage through our internet site, www.morganstanley.com, by clicking on the “About Morgan Stanley” link to the heading “Investor Relations.” You can also access our Investor Relations webpage directly at www.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through our Investor Relations webpage, its proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Morgan Stanley also makes available, through our Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of Morgan Stanley’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

 

Morgan Stanley has a Corporate Governance webpage. You can access Morgan Stanley’s Corporate Governance webpage through our internet site, www.morganstanley.com, by clicking on the “About Morgan Stanley” link to the heading “Inside the Company.” You can also access our Corporate Governance webpage directly at www.morganstanley.com/about/inside/governance. Morgan Stanley posts the following on its Corporate Governance webpage:

 

    Composite Certificate of Incorporation;

 

    Bylaws;

 

    Charters for our Audit Committee, Compensation, Management Development and Succession Committee and Nominating and Governance Committee;

 

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    Corporate Governance Policies;

 

    Procedures for Reporting Auditing and Accounting Concerns;

 

    Policy Regarding Communication with the Board of Directors;

 

    Policy Regarding Director Candidates Recommended by Shareholders;

 

    Policy Regarding Corporate Political Contributions;

 

    Policy Regarding Shareholder Rights Plan; and

 

    Code of Ethics and Business Conduct.

 

Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including our Chief Executive Officer, our Chief Financial Officer and our Controller and Principal Accounting Officer. We will post any amendments to the Code of Ethics and Business Conduct, and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange, Inc. (“NYSE”), on our internet site. You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations, 1585 Broadway, New York, NY 10036 (212-761-4000). The information on Morgan Stanley’s internet site is not incorporated by reference into this report.

 

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Business Segments.

 

Morgan Stanley maintains leading market positions in each of its business segments—Institutional Securities, Retail Brokerage, Asset Management and Discover. These segments consist of the products and activities set forth below.

 

Institutional Securities   Retail Brokerage   Asset Management   Discover

Investment banking

 

•   Capital raising

 

•   Corporate lending

 

•   Financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance

 

Sales, trading, financing and market-making activities

 

•   Equity securities and related products

 

•   Fixed income securities and related products, including foreign exchange and commodities

 

Other activities

 

•   Benchmark indices and risk management analytics

 

•   Research

 

•   Investments

 

Clients

 

•   Individuals

 

•   Small-to-medium size businesses and institutions

 

Products and Services

 

•   Brokerage and investment advisory services

 

•   Financial and wealth planning services

 

•   Annuity and insurance products

 

•   Credit and other lending products

 

•   Banking and cash management

 

•   Retirement plan services

 

•   Trust services

 

Global asset management products and services

 

•   Equity

 

•   Fixed Income

 

•   Alternatives

 

Three principal distribution channels

 

•   A proprietary channel consisting of Morgan Stanley’s representatives

 

•   A non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries

 

•   Institutional sales

 

Discover Financial Services

 

•   Discover®-branded cards

 

•   Other consumer finance products and services

 

Discover Network

 

•   A network of merchant and cash access locations primarily in the U.S.

 

•   Transaction network for Discover® Network branded cards

 

PULSE® EFT Association LP (“PULSE”)

 

•   An automated teller machine (“ATM”)/debit and electronic funds transfer network

 

Consumer Banking Group International

 

•   Morgan Stanley-branded and affinity credit cards and other consumer finance products and services in the U.K.

 

•   Credit cards issued on the MasterCard network

 

Institutional Securities.

 

Morgan Stanley provides financial advisory and capital-raising services to a diverse group of corporate and other institutional clients globally, primarily through wholly-owned subsidiaries that include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley & Co. International Limited, Morgan Stanley Japan Limited and

 

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Morgan Stanley Dean Witter Asia Limited. These and other subsidiaries also conduct sales and trading activities worldwide, as principal and agent, and provide related financing services on behalf of institutional investors.

 

Investment Banking.

 

Capital Raising.    Morgan Stanley manages and participates in public offerings and private placements of debt, equity and other securities worldwide. Morgan Stanley is a leading underwriter of common stock, preferred stock and other equity-related securities, including convertible securities and American Depositary Receipts (“ADRs”). Morgan Stanley is a leading underwriter of fixed income securities, including investment grade debt, non-investment grade instruments, mortgage-related and other asset-backed securities, tax-exempt securities and commercial paper and other short-term securities.

 

Financial Advisory Services.    Morgan Stanley provides corporate and other institutional clients globally with advisory services on key strategic matters, such as mergers and acquisitions, divestitures, corporate defense strategies, joint ventures, privatizations, spin-offs, restructurings, proxy and consent solicitations, tender offers, exchange offers and leveraged buyouts. Morgan Stanley provides advice concerning recapitalizations, rights offerings, dividend policy, valuations, foreign exchange exposure, financial risk management strategies and financial planning. Morgan Stanley furnishes advice and services regarding project financings and provides advisory services in connection with the purchase, sale, leasing and financing of real estate.

 

Corporate Lending.    Morgan Stanley provides to selected corporate clients through subsidiaries (including Morgan Stanley Bank) loans or lending commitments, including bridge financing. These loans and commitments have varying terms, may be senior or subordinated and/or secured or unsecured, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by Morgan Stanley.* The borrowers may be rated investment grade or non-investment grade (as determined by Morgan Stanley’s Institutional Credit Department using methodologies generally consistent with those employed by external rating agencies).

 

Sales, Trading, Financing and Market-Making Activities.**

 

Morgan Stanley conducts sales, trading, financing and market-making activities on securities and futures exchanges and in over-the-counter (“OTC”) markets around the world. In fiscal 2005, Morgan Stanley combined management oversight of the Equity and Fixed Income divisions to improve the delivery of services to clients across asset classes.

 

Equity Securities and Related Products.

 

Core.    Morgan Stanley acts as principal (including as a market maker) and agent in executing transactions globally in equity and equity-related products, including common stock, ADRs, global depositary receipts, and exchange-traded funds.

 

Derivatives.    Morgan Stanley’s equity derivatives sales, trading and market-making activities cover equity-related products globally, including equity swaps, options, warrants and futures overlying individual securities, indices and baskets of securities and other equity-related products. Morgan Stanley also issues and makes a principal market in equity-linked products to institutional and individual investors, including principal-protected securities, Stock Participation Accreting Redemption Quarterly-pay Securities® (SPARQS®), Performance Leveraged Upside SecuritiesSM (PLUSSM) and Strategic Total Return Securities.

 


* Revenues and expenses associated with the trading of syndicated loans are included in “Sales, Trading, Financing and Market-Making Activities.”
** See also “Risk Management” in Part II, Item 7A for a description of Morgan Stanley’s trading risk management structure, policies and procedures.

 

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Equity Finance Services.    Morgan Stanley provides equity finance services, including prime brokerage, which offers, among other services, consolidated clearance and settlement of securities trades, custody, financing and portfolio reporting services. Morgan Stanley also acts as principal and agent in stock borrowing and stock lending transactions in support of its global trading and brokerage, asset management and clearing activities and as an intermediary between broker-dealers.

 

Proprietary Trading.    Morgan Stanley engages in proprietary trading and investing activities utilizing several strategies and involving, among others, equity securities and derivative instruments related to equity securities.

 

Fixed Income Securities and Related Products.

 

Credit Products.    Morgan Stanley trades and makes markets and takes proprietary positions in fixed income securities and related products globally, including investment grade corporate debt, non-investment grade instruments, credit derivative products (including credit default swaps), distressed debt, bank loans, convertible bonds, preferred stock and commercial paper, money market and other short-term securities. Morgan Stanley trades, makes markets and takes proprietary positions in, and acts as principal with respect to, mortgage-related and other asset-backed securities and real estate loan products. Morgan Stanley also provides financing to customers for commercial and residential real estate loan products. Morgan Stanley advises on investment and liability strategies and assists corporations in their debt repurchases and tax planning. Morgan Stanley structures debt securities and derivatives with risk/return factors designed to suit client objectives, including using repackaged asset vehicles through which clients can restructure asset portfolios to provide liquidity or reconfigure risk profiles.

 

Interest Rate and Currency Products.    Morgan Stanley is a primary dealer of U.S. government securities and a member of the selling groups that distribute various U.S. agency and other debt securities. Morgan Stanley trades, makes markets and takes proprietary positions in interest rate, currency and other fixed income swaps and derivative products, OTC options on U.S. and non-U.S. government bonds and mortgage-backed forward agreements, options and swaps. Through the use of repurchase and reverse repurchase agreements, Morgan Stanley acts as an intermediary between borrowers and lenders of short-term funds and provides funding for various inventory positions. Morgan Stanley also trades fixed income futures. Through its triple-A rated subsidiary, Morgan Stanley Derivative Products Inc., Morgan Stanley enters into swaps and related derivative transactions with counterparties seeking a triple-A rated counterparty. Morgan Stanley also trades and makes markets in U.S. and non-U.S. government securities, municipal securities and emerging market securities. Morgan Stanley is a primary dealer or market-maker of government securities in numerous European, Asian and emerging market countries. Morgan Stanley is a market-maker in foreign currencies. Most of Morgan Stanley’s foreign exchange business relates to major foreign currencies such as Yen, Euro, Sterling, Swiss francs and Canadian dollars. Morgan Stanley trades on a principal basis in the spot, forward, option and futures markets and takes proprietary positions in such currencies.

 

Commodities.    Morgan Stanley trades as principal and maintains proprietary trading positions in the spot, forward and futures markets in several commodities, including precious metals, base metals, crude oil, oil products, natural gas, electric power, emission credits and related energy products. Morgan Stanley is a market-maker in exchange-traded and OTC options and swaps on commodities, such as metals, crude oil, oil products, natural gas and electricity, and offers clients hedging programs relating to production, consumption, reserve/inventory management and energy-contract securitizations. Morgan Stanley is an electricity power marketer in the U.S. and is the sole shareholder of three wholesale generators in the U.S. and one in the Netherlands from which Morgan Stanley is the exclusive purchaser of electric power.

 

Other Activities.

 

Benchmark Indices and Risk Management Analytics.    Morgan Stanley’s majority-owned subsidiary, Morgan Stanley Capital International Inc. (“MSCI®”), calculates and distributes over 25,000 international and U.S. equity benchmark indices (including the MSCI World and EAFE® Indices) covering over 55 countries, and has a

 

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36-year historical database that includes fundamental and valuation data on thousands of equity securities in developed and emerging market countries. MSCI also calculates and distributes over 7,500 fixed income and 190 hedge fund indices. MSCI’s subsidiary, Barra, Inc., is a global leader in providing risk analytic tools and services to investors to help them analyze, measure and manage portfolio and firm-wide investment risk.

 

Research.    In fiscal 2005, Morgan Stanley merged its equity research and fixed income research departments into a combined global research department (“Research”). Research, comprised of economists, strategists, and industry analysts, engages in equity and fixed income research activities and produces reports and studies on the U.S. and global economy, financial markets, portfolio strategy, technical market analyses, individual companies and industry developments. Research examines worldwide trends covering numerous industries and approximately 2,300 individual companies, approximately half of which are located outside of the U.S. Research provides analysis and forecasts relating to economic and monetary developments that affect matters such as interest rates, foreign currencies, securities, derivatives and economic trends. Research provides analytical support and publishes reports on asset-backed securities and the markets in which such securities are traded. Research reports and data are disseminated to investors through third-party distributors, proprietary internet sites such as Client Link, and Morgan Stanley’s sales forces.

 

Investments.    Morgan Stanley from time to time makes investments that represent business facilitation or principal investing activities. Business facilitation investments are strategic investments undertaken by Morgan Stanley to facilitate core business activities. Principal investing activities are capital commitments provided to private companies, generally, for proprietary purposes to maximize total returns to Morgan Stanley. Morgan Stanley has committed to increasing its principal investing activity in an attempt to improve its financial performance. Morgan Stanley expects to make additional principal investments over time. These principal investment activities are conducted within the investment banking and sales and trading areas in Institutional Securities.

 

Morgan Stanley sponsors and manages investment vehicles and separate accounts for clients seeking exposure to private equity, real estate-related and other alternative investments. Morgan Stanley may also invest in and provide capital to such investment vehicles. See also “Asset Management-Alternatives.”

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide the process and technology platform that supports Institutional Securities sales and trading activity, including post-execution trade processing and related internal controls over activity from trade entry through settlement and custody, including asset servicing. This is done for proprietary and customer transactions in listed and OTC transactions in commodities, equity and fixed income securities, including both primary and secondary trading, as well as listed, OTC and structured derivatives in markets around the world. This activity is undertaken through Morgan Stanley’s own facilities as well as through membership in various clearing and settlement organizations globally.

 

Retail Brokerage.

 

Morgan Stanley’s Retail Brokerage business provides comprehensive financial services to clients spanning the wealth spectrum through a network as of November 30, 2005 of approximately 9,500 representatives with over 530 global locations, including 485 U.S. retail locations. As of November 30, 2005, Morgan Stanley had $617 billion in client assets.

 

Clients.

 

Retail Brokerage professionals serve individual investors and small-to-medium size businesses and institutions with an emphasis on affluent and high net worth investors. In the U.S., products and services are delivered

 

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through several channels. Through Morgan Stanley’s wholly-owned subsidiary Morgan Stanley DW Inc. (“MSDWI”), Retail Brokerage’s network of financial advisors and wealth advisors provide solutions designed to accommodate individual investment objectives, risk tolerance and liquidity needs for high net worth and affluent investors, and call centers are available to meet the needs of emerging affluent clients. Specialized investment representative teams trained to leverage full firm resources provide sophisticated investment solutions and services for ultra high net worth individuals, families and foundations, primarily through MS&Co.

 

Outside the U.S., Morgan Stanley offers financial services to clients in Europe, Asia and Latin America. In addition to serving ultra high net worth clients throughout these regions, Morgan Stanley’s international operations also include Quilter & Co. Limited, a U.K.-based business, which provides asset management and advisory services to affluent private clients, charities, trusts and pension funds in the U.K.; and Morgan Stanley S.V., S.A. (Spain) and Morgan Stanley Gestión SGIIC, S.A., which provide investment advice and execution, and discretionary investment management services, respectively, to individual investors in Spain.

 

Products and Services.

 

Retail Brokerage provides clients with a comprehensive array of financial solutions comprising both Morgan Stanley’s products and services as well as products and services from third-party providers such as insurance companies and mutual fund families. Morgan Stanley offers brokerage and investment advisory services covering various investment alternatives, including equities, options, fixed income securities, mutual funds, structured products, alternative investments, unit investment trusts, managed futures, separately managed accounts and mutual fund asset allocation programs. Morgan Stanley also offers financial and wealth planning services, including education savings programs, as well as annuity and insurance products, including life, disability and long-term care insurance. Credit and other lending products are also available, including CreditSource®, which provides residential mortgages and home equity lines of credit originated through Morgan Stanley’s affiliated entities. Morgan Stanley’s BusinesScapeSM program offers cash management and commercial credit solutions to qualified small businesses in the U.S. Morgan Stanley offers banking and cash management services, including cash sweeps into bank deposits and money market funds, check writing, direct deposit, debit cards and business cash management. Morgan Stanley also provides retirement services, including defined contribution plans, 401(k) plans and stock plan administration to businesses of all sizes and trust and fiduciary services to individual and corporate clients. Retail Brokerage also provides clients with transactional services in futures, foreign currencies and precious metals.

 

Retail Brokerage offers its clients a variety of ways to establish a relationship and conduct business to help meet their unique needs and preferences, including transaction-based pricing and asset-based fee pricing. The Active Assets Account® offers clients brokerage and banking services in one transaction-based pricing account. For clients who prefer fee-based pricing, the Morgan Stanley ChoiceSM account charges an asset based fee in lieu of commissions. Clients can also choose to have a fee-based, separately managed account managed by affiliated or unaffiliated professional asset managers.

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide the process and technology platform that supports its Retail Brokerage activities from trade capture through clearance, settlement and custody, including asset servicing. This activity is undertaken through its own facilities, through systems at computer centers operated by an unaffiliated services provider and through memberships in various clearing corporations.

 

Asset Management.

 

Morgan Stanley Investment Management is one of the largest global asset management organizations of any full-service securities firm and offers individual and institutional clients a diverse array of equity, fixed income and alternative investment strategies. Morgan Stanley had $431 billion of assets under management or

 

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supervision as of November 30, 2005. Morgan Stanley’s asset management activities are principally conducted under the Morgan Stanley and Van Kampen brands. Portfolio managers located in the U.S., Europe, Japan, Singapore, and India manage investment products ranging from money market funds to equity, taxable and tax-exempt fixed income funds and alternative investment products, in developed and emerging markets. Morgan Stanley offers clients various investment styles, such as value, growth, core, fixed income and asset allocation; global investments; active and passive management; and diversified and concentrated portfolios.

 

Individual Investors.

 

Morgan Stanley offers open- and closed-end funds and separately managed accounts to individual investors through affiliated and unaffiliated broker-dealers, banks, insurance companies and financial planners. A small number of unaffiliated broker-dealers accounts for a substantial portion of Van Kampen fund sales. Morgan Stanley also sells Van Kampen funds through numerous retirement plan platforms. Internationally, Morgan Stanley distributes investment products to individuals outside the U.S. through non-proprietary distributors.

 

Institutional Investors.

 

Morgan Stanley provides asset management products and services to institutional investors worldwide, including pension plans, corporations, private funds, non-profit organizations, foundations, endowments, governmental agencies, insurance companies and banks. Products and services are available to institutional investors primarily through separate accounts, U.S. mutual funds and other pooled vehicles. Morgan Stanley Investment Management also sub-advises funds for various unaffiliated financial institutions and intermediaries. A global sales force and a team dedicated to covering the investment consultant industry serve institutional investors. Morgan Stanley offers clients alternative investment products primarily through Alternative Investment Partners, which utilizes a fund-of-funds strategy to invest in hedge funds and private equity funds.

 

Alternatives.

 

Morgan Stanley offers a range of alternative investment products for institutional investors and high net worth individuals, including hedge funds, private equity funds, funds of hedge funds, funds of private equity funds, and portable alpha overlays. Morgan Stanley typically acts as general partner and adviser of its alternative investment funds and typically commits to invest a minority of the capital of such funds with subscribing investors contributing the majority.

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide or oversee the process and technology platform required to support its asset management business. Support activities include transfer agency, mutual fund accounting and administration, transaction processing and certain fiduciary services, on behalf of institutional, retail and intermediary clients. These activities are undertaken either through its own facilities or through agreements with unaffiliated third parties.

 

Discover.*

 

Based on its approximately 45.5 million general purpose credit card accounts at November 30, 2005, Morgan Stanley, through its Discover business, is one of the largest single issuers of general purpose credit cards in the U.S. Morgan Stanley’s Discover business includes Discover Financial Services, which offers Discover-branded credit cards issued by Discover Bank and other consumer products and services; Discover Network, which operates a merchant and cash access network for Discover-branded cards; PULSE, an ATM/debit and electronic funds transfer network; and its Consumer Banking Group International in the U.K.

 


* See also “Risk Management” in Part II, Item 7A for a description of Morgan Stanley’s interest rate and credit risk management structure, policies and procedures.

 

 

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Credit Cards and Services.

 

Discover offers several general purpose credit cards that are designed to appeal to different market segments of consumers and that are used exclusively on the Discover Network, including the Discover Classic Card, the Discover Platinum Card, the Discover Gold Card, the Discover Titanium Card, and the Miles Card from Discover as well as affinity cards and Discover gift cards. Discover offers other consumer finance products and services and credit protection products. Discover offers cardmembers certificates of deposit and money market accounts and the ability to transfer balances from other accounts or credit sources. In the U.K., Consumer Banking Group International offers the Morgan Stanley Card, the i24 Card, the Leeds Building Society Card, the Black Horse Card, the Morgan Stanley buy and fly! MasterCard on the MasterCard® network, personal loan products and insurance products. In December 2005, Morgan Stanley entered into a definitive agreement to acquire the Goldfish credit card business from Lloyds TSB.

 

Discover offers cardmembers other customer services. Pursuant to the Cashback Bonus® reward program, Discover provides certain cardmembers rewards based upon their level and type of purchases. Cardmembers may register their account online at www.discovercard.com, which offers cardmembers options such as timely e-mail reminders that help cardmembers avoid late payments, the capability to redeem Cashback Bonus rewards, make payments and view detailed account information. In addition, Discover offers secure online account numbers that allow cardmembers to shop online without having to reveal their actual card number. As of November 30, 2005, Discover had over 14 million Discover cardmembers registered at www.discovercard.com.

 

Network.

 

Only participants in the Discover Network accept Discover’s general purpose credit cards. Established in 1986, Discover Network is the largest proprietary credit card network in the U.S. GE Money Bank issues two consumer credit cards, the Wal-Mart® Discover® and SAM’S CLUB® Discover® cards on the Discover Network. Discover also has entered into agreements with several other financial institutions to issue cards on the Discover Network. In addition, Discover and China UnionPay have a reciprocal agreement that enables China UnionPay cards to be accepted on the PULSE network in the U.S. and will enable Discover Network cards to be accepted at China UnionPay ATMs and point-of-sale terminals in China by the end of 2006.

 

Discover Network operates the network and acquiring businesses primarily in the U.S., provides customized programs to its merchants in such areas as processing, and otherwise tailors program terms to meet merchant needs. Discover Network utilizes its own national sales and support force, independent sales agents and telemarketing force to maintain and increase its merchant base.

 

Discover’s business also includes PULSE, an ATM/debit and electronic funds transfer network. As of November 30, 2005, PULSE links cardholders of over 4,200 financial institutions and almost 250,000 ATMs and approximately 3.4 million active POS terminals located throughout the U.S. PULSE offers financial institutions of various sizes a full-service debit platform and a complete product set, including signature debit, PIN debit, gift card, stored value card and ATM services.

 

Operations and Information Technology.

 

Discover performs the functions required to service and operate card accounts either by itself or through agreements with unaffiliated third parties. These functions include new account solicitation, application processing, new account fulfillment, transaction authorization and processing, cardmember billing, payment processing, fraud prevention and investigation, cardmember services, collection of delinquent accounts and other activities. Discover maintains several operations centers throughout the U.S. and one in Scotland. Systems at computer centers operated by an unaffiliated services provider also support the operations of Discover.

 

Competition.

 

All aspects of Morgan Stanley’s businesses are highly competitive and Morgan Stanley expects them to remain so. Morgan Stanley competes in the U.S. and globally for clients, market share and human talent in all aspects of its business segments. Morgan Stanley’s competitive position depends on its reputation, the quality of its

 

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products, services and advice. Morgan Stanley’s ability to sustain or improve its competitive position also depends substantially on its ability to continue to attract and retain qualified employees while managing compensation costs.

 

Institutional Securities and Retail Brokerage.

 

Morgan Stanley’s competitive position depends on innovation, execution capability and relative pricing. Morgan Stanley competes directly in the U.S., and globally with other securities and financial services firms, brokers and dealers, and with others on a regional or product basis. Morgan Stanley competes with commercial banks, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the internet.

 

Morgan Stanley’s ability to access capital at competitive rates (which is generally dependent on Morgan Stanley’s credit ratings) and to commit capital efficiently, particularly in its capital-intensive underwriting and sales, trading, financing and market-making activities, also affects its competitive position. Corporate clients continue to request that Morgan Stanley provide loans or lending commitments in connection with certain investment banking activities and Morgan Stanley expects this activity to continue in the future.

 

Over time, certain sectors of the financial services industry have become considerably more concentrated, as financial institutions involved in a broad range of financial services industries have been acquired by or merged into other firms. This convergence could result in Morgan Stanley’s competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. It is possible that competition may become even more intense as Morgan Stanley continues to compete with financial institutions that may be larger, or better capitalized, or may have a stronger local presence and longer operating history in certain areas. Many of these firms have greater capital than Morgan Stanley and have the ability to offer a wide range of products that may enhance their competitive position and could result in pricing pressure in our businesses. The complementary trends in the financial services industry of consolidation and globalization present, among other things, technological, risk management, regulatory and other infrastructure challenges that require effective resource allocation in order for Morgan Stanley to remain competitive.

 

Morgan Stanley has experienced intense price competition in some of its businesses in recent years. In particular, the ability to execute trades electronically through the internet and other alternative trading systems has increased the pressure on trading commissions. The trend toward the use of alternative trading systems will likely continue. It is possible that Morgan Stanley will experience competitive pressures in these and other areas in the future as some of its competitors may seek to obtain market share by reducing prices.

 

Asset Management.

 

Competition in the asset management industry is affected by several factors, including Morgan Stanley’s reputation, investment objectives, quality of investment professionals, performance of investment products relative to peers and an appropriate benchmark index, advertising and sales promotion efforts, fee levels, the effectiveness of and access to distribution channels, and the types and quality of products offered. Morgan Stanley’s products compete with the funds and separately managed account products of other asset management firms and other investment alternatives, including hedge funds.

 

Discover.

 

Discover competes directly with other bank-issued credit cards (the vast majority of which bear the MasterCard or VISA servicemark), charge cards, credit cards issued by travel and financial advisory companies and debit cards. Credit cards that may be issued on the Discover Network by other financial institutions may also compete with credit cards offered by Discover through Discover Bank. Competition centers on merchant acceptance of credit and debit cards, account acquisition and customer utilization of credit and debit cards. Merchant acceptance is based on competitive transaction pricing and the volume and usage of cards in circulation. Credit

 

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card account acquisition and customer utilization are driven by competitive and appealing credit card features, such as no annual fees, low introductory interest rates and other customized features targeting specific consumer groups. Credit card industry participants have increasingly used advertising, targeted marketing, account acquisitions and pricing competition in interest rates, annual fees, reward programs and low-priced balance transfer programs to compete and grow.

 

The Discover Network competes with other card networks, including among others, VISA, MasterCard and American Express. The principal competitive factors that affect the network business include the number of cards in force and amount of spending on these cards, the quantity and quality of places where cards can be used, the economic attractiveness to card issuers and merchants participating in the network, reputation and brand recognition, innovation in systems, technology and product offerings, and quality of customer service.

 

Regulation.

 

Most aspects of Morgan Stanley’s business are subject to stringent regulation by U.S. federal and state regulatory agencies and securities exchanges and by non-U.S. government agencies or regulatory bodies and securities exchanges. Aspects of Morgan Stanley’s public disclosure, corporate governance principles, internal control environment and the roles of auditors and counsel are subject to the Sarbanes-Oxley Act of 2002 and related regulations and rules of the SEC and the NYSE.

 

New laws or regulations or changes to existing laws and regulations (including changes in the interpretation or enforcement thereof) either in the U.S. or elsewhere could materially adversely affect the financial condition or results of operations of Morgan Stanley. As a global financial institution, to the extent that different regulatory regimes impose inconsistent or iterative requirements on the conduct of its business, Morgan Stanley faces complexity and additional costs in its compliance efforts.

 

Consolidated Supervision and Revised Capital Standards.

 

In June 2004, the SEC issued rules that permit certain highly capitalized broker-dealers that are part of a consolidated supervised entity to apply to the SEC for approval to use an alternative method for calculating net capital charges (the “CSE Rules”). To obtain approval to calculate capital under the alternative method in the CSE Rules, a broker-dealer’s holding company must consent, on a voluntary basis, to group-wide supervision and examination by the SEC and must have in place group-wide internal risk management controls and calculate capital in a manner generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). The CSE Rules are intended to reduce regulatory capital costs for qualifying firms by permitting such firms to use proprietary mathematical risk measurement models for regulatory capital computation and internal control purposes.

 

On July 28, 2005, the SEC approved an application by MS&Co., one of Morgan Stanley’s U.S. broker-dealers, for authorization to use, effective December 1, 2005, the alternative method of computing net capital set forth in the CSE Rules. The approval allows MS&Co. to use an alternative method based on mathematical models to calculate net capital charges for market and derivatives-related credit risk.

 

The CSE Rules are also designed to minimize the duplicative regulatory requirements on U.S. securities firms resulting from the European Union (“EU”) Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. Under this directive, financial groups that conduct business through regulated financial entities in the EU must first demonstrate that they are subject to equivalent consolidated supervision at the ultimate holding company level. On November 30, 2005, the U.K. Financial Services Authority determined that the SEC undertakes equivalent consolidated supervision for Morgan Stanley.

 

Morgan Stanley continues to work with its regulators on the implementation of the CSE Rules and Basel II capital standards. As rules related to Basel II are released, Morgan Stanley will consult with regulators on the

 

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new requirements. Compliance with EU requirements (capital, oversight and reporting) will be a focus item through 2008.

 

Anti-Money Laundering.

 

Morgan Stanley’s Anti-Money Laundering (“AML”) Program is coordinated and implemented on an enterprise-wide basis. In the U.S., for example, the USA PATRIOT Act of 2001 (the “PATRIOT Act”) imposes significant obligations to detect and deter money laundering and terrorist financing activity, including requiring banks, broker-dealers and mutual funds to identify and verify customers that maintain accounts. The PATRIOT Act also mandates that certain types of financial institutions report suspicious activity to appropriate law enforcement or regulatory authorities. An institution subject to the PATRIOT Act also must provide employees with AML training, designate an AML compliance officer and undergo an annual, independent audit to assess the effectiveness of its AML Program. Outside the U.S., applicable laws and regulations subject designated types of financial institutions to similar AML requirements. Morgan Stanley has established policies, procedures and internal controls that are designed to comply with these AML requirements.

 

Protection of Client Information.

 

Many aspects of Morgan Stanley’s business are subject to increasingly comprehensive legal requirements concerning the use and protection of certain client information including those adopted pursuant to the Gramm-Leach-Bliley Act of 1999 and the Fair and Accurate Credit Transactions Act of 2003 in the U.S., the European Union Data Protection Directive in the EU and various laws in Asia, including the Japanese Personal Information (Protection) Law, the Hong Kong Personal Data (Protection) Ordinance and the Australian Privacy Act. Morgan Stanley has adopted measures in response to such requirements.

 

Institutional Securities and Retail Brokerage.

 

Broker-Dealer Regulation.    MS&Co. and MSDWI are registered as broker-dealers with the SEC and in all 50 states, the District of Columbia and Puerto Rico, and are members of self-regulatory organizations, including the National Association of Securities Dealers, Inc. (the “NASD”) and securities exchanges, including the NYSE. Broker-dealers are subject to laws and regulations covering all aspects of the securities business, including sales and trading practices, public offerings, publication of research reports, use of customers’ funds and securities, capital structure, record-keeping and retention, and the conduct of their directors, officers, employees and other associated persons. Broker-dealers are also regulated by securities administrators in those states where they do business. Violations of the laws and regulations governing a broker-dealer’s actions could result in censures, fines, the issuance of cease-and-desist orders, revocation of licenses or registrations, the suspension or expulsion from the securities industry of such broker-dealer or its officers or employees, or other similar consequences by both federal and state securities administrators.

 

Margin lending by broker-dealer subsidiaries is regulated by the Federal Reserve Board’s restrictions on lending in connection with customer and proprietary purchases and short sales of securities, as well as securities borrowing and lending activities. Such subsidiaries are also required by NASD and NYSE rules to impose maintenance requirements on the value of securities contained in margin accounts. In many cases, Morgan Stanley’s margin policies are more stringent than these rules.

 

Morgan Stanley conducts some of its government securities activities through Morgan Stanley Market Products Inc., an NASD member registered as a government securities broker-dealer with the SEC and in certain states. The Department of Treasury has promulgated regulations concerning, among other things, capital adequacy, custody and use of government securities and transfers and control of government securities subject to repurchase transactions. The rules of the Municipal Securities Rulemaking Board, which are enforced by the NASD, govern the municipal securities activities of Morgan Stanley.

 

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As registered U.S. broker-dealers, certain subsidiaries of Morgan Stanley, including MS&Co. and MSDWI, are subject to the SEC’s net capital rule and the net capital requirements of various securities exchanges. Many non-U.S. securities exchanges and regulatory authorities either have imposed or are proposing rules relating to capital requirements applicable to Morgan Stanley’s non-U.S. broker-dealer subsidiaries. These rules, which specify minimum capital requirements, are generally designed to measure general financial integrity and liquidity and require that at least a minimum amount of net assets be kept in relatively liquid form. See also “Consolidated Supervision and Revised Capital Standards” above and Note 13 in “Notes to Consolidated Financial Statements” in Part II, Item 8. Rules of the NASD, NYSE, Chicago Mercantile Exchange and Chicago Board of Trade also impose limitations on the transfer of a broker-dealer’s assets.

 

Compliance with the capital requirements may limit Morgan Stanley’s operations requiring the intensive use of capital. Such requirements restrict Morgan Stanley’s ability to withdraw capital from its broker-dealer subsidiaries, which in turn may limit its ability to pay dividends, repay debt or redeem or purchase shares of its own outstanding stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect Morgan Stanley’s ability to pay dividends or to expand or maintain present business levels. In addition, such rules may require Morgan Stanley to make substantial capital infusions into one or more of its broker-dealer subsidiaries in order for such subsidiaries to comply with such rules, either in the form of cash or subordinated loans made in accordance with the requirements of the SEC’s net capital rule.

 

Regulation of Power Generation and Energy Trading Activities.    Morgan Stanley conducts certain power generation and energy trading activities through Morgan Stanley Capital Group Inc. and/or entities in which Morgan Stanley is the sole or majority shareholder. These activities are subject to extensive and evolving energy, environmental and other governmental laws and regulations in the U.S. and abroad. In the past several years, intensified scrutiny of the energy markets by U.S. federal, state and local authorities in the U.S. and abroad and the public has resulted in increased regulatory and legal enforcement and remedial proceedings involving energy companies, including those engaged in power generation and liquid hydrocarbons trading. The European Union has increased its focus on the energy markets which has resulted in increased regulation of companies participating in the energy markets, including those engaged in power generation and liquid hydrocarbons trading.

 

Additional Regulation of U.S. Entities.    As registered futures commission merchants, MS&Co. and MSDWI are subject to the net capital requirements of, and their activities are regulated by, the Commodity Futures Trading Commission (the “CFTC”) and various commodity exchanges. Certain subsidiaries of Morgan Stanley are registered with the CFTC as commodity trading advisors and/or commodity pool operators. Morgan Stanley’s futures and options-on-futures businesses are also regulated by the National Futures Association (the “NFA”), a registered futures association, of which MS&Co. and MSDWI and certain of their affiliates are members. Violations of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration restrictions or terminations, trading prohibitions or revocations of commodity exchange memberships.

 

Morgan Stanley Bank, through which Morgan Stanley conducts certain financing and lending activities, is an industrial bank chartered under the laws of the State of Utah. It has deposits that are eligible for insurance by the Federal Deposit Insurance Corporation (“FDIC”) in accordance with FDIC rules and is subject to comprehensive regulation and periodic examination by the Utah Department of Financial Institutions and the FDIC. Morgan Stanley Bank is not considered a “bank” under the Bank Holding Company Act of 1956, as amended (the “BHCA”). See also “Discover” below.

 

Morgan Stanley Trust National Association, a wholly-owned subsidiary, is a federally chartered national bank whose activities are limited to fiduciary activities, primarily personal trust services. It is subject to comprehensive regulation and periodic examination by the Office of the Comptroller of the Currency. Morgan Stanley Trust National Association is not FDIC-insured and is not considered a “bank” for purposes of the BHCA.

 

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Non-U.S. Regulation.    Morgan Stanley’s securities and futures businesses are also regulated extensively by non-U.S. regulators, including governments, securities exchanges, commodity exchanges, self-regulatory organizations, central banks and regulatory bodies, especially in those jurisdictions in which Morgan Stanley maintains an office. Certain Morgan Stanley subsidiaries are regulated as broker dealers under the laws of the jurisdictions in which they operate. Subsidiaries engaged in banking and trust activities outside the U.S. are regulated by various government agencies in the particular jurisdiction where they are chartered, incorporated and/or conduct their business activity. For instance, the Financial Services Authority, the London Stock Exchange and Euronext.liffe regulate the Company’s activities in the U.K.; the Deutsche Borse AG and the Bundesanstalt für Finanzdienstleistungsaufsicht (the Federal Financial Supervisory Authority) regulate its activities in the Federal Republic of Germany; The Swiss Federal Banking Commission regulates its activities in Switzerland; the Comisión Nacional del Mercado del Valores (C.N.M.V.) regulates its activities in Spain; the Financial Services Agency, the Bank of Japan, the Japanese Securities Dealers Association and several Japanese securities and futures exchanges, including the Tokyo Stock Exchange, the Osaka Securities Exchange and the Tokyo International Financial Futures Exchange, regulate its activities in Japan; the Hong Kong Securities and Futures Commission, the Stock Exchange of Hong Kong Limited and the Hong Kong Futures Exchange Limited regulate its operations in Hong Kong; and the Monetary Authority of Singapore and the Singapore Exchange Securities Trading Limited regulate its business in Singapore. See also “Regulation of Power Generation and Energy Trading Activities” above.

 

The EU’s European Markets in Financial Instruments Directive (Directive 2004/39/EC) will affect several of our subsidiaries by imposing detailed pan-European requirements in areas such as internal organization (including conflict management), best execution, real-time disclosure of completed transactions in shares, quoting obligations for internalized client orders in shares, transaction reporting to regulators, client documentation and regulation of investment services related to commodity derivatives. The practical consequences of some of these changes on the European markets are still unclear.

 

Research.    Both U.S. and non-U.S. regulators continue to focus on research conflicts of interest. Research-related regulations have been implemented in many jurisdictions and are proposed or under consideration in other jurisdictions. New and revised requirements resulting from these regulations and the global research settlement with U.S. Federal and state regulators (to which Morgan Stanley is a party) have necessitated the development or enhancement of corresponding policies and procedures.

 

Asset Management.

 

The majority of subsidiaries related to Morgan Stanley’s asset management activities and others, including MS&Co. and MSDWI, are registered as investment advisers with the SEC, and, in certain states, some employees or representatives of subsidiaries are registered as investment adviser representatives. Many aspects of Morgan Stanley’s asset management activities are subject to federal and state laws and regulations primarily intended to benefit the investor or client. These laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict Morgan Stanley from carrying on its asset management activities in the event that it fails to comply with such laws and regulations. Sanctions that may be imposed for such failure include the suspension of individual employees, limitations on Morgan Stanley engaging in various asset management activities for specified periods of time, the revocation of registrations, other censures and fines. The SEC has also recently adopted numerous rules and requirements relating to the operation of the asset management business.

 

Morgan Stanley’s Asset Management business is also regulated outside the U.S. For example, the Financial Services Authority regulates Morgan Stanley’s business in the U.K.; the Financial Services Agency regulates Morgan Stanley’s business in Japan; the Securities and Exchange Board of India regulates Morgan Stanley’s business in India; and the Monetary Authority of Singapore regulates Morgan Stanley’s business in Singapore.

 

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Morgan Stanley Trust, a wholly-owned subsidiary, is a federally chartered savings bank subject to comprehensive regulation and periodic examination by the Office of Thrift Supervision (“OTS”). As a result of its ownership of Morgan Stanley Trust, Morgan Stanley is registered with the OTS as a unitary savings and loan holding company (“SLHC”) and subject to regulation and examination by the OTS as a SLHC. Subsidiaries of Morgan Stanley, including Morgan Stanley Trust, are registered transfer agents subject to regulation and examination by the SEC.

 

Discover.

 

Morgan Stanley conducts substantial portions of its Discover business in the U.S. through its wholly-owned indirect subsidiary, Discover Bank, a Delaware chartered state bank. Discover Bank’s deposits are eligible for insurance by the FDIC in accordance with FDIC rules and is subject to comprehensive regulation and periodic examination by the Office of the Delaware Bank Commissioner and by the FDIC.

 

Generally, a company that controls a “bank,” as defined in the BHCA, is required to register as a bank holding company and is regulated as a bank holding company by the Board of Governors of the Federal Reserve System. Discover Bank is considered a “bank” under the BHCA; however, under the BHCA, Morgan Stanley’s control of Discover Bank is grandfathered and Morgan Stanley is generally not treated as a bank holding company for purposes of the BHCA as long as Discover Bank refrains from either engaging in commercial lending or taking demand deposits.

 

Federal and state consumer protection laws and regulations regulate extensively the relationships among cardholders and credit card issuers. Under federal law, Discover Bank may charge interest at the rate allowed by Delaware law, the state in which it is located, and export such interest rate to all other states. Delaware law does not limit the amount of interest that may be charged on loans of the type offered by Discover Bank. Federal and state bankruptcy laws, debtor relief laws and bank regulatory guidance may have a financial impact on Discover to the extent such laws or guidance result in any loans being charged off as uncollectible.

 

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the federal bank regulatory agencies are required to take “prompt corrective action” in respect of banks that do not meet minimum capital requirements, and certain restrictions are imposed upon banks that meet certain capital requirements but are not “well capitalized” for purposes of FDICIA. A bank that is not well capitalized, as defined for purposes of FDICIA, is, among other consequences, generally prohibited from accepting brokered deposits and offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited). Discover Bank and Morgan Stanley Bank currently use brokered deposits as a funding source and, if they were not able to do so, their funding costs could be impacted.

 

Morgan Stanley conducts its U.K. credit card and personal loan business through Morgan Stanley Bank International Limited, Morgan Stanley’s chartered bank in the U.K., which is subject to regulation related to capital adequacy, consumer protection and deposit protection. The bank is governed primarily by the U.K.’s Financial Services and Markets Act 2000 and its activities are supervised by the Financial Services Authority and by the Office of Fair Trading in relation to its consumer credit activities.

 

Executive Officers of Morgan Stanley.

 

The executive officers of Morgan Stanley (all of whom are members of Morgan Stanley’s Management Committee) and their ages and titles as of February 13, 2006 are set forth below. Business experience for the past five years is provided in accordance with SEC rules.

 

John J. Mack (61).    Chairman of the Board of Directors and Chief Executive Officer (since June 2005). Chairman of Pequot Capital Management (June 2005). Co-Chief Executive Officer of Credit Suisse Group (January 2003 to June 2004). President, Chief Executive Officer and Director of Credit Suisse First Boston (July 2001 to June 2004). President and Chief Operating Officer of Morgan Stanley (May 1997 to March 2001).

 

Walid A. Chammah (51).    Head of Investment Banking (since August 2005). Head of Global Capital Markets (July 2002 to August 2005). Head of Fixed Income Capital Markets Services (March 1996 to June 2002).

 

Jonathan Chenevix-Trench (44).    Chairman of Morgan Stanley International Limited (since January 2006). Chairman of European Management Committee (since March 2005). Head of the Interest Rate and Currency Group (December 2000 to March 2005). Head of Fixed Income in Europe (January 1999 to March 2005).

 

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Zoe Cruz (51).    Co-President (since February 2006 and March 2005 to July 2005). Acting President (July 2005 to February 2006). Director (March 2005 to June 2005). Head of Fixed Income Division (September 2000 to March 2005).

 

Thomas V. Daula (53).    Chief Risk Officer (since April 2005). Head of Market Risk Department (since January 2002). Managing Director of MS&Co. (since December 2001). Executive Director of MS&Co. (October 1999 to December 2001).

 

Raymond Harris (49).*    Acting President and Chief Operating Officer of Retail Brokerage (since July 2005). Head of Client Solutions for Retail Brokerage (December 2003 to July 2005). Head of Investment Management Global Products and Services (July 2000 to December 2003). Chief Administrative Officer of Asset Management (January 1999 to July 2000).

 

David W. Heleniak (60).    Vice Chairman (since May 2005). Senior partner and head of the law firm of Shearman & Sterling (June 2001 to May 2005). Partner at the law firm of Shearman & Sterling (July 1981 to June 2001).

 

Roger C. Hochschild (41).    President and Chief Operating Officer of Discover Financial Services (since January 2004). Executive Vice President and Chief Strategic and Administrative Officer (March 2001 to January 2004). Executive Vice President of Discover Financial Services (November 1998 to February 2001).

 

Jerker M. Johansson (49).    Co-Head of Institutional Sales and Trading (since August 2005) and Head of Worldwide Institutional Equities Division (since April 2005). Head of European Equities (January 2002 to April 2005). Chief Operating Officer of European Institutional Equity Division (September 1997 to January 2002).

 

Gary G. Lynch (55).    Chief Legal Officer (since October 2005). Global General Counsel (October 2001 to October 2005) of Credit Suisse First Boston. Vice Chairman (December 2002 to July 2004) and Executive Vice Chairman (July 2004 to October 2005) of Credit Suisse First Boston. Partner at the law firm of Davis Polk & Wardwell (September 1989 to October 2001).

 

Alasdair Morrison (57).    Chairman and Chief Executive Officer of Morgan Stanley Asia and Chairman of Asia Executive Committee (since October 2003). Chairman and CEO of Morgan Stanley Asia Pacific (excluding Japan) (December 2001 to October 2003). Chairman of Morgan Stanley Asia Pacific (September 2000 to December 2001).

 

Eileen Murray (47).    Head of Global Operations and Technology (since October 2005). Head of Global Technology and Operations of Credit Suisse First Boston (February 2002 to October 2005). Chief Administrative Officer of Institutional Securities of Morgan Stanley (March 1999 to February 2002).

 

David W. Nelms (44).    Chairman and Chief Executive Officer of Discover Financial Services (since January 2004). President and Chief Operating Officer of Discover Financial Services (September 1998 to January 2004).

 

Thomas R. Nides (44).    Chief Administrative Officer (since September 2005). Worldwide President and CEO of Burson-Marsteller (November 2004 to August 2005). Chief Administrative Officer of Credit Suisse First Boston (June 2001 to June 2004). Senior Vice President of Fannie Mae (June 1998 to April 2001).

 

Robert W. Scully (56).    Co-President (since February 2006). Chairman of Global Capital Markets (December 2004 to February 2006) and Vice Chairman of Investment Banking (September 1999 to February 2006).

 

Neal A. Shear (51).    Co-Head of Institutional Sales and Trading (since August 2005) and Head of Worldwide Fixed Income Division (since April 2005). Head of Commodities (January 1987 to April 2005).

 


* On August 16, 2005, Morgan Stanley announced that James P. Gorman would become President and Chief Operating Officer of Retail Brokerage. Mr. Gorman (47) will join Morgan Stanley in mid-February 2006. Mr. Gorman was previously employed by Merrill Lynch & Co., Inc. (“Merrill Lynch”) where he was Executive Vice President and Head of Acquisitions, Strategy and Research. Mr. Gorman joined Merrill Lynch in 1999 as Chief Marketing Officer. In 2000, he was named head of Merrill Lynch’s brokerage business. In 2001, he become President of the U.S. private client business and in 2002 was named President of the private client business worldwide.

 

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David H. Sidwell (52).    Executive Vice President and Chief Financial Officer (since March 2004). Chief Financial Officer of the investment bank of J.P. Morgan Chase & Co. (December 2000 to March 2004). Controller of J.P. Morgan & Co. Incorporated (April 1994 to January 2001).

 

Cordell G. Spencer (42).    Deputy Head of Worldwide Investment Banking (since August 2005). Co-Head of Investment Banking (April 2005 to August 2005). Deputy Head of Investment Banking (April 2002 to April 2005). Managing Director of Morgan Stanley & Co. Incorporated (since 1998).

 

Owen D. Thomas (44).    President and Chief Operating Officer of Investment Management and Chairman of Morgan Stanley Real Estate (since December 2005). Acting President and Chief Operating Officer of Investment Management (September 2005 to December 2005). Head of Morgan Stanley Real Estate (July 2000 to December 2005).

 

Item 1A. Risk Factors.

 

Our results of operations may be materially affected by market fluctuations and by economic and other factors.

 

Our results of operations may be materially affected by market fluctuations and by economic and other factors. Results of operations in the past have been, and in the future may continue to be, materially affected by many factors of a global nature, including political, economic and market conditions; the availability and cost of capital; the level and volatility of equity prices, commodity prices and interest rates; currency values and other market indices; technological changes and events; the availability and cost of credit; inflation; and investor sentiment and confidence in the financial markets. In addition, there have been legislative, legal and regulatory developments related to our businesses that potentially could increase costs, thereby affecting future results of operations. These factors also may have an impact on our ability to achieve our strategic objectives.

 

The results of our Institutional Securities business, particularly results relating to our involvement in primary and secondary markets for all types of financial products, are subject to substantial fluctuations due to a variety of factors that we cannot control or predict with great certainty, including variations in the fair value of securities and other financial products and the volatility and liquidity of global markets. Fluctuations also occur due to the level of global market activity, which, among other things, affects the size, number, and timing of investment banking client assignments and transactions and the realization of returns from our principal investments.

 

During periods of unfavorable market or economic conditions, the level of individual investor participation in the global markets may also decrease, which would negatively impact the results of our Retail Brokerage business. In addition, fluctuations in global market activity could impact the flow of investment capital into or from assets under management and supervision and the way customers allocate capital among money market, equity, fixed income or other investment alternatives, which could negatively impact our Asset Management business. Furthermore, changes in economic variables, such as the number and size of personal bankruptcy filings, the rate of unemployment, and the level of consumer confidence and consumer debt, may substantially affect consumer loan levels and credit quality, which, in turn, could impact the results of our Discover business.

 

Liquidity is essential to our businesses and we rely on external sources to finance a significant portion of our operations.

 

General.    Liquidity is essential to our businesses. Our liquidity could be substantially negatively affected by an inability to raise funding in the long-term or short-term debt capital markets or an inability to access the secured lending markets. Factors that we cannot control, such as disruption of the financial markets or negative views about the financial services industry generally, could impair our ability to raise funding. In addition, our ability to raise funding could be impaired if lenders develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could be developed if we incur large trading losses, we suffer a decline in the level of our business activity, regulatory authorities take significant action against us, or we discover serious employee misconduct or illegal activity, among other reasons. If we are unable to raise funding using the

 

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methods described above, we would likely need to liquidate unencumbered assets, such as our investment and trading portfolios, to meet maturing liabilities. We may be unable to sell some of our assets, or we may have to sell assets at a discount from market value, either of which could adversely affect our results of operations.

 

Credit Ratings.    The cost and availability of unsecured financing generally are dependent on our short-term and long-term credit ratings. Factors that are significant to the determination of our credit ratings or otherwise affect our ability to raise short-term and long-term financing include the level and volatility of our earnings; our relative competitive position in the markets in which we operate; our geographic and product diversification; our ability to retain key personnel; our risk management policies; our cash liquidity; our capital adequacy; our corporate lending credit risk; and legal and regulatory developments. A deterioration in any of these factors or combination of these factors may lead rating agencies to downgrade our credit ratings, thereby increasing our cost of obtaining unsecured funding.

 

Our debt ratings also can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as OTC derivative transactions, including credit derivatives and interest rate swaps. In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business, we would be required to provide additional collateral to certain counterparties in the event of a downgrade by either Moody’s Investors Service or Standard & Poor’s.

 

Payments From Subsidiaries.    We depend on dividends, distributions and other payments from our subsidiaries to fund dividend payments and to fund all payments on our obligations, including debt obligations. Regulatory and other legal restrictions may limit our ability to transfer funds freely, either to or from our subsidiaries. In particular, many of our subsidiaries, including our broker-dealer subsidiaries, are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to the parent holding company, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations.

 

Liquidity and Funding Policies.    Our liquidity and funding policies have been designed to ensure that we maintain sufficient liquid financial resources to continue to conduct our business for an extended period in a stressed liquidity environment. If our liquidity and funding policies are not adequate, we may be unable to access sufficient financing to service our financial obligations when they come due, which could have a material adverse franchise or business impact. See “Management’s Discussion and Analysis of Results of Operations—Liquidity and Capital Resources” in Part II, Item 7 for a discussion of how we monitor and manage liquidity risk.

 

We are exposed to the risk that third parties that are indebted to us will not perform their obligations.

 

Credit risk refers to the risk of loss arising from the default by a borrower, counterparty or other obligor when it is unable or unwilling to meet its obligations to us. We are exposed to three distinct types of credit risk in our businesses. We incur significant, “single-name” credit risk exposure through the Institutional Securities business. This risk may arise, for example, from entering into swap or other derivative contracts under which counterparties have long-term obligations to make payments to us and by extending credit to our clients through various credit arrangements. We incur “individual consumer” credit risk in the Retail Brokerage business through margin loans to individual investors and loans to small businesses, both of which are generally collateralized. We incur “consumer portfolio” credit risk in the Discover business primarily through cardholder receivables. Credit risk in a pool of cardholder receivables is generally highly diversified, without significant individual exposures, and, accordingly, is managed on a portfolio and not a single-name basis.

 

The amount, duration and range of our credit exposures have been increasing over the past several years, and may continue to do so. In recent years, we have significantly expanded our use of swaps and other derivatives and we may continue to do so. Corporate clients are increasingly seeking loans or lending commitments from us in connection with investment banking and other assignments. In addition, we have experienced, due to competitive factors, increased pressure to assume longer-term credit risk, to extend credit against less liquid collateral and to price derivatives instruments more aggressively based on the credit risks that we take. As a

 

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clearing member firm, we finance our customer positions and we could be held responsible for the defaults or misconduct of our customers. Although we regularly review our credit exposures, default risk may arise from events or circumstances that are difficult to detect or foresee. For more information regarding our credit risk, see “Credit Risk” in Part II, Item 7A below.

 

We face strong competition from other financial services firms, which could lead to pricing pressures that could materially adversely affect our revenue and profitability.

 

The financial services industry, and all of our businesses, are intensely competitive, and we expect them to remain so. We compete with commercial banks, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the internet. We compete on the basis of several factors, including transaction execution, capital or access to capital, products and services, innovation, reputation and price. Over time, certain sectors of the financial services industry have become considerably more concentrated, as financial institutions involved in a broad range of financial services have been acquired by or merged into other firms. This convergence could result in our competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. We may experience pricing pressures as a result of these factors and as some of our competitors seek to increase market share by reducing prices. For more information regarding the competitive environment in which we operate, see “Competition” in Part I, Item 1 above.

 

Our ability to retain and attract qualified employees is critical to the success of our business and the failure to do so may materially adversely affect our performance.

 

Our people are our most important resource and competition for qualified employees is intense. In order to attract and retain qualified employees, we must compensate such employees at market levels. Typically, those levels have caused employee compensation to be our greatest expense as compensation is highly variable and moves with performance. If we are unable to continue to attract and retain qualified employees, or if compensation costs required to attract and retain employees become more expensive, our performance, including our competitive position, could be materially adversely affected.

 

We are subject to extensive regulation in the jurisdictions in which we conduct our businesses.

 

We are subject to extensive regulation globally and face the risk of significant intervention by regulatory authorities in the jurisdictions in which we conduct our businesses. Among other things, we could be fined, prohibited from engaging in some of our business activities or subject to limitations or conditions on our business activities. Significant regulatory action against us could have material adverse financial effects, cause significant reputational harm to us, or harm our business prospects. New laws or regulations or changes in the enforcement of existing laws or regulations applicable to our clients may also adversely affect our business. For more information regarding the regulatory environment in which we operate, see “Regulation” in Part I, Item 1 above.

 

The financial services industry faces substantial litigation and regulatory risks, and we may face damage to our reputation and legal liability.

 

We have been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions, and other litigation, arising in connection with our activities as a global diversified financial services institution. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

We are also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding our business, including, among other things, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including us. We are also subject to risk from

 

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potential employee misconduct, including non-compliance with policies and improper use or disclosure of confidential information. Substantial legal liability or significant regulatory action against us could materially adversely affect our business, financial condition or results of operations or cause us significant reputational harm, which could seriously harm our business. For more information regarding legal proceedings in which we are involved and in particular, the Coleman Litigation, see “Legal Proceedings” in Part I, Item 3 below.

 

Conflicts of interest are increasing and a failure to appropriately deal with conflicts of interest could adversely affect our businesses.

 

Our reputation is one of our most important assets. As we have expanded the scope of our businesses and our client base, we increasingly have to address potential conflicts of interest, including those relating to our proprietary activities. For example, conflicts may arise between our position as a financial advisor in a merger transaction and a principal investment we hold in one of the parties to the transaction. In addition, hedge funds and private equity funds are an increasingly important portion of our client base, and also compete with us in a number of our businesses. We have procedures and controls that are designed to address conflicts of interest. However, appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with conflicts of interest. In addition, the SEC and other federal and state regulators have increased their scrutiny of potential conflicts of interest. It is possible that potential or perceived conflicts could give rise to litigation or enforcement actions. It is possible that the regulatory scrutiny of, and litigation in connection with, conflicts of interest will make our clients less willing to enter into transactions in which such a conflict may occur, and will adversely affect our businesses.

 

We are subject to tax contingencies that could adversely affect reserves.

 

We are subject to the income tax laws of the U.S., its states and municipalities and those of the foreign jurisdictions in which we have significant business operations. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. We must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes and must also make estimates about when in the future certain items affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be settled with the taxing authority upon examination or audit.

 

We are subject to operational risk and an operational failure could materially adversely affect our businesses.

 

Operational risk refers to the risk of loss arising from inadequate or failed internal processes, people and/or systems. Operational Risk also refers to the risk that external events, such as external changes (e.g., natural disasters, terrorist attacks and/or health epidemics), failures or frauds, will result in losses to our businesses. We incur operational risk across all of our business activities, including revenue generating activities (e.g., such as sales and trading) and support functions (e.g., information technology and facilities management).

 

Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies and the transactions we process have become increasingly complex. We perform the functions required to operate our different businesses either by ourselves or through agreements with third parties. We rely on the ability of our employees, our internal systems and systems at technology centers operated by third parties to process high numbers of transactions. We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions. In the event of a breakdown or improper operation of our or third-party’s systems or improper action by third parties or employees, we could suffer financial loss, an impairment to our liquidity, a disruption of our businesses, regulatory sanctions and damage to our reputation. For more information regarding operational risk, see “Operational Risk” in Part II, Section 7A below.

 

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Our commodities activities subject us to extensive regulation, potential catastrophic events and environmental risks and regulation.

 

In connection with the commodities activities in our Institutional Securities business, we engage in the production, storage, transportation, marketing and trading of power, natural gas and petroleum. In addition, we are the sole shareholder of wholesale electrical generators. As a result of these activities, we are subject to extensive and evolving energy, environmental, safety and other governmental laws and regulations. Our commodities business also exposes us to the risk of unforeseen and catastrophic events, including leaks, spills and terrorist attacks.

 

The power generation facilities in which we are the sole shareholder are subject to wide-ranging U.S. federal, state and local environmental laws and regulations in the U.S. and abroad relating to air quality, water quality and hazardous and solid waste management. They also are regulated under U.S. health and safety regulations. These laws may require capital expenditures as well as remediation where the facility has failed to comply with environmental, health or safety rules or has released pollutants into the environment. Additionally, the owners of such facilities may be subject to fines or penalties for failure to comply with environmental, health or safety rules.

 

The U.S. water pollution laws and numerous specific oil spill anti-pollution statutes apply to our oil trading activities to the extent we own petroleum in storage or during waterborne or overland transit or we arrange for transportation or storage. In the event of an oil spill, one or more entities we own could be held responsible for remediation as well as property and natural resource damages. Other U.S. federal and state laws apply to the specifications of the gasoline and diesel fuel that we blend and import and provide for substantial penalties in the event of non-compliance.

 

Oil pollution laws in non-U.S. jurisdictions also apply to us in certain instances when we trade petroleum internationally and/or charter vessels. Like the U.S. statutes, these laws often provide for penalties and damage assessments should a spill event occur.

 

Although we have attempted to mitigate our pollution and other environmental risks by, among other measures, adopting appropriate policies and procedures for power plant operations, monitoring the quality of petroleum storage facilities and transport vessels and implementing emergency response programs, these actions may not prove adequate to address every contingency. In addition, insurance covering some of these risks may not be available, and the proceeds from insurance recovery, if any, may not be adequate to cover liabilities with respect to particular incidents. As a result, our financial condition and results of operations may be adversely affected by these events.

 

We also expect the other laws and regulations affecting our energy business to increase in both scope and complexity. During the past several years, intensified scrutiny of the energy markets by federal, state and local authorities in the U.S. and abroad and the public has resulted in increased regulatory and legal enforcement, litigation and remedial proceedings involving companies engaged in the activities in which we are engaged. We may incur substantial costs in complying with current or future laws and regulations and our overall businesses and reputation may be adversely affected by the current legal environment.

 

We are subject to numerous political, economic, legal, operational and other risks as a result of our international operations which could adversely impact our businesses in many ways.

 

We are subject to political, economic, legal, operational and other risks that are inherent in operating in many countries, including risks of possible nationalization, expropriation, price controls, capital controls, exchange controls and other restrictive governmental actions, as well as the outbreak of hostilities. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market. Our inability to remain in compliance with local laws in a particular market could have a significant and negative effect not only

 

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on our businesses in that market but also on our reputation generally. We are also subject to the enhanced risk that transactions we structure might not be legally enforceable in all cases.

 

In the last several years, various emerging market countries have experienced severe economic and financial disruptions, including significant devaluations of their currencies, capital and currency exchange controls, and low or negative growth rates in their economies. These conditions could adversely impact our businesses and increase volatility in financial markets generally.

 

The emergence of a pandemic or other widespread health emergency, or concerns over the possibility of such an emergency, could create economic and financial disruptions in emerging markets and other areas throughout the world, and could lead to operational difficulties (including travel limitations) that could impair our ability to manage our businesses around the world.

 

We may be unable to fully integrate future acquisitions or joint ventures into our businesses and systems.

 

We expect to grow in part through acquisitions and joint ventures. To the extent we make acquisitions or enter into combinations or joint ventures, we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls and to integrate relationships with clients and business partners. In the case of joint ventures, we are subject to additional risks and uncertainties in that we may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that are not under our control. In addition, conflicts or disagreements between us and our joint venture partners may negatively impact the benefits to be achieved by the joint venture.

 

Our Discover business subjects us to risks that impact the credit card industry.

 

The performance of our Discover business is subject to numerous risks that impact the credit card industry, including rising cost of funds pressuring spreads; slow industry growth with rising payment rates; future loan loss rate uncertainty, especially given bankruptcy reform and changing minimum payment requirements; and a consolidating industry with competitive pressures and increasing marketing constraints. Changes in economic variables, such as the number and size of personal bankruptcy filings, the rate of unemployment and the level of consumer confidence and consumer debt may substantially affect consumer loan levels and credit quality. Our financial condition and results of operations may be adversely affected by these factors.

 

Item 1B. Unresolved Staff Comments.

 

Morgan Stanley, like other well-known seasoned issuers, from time to time receives written comments from the staff of the SEC regarding its periodic or current reports under the Exchange Act. There are no comments that remain unresolved that Morgan Stanley received not less than 180 days before the end of its fiscal year to which this report relates.

 

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Item 2. Properties.

 

Morgan Stanley has offices, operations and processing centers and warehouse facilities located throughout the U.S., and certain subsidiaries maintain offices and other facilities in international locations. Morgan Stanley’s properties that are not owned are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. Morgan Stanley believes the facilities it owns or occupies are adequate for the purposes for which they are currently used and are well maintained. Our principal offices consist of the following properties:

 

Location

  Owned/Leased   Lease Expiration   Approximate Square Footage
as of November 30, 2005*

U.S. Locations

           

1585 Broadway

New York, New York

(Executive Office)

  Owned   N/A   925,000 square feet

2000 Westchester Avenue

Purchase, New York

Westchester County, New York

(Retail Brokerage Headquarters)

  Owned   N/A   748,000 square feet

2500 Lake Cook Road

Riverwoods, Illinois

(Discover Executive Office)

  Owned   N/A   1,200,000 square feet
New York, New York   Leased   2006 – 2014   2,400,000 square feet
Brooklyn, New York   Leased   2013   420,000 square feet
Jersey City, New Jersey   Leased   2008 – 2013   440,000 square feet
International Locations            

25 Cabot Square, Canary Wharf

(London Headquarters)

  Owned**   N/A   450,000 square feet
Canary Wharf   Leased   2006 – 2028   1,170,000 square feet

Sapporo’s Yebisu Garden Place,
Ebisu, Shibuya-ku

(Tokyo Headquarters)

  Leased   Option to cancel in 2006,
or at any time thereafter
  280,000 square feet

 


* The indicated total aggregate square footage leased does not include space occupied by Morgan Stanley securities branch offices.
** Morgan Stanley holds the freehold interest in the land and building.

 

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Item 3. Legal Proceedings.

 

In addition to the matters described below, in the normal course of business, Morgan Stanley has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions, and other litigation, arising in connection with its activities as a global diversified financial services institution. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

Morgan Stanley is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding Morgan Stanley’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these reviews, investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including Morgan Stanley.

 

Morgan Stanley contests liability and/or the amount of damages in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Morgan Stanley cannot predict with certainty the loss or range of loss, if any, related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief, if any, might be. Subject to the foregoing, and except for the pending matters described in Note 9 in “Notes to Consolidated Financial Statements” in Part II, Item 8, Morgan Stanley believes, based on current knowledge and after consultation with counsel, that the outcome of the pending matters will not have a material adverse effect on the consolidated financial condition of Morgan Stanley, although the outcome of such matters could be material to Morgan Stanley’s operating results for a particular future period, depending on, among other things, the level of Morgan Stanley’s revenues or income for such period.

 

Coleman Litigation.

 

On May 8, 2003, Coleman (Parent) Holdings Inc. (“CPH”) filed a complaint against Morgan Stanley in the Circuit Court of the Fifteenth Judicial Circuit for Palm Beach County. The complaint relates to the merger between The Coleman Company, Inc. (“Coleman”) and Sunbeam, Inc. (“Sunbeam”) in 1998. The complaint, as amended, alleges that CPH was induced to agree to the transaction with Sunbeam based on certain financial misrepresentations, and it asserts claims against Morgan Stanley for aiding and abetting fraud, conspiracy and punitive damages. Shortly before trial, which commenced in April 2005, the trial court granted, in part, a motion for entry of a default judgment against Morgan Stanley and ordered that portions of CPH’s complaint, including those setting forth CPH’s primary allegations against Morgan Stanley, be read to the jury and deemed established for all purposes in the action. In May 2005, the jury returned a verdict in favor of CPH and awarded CPH $604 million in compensatory damages and $850 million in punitive damages. On June 23, 2005, the trial court issued a final judgment in favor of CPH in the amount of $1,578 million, which includes prejudgment interest and excludes certain payments received by CPH in settlement of related claims against others.

 

On June 27, 2005, Morgan Stanley filed a notice of appeal with the District Court of Appeal for the Fourth District of Florida and posted a supersedeas bond, which automatically stayed execution of the judgment pending appeal. Morgan Stanley filed its initial brief in support of its appeal on December 7, 2005. Morgan Stanley’s appeal seeks to reverse the judgment of the trial court on several grounds and asks that the case be remanded for entry of a judgment in favor of Morgan Stanley or, in the alternative, for a new trial.

 

IPO Fee Litigation.

 

Starting in late 1998, purported class actions, later captioned In re Public Offering Fee Antitrust Litigation and In re Issuer Plaintiff Initial Public Offering Fee Antitrust Litigation, were initiated in the U.S. District Court for the

 

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Southern District of New York (the “SDNY”) against Morgan Stanley and numerous other underwriters. The consolidated proceedings, one on behalf of purchasers and the other on behalf of issuers of certain shares in initial public offerings (“IPOs”), allege that defendants conspired to fix the underwriters’ spread at 7% in IPOs of U.S. companies in the $20 million to $80 million range, in violation of Section 1 of the Sherman Act. The complaints seek treble damages and injunctive relief. Plaintiffs’ claims for damages in the purchaser actions have been dismissed, but the claims for injunctive relief remain. Plaintiffs’ claims for damages and injunctive relief remain in the issuer actions. Plaintiffs moved for class certification in both actions, and defendants opposed that motion on May 25, 2005. On October 25, 2005, plaintiffs moved for summary judgment which defendants opposed.

 

IPO Allocation Matters.

 

In March 2001, a purported class action, now captioned In re Initial Public Offering Antitrust Litigation, was initiated in the SDNY against Morgan Stanley and numerous other underwriters of various IPOs. The consolidated amended complaint alleges that defendants required customers that wanted allocations of “hot” IPO securities to pay undisclosed and excessive underwriters’ compensation in the form of increased brokerage commissions and to buy shares of securities offered in the IPOs after the IPOs were completed (“tie-in purchases”) at escalating price levels higher than the IPO price (a practice plaintiffs refer to as “laddering”). The complaint alleges violations of federal and/or state antitrust laws, including Section 1 of the Sherman Act. On September 28, 2005, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) reversed the district court’s dismissal of this matter. On November 2, 2005, defendants filed a petition for rehearing en banc to the Second Circuit.

 

Also beginning in March 2001, numerous purported class actions, now captioned In re Initial Public Offering Securities Litigation, were filed in the SDNY against certain issuers of IPO securities, certain individual officers of those issuers, Morgan Stanley and other underwriters of those IPOs, purportedly on behalf of purchasers of stock in the IPOs or the aftermarket. These complaints make factual allegations similar to the complaint in the antitrust action described above, but claim violations of the federal securities laws, including Sections 11 and 12(a)(2) of the Securities Act of 1933 (the “Securities Act”) and Section 10(b) of the Exchange Act. Some of the complaints also allege that continuous “buy” recommendations by the defendants’ research analysts improperly increased or sustained the prices at which the securities traded after the IPOs. On February 19, 2003, the underwriter defendants’ joint motion to dismiss was denied, except as to certain specified offerings. On October 13, 2004, the Court granted in large part plaintiffs’ motions for class certification in six focus cases selected for class certification briefing. On June 30, 2005, the Second Circuit granted defendants’ petition for permission to appeal the SDNY’s order granting plaintiffs’ motion for class certification.

 

On June 10, 2004, plaintiffs and issuer defendants entered into a definitive settlement agreement under which insurers of the issuers would guarantee recovery of at least $1 billion by class members. As part of the settlement, the settling issuer defendants agreed to assign to class members certain claims they had against the underwriters. Starting in late 2004, purported assignees of certain issuers filed suits in the SDNY against several underwriter defendants, including Morgan Stanley, on the ground that underwriters breached the underwriting agreement and related duties by allocating shares in each company’s IPO to customers who allegedly paid the underwriters “excess compensation.” On October 11, 2005, the Court dismissed the complaint with leave to replead. Plaintiff filed a second amended complaint on October 28, 2005, re-alleging a breach of fiduciary duty claim, and defendants moved to dismiss on November 21, 2005.

 

On April 2, 2002, a purported class action complaint, captioned Breakaway Solutions, Inc. v. Morgan Stanley & Co. Incorporated, et al., was filed in the Delaware Court of Chancery against Morgan Stanley and two other underwriters. The complaint was brought on behalf of a class of issuers that issued IPO securities from January 1, 1998 to October 31, 2000 pursuant to underwriting agreements with defendants and whose securities increased in value by 15 percent or more within 30 days following the IPO. The complaint alleges that defendants allocated underpriced stock to certain of defendants’ favored clients and, directly or indirectly, shared in portions of the

 

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profits of such favored clients pursuant to side agreements or understandings, with the alleged effect of depriving issuers of millions of dollars in IPO proceeds. The complaint alleges breach of contract, breach of covenant of good faith, breach of fiduciary duty, indemnification or contribution and unjust enrichment and restitution. The Court dismissed plaintiff’s claims except for its breach of fiduciary duty claim.

 

On September 30, 2005, Breakaway Solutions, Inc. (“Breakaway”) filed another complaint in an individual action against Morgan Stanley and two other underwriters in the Supreme Court of the State of New York. The complaint alleges that defendants underpriced Breakaway’s IPO stock, allocated this underpriced stock to favored clients pursuant to a profit sharing arrangement, and that Morgan Stanley improperly sold Breakaway shares before expiration of the lock-up period. The complaint alleges breach of fiduciary duty and breach of the covenant of good faith against all the defendants and fraud and unjust enrichment against Morgan Stanley. This action has been stayed by agreement of the parties.

 

Mutual Fund Sales Practices.

 

From October 2003 to December 2003, nine purported class actions, now consolidated and captioned In re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation, were filed in the SDNY against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen mutual funds, and certain officers of Morgan Stanley and its affiliates and certain trustees of the named Morgan Stanley funds. The consolidated amended complaint was filed on behalf of all persons or entities, other than defendants, who purchased or held shares of certain Morgan Stanley or Van Kampen mutual funds from October 1, 1999 to November 17, 2003 against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen funds. Plaintiffs allege that defendants gave their sales force economic incentives to promote the sale of proprietary mutual funds and that they improperly failed to disclose these economic incentives. The complaint also alleges that defendants improperly used Rule 12b-1 fees and that the named funds paid excessive commissions to MSDWI in connection with the sale of proprietary funds. The complaint alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act, Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 20(a) of the Exchange Act, Section 206 of the Investment Advisers Act of 1940 (the “Investment Advisers Act”), Sections 34(b), 36(b) and 48(a) of the Investment Company Act of 1940 (the “Investment Company Act”), and of common law fiduciary duties. The consolidated amended complaint seeks, among other things, compensatory damages, rescissionary damages, fees and costs. On July 2, 2004, defendants filed a motion to dismiss the consolidated amended complaint. On March 9, 2005, plaintiffs filed a Motion for Leave to file a Supplemental Pleading that would, among other things, expand the allegations and alleged class to encompass the sale of certain non-proprietary mutual funds. Both motions are pending.

 

On February 20, 2004, a derivative action, captioned Starr v. Van Kampen Investments Inc., et al., was filed in the U.S. District Court for the Northern District of Illinois on behalf of various Van Kampen mutual funds against Van Kampen Investments Inc., Van Kampen Asset Management Inc., Morgan Stanley and individual trustees of the funds. The case was subsequently transferred to the SDNY for coordination with In re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation. The complaint alleges violations of the Investment Company Act, the Investment Advisers Act, and common law breach of fiduciary duty with respect to Van Kampen’s participation in certain mutual fund marketing programs operated by MSDWI. Plaintiff seeks, among other things, to remove current trustees, to rescind the management contracts for the Van Kampen Funds and to replace the manager, disgorgement, monetary damages, including punitive damages and interest, and fees and expenses. Defendants have moved to dismiss the action, which is currently stayed pending certain procedural developments.

 

Late Trading and Market Timing

 

Starting in July 2003, Morgan Stanley received subpoenas and requests for information from various regulatory and governmental agencies, including the SEC, the NYSE, and various states, in connection with industry-wide investigations of broker-dealers and mutual fund complexes relating to possible late trading and market timing of mutual funds. Morgan Stanley continues to cooperate with and provide information to regulators in connection with their inquiries.

 

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AOL Time Warner Litigation.

 

Since 2003, Morgan Stanley has been named as a defendant in a number of state court actions involving AOL Time Warner, including cases in Alaska, California, Ohio and West Virginia. All these cases also name as defendants AOL Time Warner, numerous individual defendants, AOL Time Warner’s auditors, and other investment banking defendants. The complaints allege that AOL Time Warner issued false and misleading financial statements by, among other things, inflating advertising revenues. These complaints name Morgan Stanley in its capacity as financial advisor to Time Warner in the merger of America Online and Time Warner and/or as underwriter of bond offerings completed in 2001 and 2002. The complaints allege violations of Section 11 of the Securities Act and Section 14(a) of the Exchange Act (and Rule 14a-9 thereunder) in connection with the merger registration statement, as well as various state and common laws, and violations of Section 11 and 12(a)(2) of the Securities Act in connection with the bond registration statements.

 

In Alaska, a claim for negligent misrepresentation remains against Morgan Stanley. The Alaska plaintiffs have also amended their claims under the Alaska Securities Act, and Morgan Stanley’s renewed motion to dismiss these claims is pending. In the coordinated California proceedings, claims based on California common law fraud and Sections 25400 and 25500 of the California Corporations Code remain against Morgan Stanley. In the Ohio action, state securities law claims remain against Morgan Stanley. Motions to dismiss remain pending in the West Virginia action.

 

On January 30, 2006, numerous new individual actions were filed against Morgan Stanley and other defendants by plaintiffs opting out of the class settlement of a previously filed federal class action. The claims against Morgan Stanley in that class action had been dismissed by the SDNY. The new complaints contain similar factual allegations against Morgan Stanley, and assert similar claims, but also include a claim for violation of Section 10(b) of the Exchange Act.

 

LVMH Litigation.

 

On October 30, 2002, the French company LVMH Moet Hennessey Louis Vuitton (“LVMH”) initiated proceedings in the Paris Commercial Court against Morgan Stanley alleging that, between 1999 and 2002, in research reports and newspaper interviews concerning the luxury goods sector, Morgan Stanley failed in its duties of independence and impartiality and denigrated LVMH to the benefit of Gucci, a Morgan Stanley client.

 

In a judgment dated January 12, 2004, the Paris Commercial Court awarded LVMH €30 million for damage to its image and appointed an expert to assist it in assessing whether LVMH is entitled to additional damages, and, if so, in what amount. On October 18, 2004, LVMH filed submissions before the expert claiming €182.9 million in additional damages. On February 12, 2004, Morgan Stanley filed a notice of appeal against the judgment. The parties are in the process of filing appeal submissions. LVMH’s appeal submissions include a claim for additional damages of €125 million (€106.9 million of which is also the subject of LVMH’s claim before the expert appointed by the Commercial Court to assess additional damages) beyond the €30 million previously awarded to LVMH by the Commercial Court for damage to its image. The appeal is listed to be heard on March 31, 2006.

 

Indonesian Litigation.

 

In November 2003, two proceedings were initiated in the Indonesian District Courts by two members of the Asia Pulp & Paper Group (PT Indah Kiat Pulp & Paper Tbk and PT Lontar Papyrus Pulp & Paper Industry, respectively) against Morgan Stanley and thirteen other defendants, with respect to two bond issues in 1994 and 1995, guaranteed by plaintiffs, in which Morgan Stanley acted as underwriter. The claims allege that the bond issues were invalid and contrary to Indonesian law, and allege damages in the amount of all principal and interest paid under the bonds as well as other amounts. In September 2004, the Indonesian District Courts issued their judgments, declaring the bond issues to be illegal and void, holding that defendants (including Morgan Stanley) had committed unspecified tortious acts, but awarding no damages. Defendants appealed those decisions to the Indonesian High Court. In September 2005 and November 2005, respectively, the Indonesian High Court upheld on appeal the decisions of the Indonesian District Court in favor of the plaintiff. Morgan Stanley and others are appealing those decisions to the Indonesian Supreme Court in Jakarta.

 

In April 2004, another proceeding was filed in the Indonesian District Courts by PT Lontar Papyrus against Morgan Stanley and 28 other defendants, alleging that the defendants violated injunctions issued by the

 

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Indonesian District Court in the first claim brought by PT Lontar Papyrus and conspired to cause the failure of plaintiff’s restructuring negotiations. Plaintiff seeks damages in respect of losses allegedly suffered. On September 28, 2005, the Indonesian District Court rejected the plaintiff’s claim against Morgan Stanley.

 

In October 2004, an additional proceeding was filed in the Indonesian District Courts by APP International Finance Company BV, a member of the Asia Pulp & Paper Group and the issuer of the 1995 bond issue, against Morgan Stanley and eighteen other defendants, making allegations similar to those in the November 2003 claim brought by PT Lontar Papyrus. Plaintiff seeks damages in respect of losses allegedly suffered.

 

In January 2005, an additional proceeding was filed in the Indonesian District Courts by Indah Kiat International Finance Company BV, a member of the Asia Pulp & Paper Group and the issuer of the 1994 bond issue, against Morgan Stanley and other defendants, making allegations similar to those in the November 2003 claim brought by PT Indah Kiat. Plaintiff seeks damages in respect of losses allegedly suffered.

 

Email Matters.

 

In December 2005, Morgan Stanley reached an agreement in principle with the staff of the Division of Enforcement of the SEC (the “Staff”) to resolve the Staff’s investigation relating to MS&Co.’s production of emails. Pursuant to the agreement in principle, MS&Co. would be charged with a violation of Section 17(b) of the Exchange Act and Rule 17a-4(j) thereunder, and pay a $15 million civil penalty (a portion of which will be shared with other regulators), and be subject to other relief. The Staff has not yet presented the proposed settlement to the Commission and no assurance can be given that it will be accepted. In addition, MSDWI is discussing resolution of related charges with the NASD, although no agreement has been reached.

 

Retail Brokerage Employment Matters.

 

Several financial services firms, including Morgan Stanley, have been named in purported class actions alleging that certain present and former employees in California are entitled to overtime pay and other wages and that certain deductions from employees’ compensation are improper under state law. On July 12, 2004, one of these purported class actions, captioned Garett v. Morgan Stanley & Co., Inc., and Morgan Stanley DW Inc., was filed in California Superior Court in San Diego. On September 14, 2004, defendants filed their answer, and on September 15, 2004, defendants removed the action to the U.S. District Court for the Southern District of California. On July 18, 2005, plaintiffs filed a first amended complaint in that court seeking damages in an unspecified amount and other relief on behalf of certain present and former employees in California. On September 20, 2005, Morgan Stanley entered into an agreement in principle to resolve the matter, which agreement is, among other things, subject to court approval.

 

Complaints raising wage and hour allegations against Morgan Stanley have also been filed in New Jersey and New York. On September 1, 2005, a purported class action, captioned Steinberg v. Morgan Stanley & Co., Inc. and Morgan Stanley DW Inc., was filed in the Superior Court of New Jersey, Law Division, Bergen County. On October 7, 2005, the matter was removed to the U.S. District Court for the District of New Jersey. Plaintiff filed a first amended complaint on January 13, 2006 seeking damages in an unspecified amount and relief on behalf of certain present and former employees in New Jersey and nationwide.

 

On September 9, 2005, a purported class action, captioned Gasman v. Morgan Stanley, was filed in the SDNY. The complaint seeks damages and other relief on behalf of certain present and former employees in New York. On September 23, 2005, a purported class action, captioned, Roles v. Morgan Stanley et al., was filed in the U.S. District Court for the Eastern District of New York. The complaint seeks damages and other relief on behalf of certain present and former employees in New York and nationwide. On November 3, 2005, Morgan Stanley filed a motion to transfer the Roles matter to the SDNY for purposes of consolidating the Roles and Gasman matters for pre-trial proceedings.

 

Morgan Stanley has also been the subject of gender discrimination claims, including threatened class action litigation, challenging certain of Morgan Stanley’s employment practices in its retail brokerage business.

 

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Shareholder Derivative Matters.

 

Beginning on July 19, 2005, shareholder plaintiffs filed purported derivative actions on behalf of Morgan Stanley against certain present and former directors and its former chief legal officer based on, among other things, agreements to pay the former CEO and co-President of Morgan Stanley and the handling of a lawsuit resulting in an adverse judgment against Morgan Stanley. Four lawsuits filed in the SDNY have been consolidated under the heading In re Morgan Stanley Derivative Litigation, and on January 23, 2006, plaintiffs filed a second amended consolidated complaint that includes claims for, among other things, violations of Sections 10(b) and 14(a) of the Exchange Act and breach of fiduciary duties and seeks, among other things, rescission of the severance and compensation agreements and damages.

 

On July 19, 2005, a derivative lawsuit was filed in a New York state court challenging the agreement to pay the former co-President of Morgan Stanley and seeking an accounting for losses as a result thereof.

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

There were no matters submitted to a vote of security holders during the fourth quarter of our fiscal year ended November 30, 2005.

 

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Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Morgan Stanley’s common stock trades on the NYSE and the Pacific Exchange under the symbol “MS.” At November 30, 2005, Morgan Stanley had approximately 117,000 holders of record; however, Morgan Stanley believes the number of beneficial owners of common stock exceeds this number.

 

The table below sets forth, for each of the last eight fiscal quarters, the low and high sales prices per share of Morgan Stanley’s common stock as reported by Bloomberg Financial Markets and the amount of any cash dividends declared per share of Morgan Stanley’s common stock.

 

     Low
Sale Price


   High
Sale Price


   Dividends

Fiscal 2005:

                    

Fourth Quarter

   $ 50.61    $ 57.98    $ 0.27

Third Quarter

   $ 48.61    $ 54.61    $ 0.27

Second Quarter

   $ 47.66    $ 60.40    $ 0.27

First Quarter

   $ 51.00    $ 60.51    $ 0.27

Fiscal 2004:

                    

Fourth Quarter

   $ 47.27    $ 54.00    $ 0.25

Third Quarter

   $ 46.54    $ 54.74    $ 0.25

Second Quarter

   $ 50.22    $ 62.83    $ 0.25

First Quarter

   $ 54.40    $ 62.16    $ 0.25

 

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The table below sets forth the information with respect to purchases made by or on behalf of Morgan Stanley of its common stock during the fourth quarter of our fiscal year ended November 30, 2005.

 

Issuer Purchases of Equity Securities

(dollars in millions, except per share amounts)

 

Period


   Total
Number of
Shares
Purchased


   Average Price
Paid Per
Share


   Total Number of
Shares Purchased
As Part of Publicly
Announced Plans
or Programs (C)


   Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs


 

Month #1 (Sept. 1, 2005—Sept. 30, 2005)

                     

Equity Anti-dilution Program (A)

   1,000,000    $52.28    1,000,000    (A )

Capital Management Program (B)

   —      N/A    —      $600  

Employee Transactions (D)

   4,309,760    $52.24    N/A    N/A  

Month #2 (Oct. 1, 2005—Oct. 31, 2005)

                     

Equity Anti-dilution Program (A)

   12,132,326    $52.99    12,132,326    (A )

Capital Management Program (B)

   —      N/A    —      $600  

Employee Transactions (D)

   149,314    $53.69    N/A    N/A  

Month #3 (Nov. 1, 2005—Nov. 30, 2005)

                     

Equity Anti-dilution Program (A)

   9,283,024    $53.53    9,283,024    (A )

Capital Management Program (B)

   —      N/A    —      $600  

Employee Transactions (D)

   63,396    $54.71    N/A    N/A  

Total

                     

Equity Anti-dilution Program (A)

   22,415,350    $53.18    22,415,350    (A )

Capital Management Program (B)

   —      N/A    —      $600  

Employee Transactions (D)

   4,522,470    $52.33    N/A    N/A  

(A) Morgan Stanley’s board of directors authorized this program to purchase common stock to offset the dilutive impact of grants and exercises of awards under Morgan Stanley’s equity-based compensation and benefit plans. The program was publicly announced on January 7, 1999 and has no set expiration or termination date. There is no maximum amount of shares that may be purchased under the program.
(B) Morgan Stanley’s board of directors authorized this program to purchase common stock for capital management purposes. The program was publicly announced on February 12, 1998 at which time up to $3 billion of stock was authorized to be purchased. The program was subsequently increased by $1 billion on December 18, 1998, $1 billion on December 20, 1999 and $1.5 billion on June 20, 2000. This program has a remaining capacity of $600 million at November 30, 2005 and has no set expiration or termination date.
(C) Share purchases under publicly announced programs are made pursuant to open-market purchases, Rule 10b5-1 plans or privately negotiated transactions (including with employee benefit plans) as market conditions warrant and at prices Morgan Stanley deems appropriate.
(D) Includes: (1) shares delivered or attested to in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options (granted under employee stock compensation plans) who exercised options; (2) restricted shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares; and (3) shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units. Morgan Stanley’s employee stock compensation plans provide that the value of the shares delivered or attested, or withheld, shall be the average of the high and low price of Morgan Stanley’s common stock on the date the relevant transaction occurs.

 

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Item 6. Selected Financial Data.

 

MORGAN STANLEY

 

SELECTED FINANCIAL DATA

(dollars in millions, except share and per share data)

 

     Fiscal Year(1)

 
     2005

    2004

    2003

    2002

    2001

 

Income Statement Data:

                                        

Revenues:

                                        

Investment banking

   $ 3,843     $ 3,341     $ 2,440     $ 2,478     $ 3,413  

Principal transactions:

                                        

Trading

     7,365       5,510       6,262       3,521       5,600  

Investments

     981       607       110       (25 )     (371 )

Commissions

     3,363       3,264       2,887       3,191       3,066  

Fees:

                                        

Asset management, distribution and administration

     4,958       4,473       3,814       4,033       4,304  

Merchant, cardmember and other

     1,323       1,317       1,377       1,421       1,348  

Servicing and securitization income

     1,609       1,921       1,922       2,032       1,861  

Interest and dividends

     28,175       18,584       15,738       15,876       24,112  

Other

     464       324       226       399       217  
    


 


 


 


 


Total revenues

     52,081       39,341       34,776       32,926       43,550  

Interest expense

     24,425       14,707       12,693       12,515       20,491  

Provision for consumer loan losses

     878       926       1,266       1,337       1,051  
    


 


 


 


 


Net revenues

     26,778       23,708       20,817       19,074       22,008  
    


 


 


 


 


Non-interest expenses:

                                        

Compensation and benefits

     11,313       9,853       8,522       7,910       9,352  

Other

     8,355       7,037       6,135       6,070       6,847  

Restructuring and other charges

     —         —         —         235       —    

September 11th related insurance recoveries, net

     (251 )     —         —         —         —    
    


 


 


 


 


Total non-interest expenses

     19,417       16,890       14,657       14,215       16,199  
    


 


 


 


 


Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change, net

     7,361       6,818       6,160       4,859       5,809  

Losses from unconsolidated investees

     311       328       279       77       30  

Provision for income taxes

     1,858       1,856       1,707       1,625       2,076  

Dividends on preferred securities subject to mandatory redemption

     —         45       154       87       50  
    


 


 


 


 


Income from continuing operations before cumulative effect of accounting change, net

     5,192       4,589       4,020       3,070       3,653  
    


 


 


 


 


Discontinued operations:

                                        

Loss from discontinued operations

     (486 )     (172 )     (393 )     (138 )     (124 )

Income tax benefit

     184       69       160       56       51  
    


 


 


 


 


Loss on discontinued operations

     (302 )     (103 )     (233 )     (82 )     (73 )

Cumulative effect of accounting change, net

     49       —         —         —         (59 )
    


 


 


 


 


Net income

   $ 4,939     $ 4,486     $ 3,787     $ 2,988     $ 3,521  
    


 


 


 


 


Earnings applicable to common shares(2)

   $ 4,939     $ 4,486     $ 3,787     $ 2,988     $ 3,489  
    


 


 


 


 


 

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     Fiscal Year(1)

 
     2005

    2004

    2003

    2002

    2001

 

Per Share Data:

                                        

Earnings per basic share:

                                        

Income from continuing operations

   $ 4.94     $ 4.25     $ 3.74     $ 2.84     $ 3.33  

Loss on discontinued operations

     (0.29 )     (0.10 )     (0.22 )     (0.08 )     (0.07 )

Cumulative effect of accounting change, net

     0.05       —         —         —         (0.05 )
    


 


 


 


 


Earnings per basic share

   $ 4.70     $ 4.15     $ 3.52     $ 2.76     $ 3.21  
    


 


 


 


 


Earnings per diluted share:

                                        

Income from continuing operations

   $ 4.81     $ 4.15     $ 3.66     $ 2.76     $ 3.23  

Loss on discontinued operations

     (0.29 )     (0.09 )     (0.21 )     (0.07 )     (0.07 )

Cumulative effect of accounting change, net

     0.05       —         —         —         (0.05 )
    


 


 


 


 


Earnings per diluted share

   $ 4.57     $ 4.06     $ 3.45     $ 2.69     $ 3.11  
    


 


 


 


 


Book value per common share

   $ 27.59     $ 25.95     $ 22.93     $ 20.24     $ 18.64  

Dividends per common share

   $ 1.08     $ 1.00     $ 0.92     $ 0.92     $ 0.92  

Balance Sheet and Other Operating Data:

                                        

Total assets

   $ 898,523     $ 747,334     $ 602,843     $ 529,499     $ 482,628  

Consumer loans, net

     22,916       20,226       19,382       23,014       19,677  

Total capital(3)

     125,891       110,793       82,769       65,936       61,633  

Long-term borrowings(3)

     96,709       82,587       57,902       44,051       40,917  

Shareholders’ equity

     29,182       28,206       24,867       21,885       20,716  

Return on average common shareholders’ equity

     17.3 %     16.8 %     16.5 %     14.1 %     18.0 %

Average common and equivalent shares(2)

     1,049,896,047       1,080,121,708       1,076,754,740       1,083,270,783       1,086,121,508  

(1) Certain prior-period information has been reclassified to conform to the current year’s presentation.
(2) Amounts shown are used to calculate earnings per basic share.
(3) These amounts exclude the current portion of long-term borrowings and include Capital Units and junior subordinated debt issued to capital trusts.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Introduction.

 

Morgan Stanley (the “Company”) is a global financial services firm that maintains leading market positions in each of its business segments—Institutional Securities, Retail Brokerage, Asset Management and Discover. The Company, through its subsidiaries and affiliates, provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. The Company’s Institutional Securities business includes capital raising, financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; corporate lending; sales, trading, financing and market-making activities in equity securities and related products and fixed income securities and related products, including foreign exchange and commodities; benchmark indices and risk management analytics; research; and investments. The Company’s Retail Brokerage business provides brokerage and investment advisory services covering various investment alternatives; financial and wealth planning services; annuity and insurance products; credit and other lending products; banking and cash management and credit solutions; retirement services; and trust and fiduciary services. The Company’s Asset Management business provides global asset management products and services in equities, fixed income and alternative investment products through three principal distribution channels: a proprietary channel consisting of the Company’s representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional sales channel. The Company’s Discover business offers Discover®-branded credit cards and other consumer products and services, and includes the operations of Discover Network, which operates a merchant and cash access network for Discover Network branded cards, and includes PULSE EFT Association LP (“PULSE®”), an automated teller machine/debit and electronic funds transfer network. Morgan Stanley-branded and affinity credit cards issued on the MasterCard network and other consumer finance products and services in the U.K. are also included in the Discover business segment.

 

The Company’s results of operations for the 12 months ended November 30, 2005 (“fiscal 2005”), November 30, 2004 (“fiscal 2004”) and November 30, 2003 (“fiscal 2003”) are discussed below. The results of the Company’s aircraft leasing business are reported as discontinued operations for all periods presented (see “Discontinued Operations” herein).

 

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Results of Operations.

 

Executive Summary.

 

Financial Information.

 

     Fiscal Year

 
     2005

    2004(1)

    2003(1)

 

Net revenues (dollars in millions):

                        

Institutional Securities

   $ 15,673     $ 13,113     $ 11,301  

Retail Brokerage

     5,019       4,615       4,242  

Asset Management

     2,907       2,738       2,276  

Discover

     3,452       3,533       3,303  

Intersegment Eliminations

     (273 )     (291 )     (305 )
    


 


 


Consolidated net revenues

   $ 26,778     $ 23,708     $ 20,817  
    


 


 


Income before taxes (dollars in millions)(2):

                        

Institutional Securities

   $ 4,754     $ 4,281     $ 4,066  

Retail Brokerage

     585       371       464  

Asset Management

     1,007       827       482  

Discover

     921       1,221       1,027  

Intersegment Eliminations

     94       118       121  
    


 


 


Consolidated income before taxes

   $ 7,361     $ 6,818     $ 6,160  
    


 


 


Consolidated net income (dollars in millions)

   $ 4,939     $ 4,486     $ 3,787  
    


 


 


Basic earnings per common share:

                        

Income from continuing operations

   $ 4.94     $ 4.25     $ 3.74  

Loss on discontinued operations

     (0.29 )     (0.10 )     (0.22 )

Cumulative effect of accounting change, net

     0.05       —         —    
    


 


 


Basic earnings per common share

   $ 4.70     $ 4.15     $ 3.52  
    


 


 


Diluted earnings per common share:

                        

Income from continuing operations

   $ 4.81     $ 4.15     $ 3.66  

Loss on discontinued operations

     (0.29 )     (0.09 )     (0.21 )

Cumulative effect of accounting change, net

     0.05       —         —    
    


 


 


Diluted earnings per common share

   $ 4.57     $ 4.06     $ 3.45  
    


 


 


Statistical Data.

                        

Book value per common share(3)

   $ 27.59     $ 25.95     $ 22.93  

Average common equity (dollars in billions)(4):

                        

Institutional Securities

   $ 14.6     $ 13.3       n/a  

Retail Brokerage

     3.7       3.5       n/a  

Asset Management

     1.7       1.7       n/a  

Discover

     4.4       3.9       n/a  
    


 


 


Total from operating segments

     24.4       22.4       n/a  

Discontinued operations

     1.2       1.5       n/a  

Unallocated capital

     2.9       2.8       n/a  
    


 


 


Consolidated

   $ 28.5     $ 26.7     $ 23.0  
    


 


 


 

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Statistical Data (Continued).    Fiscal Year

 
     2005

    2004(1)

    2003(1)

 

Return on average common equity(4):

                        

Consolidated

     17.3 %     16.8 %     16.5 %

Institutional Securities

     24.2 %     22.4 %     n/a  

Retail Brokerage

     10.6 %     7.2 %     n/a  

Asset Management

     36.2 %     29.5 %     n/a  

Discover

     13.1 %     19.8 %     n/a  

Return on average common equity (consolidated) from continuing operations on a pro forma basis(5)

     19.0 %     18.2 %     18.6 %

Effective income tax rate

     26.5 %     28.8 %     29.8 %

Worldwide employees

     53,218       53,284       51,196  

Consolidated assets under management or supervision (dollars in billions):

                        

Equity

   $ 285     $ 246     $ 203  

Fixed income

     108       118       109  

Money market

     83       87       64  

Alternative investments

     19       19       16  

Real estate

     41       31       20  
    


 


 


Total assets under management

     536       501       412  

Unit investment trusts

     12       11       10  

Other(6)

     51       44       40  
    


 


 


Total assets under management or supervision(7)

   $ 599     $ 556     $ 462  
    


 


 


Institutional Securities:

                        

Mergers and acquisitions completed transactions (dollars in billions)(8):

                        

Global market volume

   $ 511.8     $ 352.8     $ 209.9  

Market share

     25.5 %     24.1 %     17.5 %

Rank

     3       2       3  

Mergers and acquisitions announced transactions (dollars in billions)(8):

                        

Global market volume

   $ 728.6     $ 360.7     $ 249.2  

Market share

     29.2 %     20.4 %     18.1 %

Rank

     2       4       2  

Global equity and equity-related issues (dollars in billions)(8):

                        

Global market volume

   $ 45.1     $ 54.3     $ 39.6  

Market share

     8.7 %     10.6 %     10.2 %

Rank

     3       1       3  

Global debt issues (dollars in billions)(8):

                        

Global market volume

   $ 340.8     $ 362.1     $ 367.3  

Market share

     5.7 %     6.9 %     7.4 %

Rank

     5       3       3  

Global initial public offerings (dollars in billions)(8):

                        

Global market volume

   $ 13.9     $ 13.9     $ 2.8  

Market share

     8.6 %     10.1 %     4.9 %

Rank

     2       1       5  

Pre-tax profit margin(9)

     30 %     32 %     35 %

 

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Statistical Data (Continued).    Fiscal Year

 
     2005

    2004(1)

    2003(1)

 

Retail Brokerage (dollars in billions, unless otherwise noted):

                        

Global representatives

     9,526       10,962       11,086  

Annualized net revenue per global representative (dollars in thousands)(10)

   $ 490     $ 419     $ 359  

Retail Brokerage assets by client segment:

                        

$10 million or more

   $ 124     $ 111     $ 108  

$1 million – $10 million

     204       188       156  

$100,000 – $1 million

     174       188       185  

Less than $100,000

     31       39       46  
    


 


 


Total U.S. Retail Brokerage assets

     533       526       495  

International

     56       50       44  

Corporate and other accounts

     28       26       26  
    


 


 


Total client assets

   $ 617     $ 602     $ 565  
    


 


 


Fee-based assets as a percentage of total client assets

     28 %     26 %     23 %

Bank deposit program(dollars in millions)(11)

   $ 1,689     $ 435     $ 469  

Pre-tax profit margin(9)

     12 %     8 %     11 %

Asset Management:

                        

Assets under management or supervision (dollars in billions)

   $ 431     $ 424     $ 357  

Percent of fund assets in top half of Lipper rankings(12)

     61 %     63 %     44 %

Pre-tax profit margin(9)

     35 %     30 %     21 %

Pre-tax profit margin(9) (excluding private equity)

     29 %     26 %     22 %

Discover (dollars in millions, unless otherwise noted)(13):

                        

Period-end credit card loans—Owned

   $ 22,496     $ 19,724     $ 18,930  

Period-end credit card loans—Managed

   $ 46,936     $ 48,261     $ 48,358  

Average credit card loans—Owned

   $ 19,932     $ 17,608     $ 19,531  

Average credit card loans—Managed

   $ 47,330     $ 47,387     $ 50,864  

Net principal charge-off rate—Owned

     4.84 %     5.53 %     6.05 %

Net principal charge-off rate—Managed

     5.23 %     6.00 %     6.60 %

Return on receivables—Owned

     2.92 %     4.43 %     3.32 %

Return on receivables—Managed

     1.23 %     1.65 %     1.28 %

Transaction volume (dollars in billions):

                        

Net sales

   $ 86.0     $ 79.5     $ 76.8  

Other transaction volume

     18.1       20.1       21.1  
    


 


 


Total

   $ 104.1     $ 99.6     $ 97.9  
    


 


 


Payment services (in millions):

                        

Discover network transaction volume

     1,301       1,226       1,209  

PULSE network transaction volume

     1,556       —         —    
    


 


 


Total network transaction volume

     2,857       1,226       1,209  
    


 


 


Pre-tax profit margin(9)

     27 %     35 %     31 %

(1) Certain prior-year information has been reclassified to conform to the current year’s presentation.
(2) Amounts represent income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change, net.
(3) Book value per common share equals shareholders’ equity of $29,182 million at November 30, 2005, $28,206 million at November 30, 2004 and $24,867 million at November 30, 2003, divided by common shares outstanding of 1,058 million at November 30, 2005, 1,087 million at November 30, 2004 and 1,085 million at November 30, 2003.

 

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(4) The Company uses an economic capital model to determine the amount of equity capital needed to support the risk of its business activities and to ensure that the Company remains adequately capitalized. Economic capital is defined as the amount of capital needed to run the business through the business cycle and satisfy the requirements of regulators, rating agencies and the market. The Company’s methodology is based on an approach that assigns economic capital to each segment based on regulatory capital usage plus additional capital for stress losses, goodwill and principal investment risk. The economic capital model and allocation methodology may be enhanced over time in response to changes in the business and regulatory environment. Capital data for fiscal 2003 have not been provided. The effective tax rates used in the computation of segment return on average common equity were determined on a separate entity basis.
(5) Pro forma return on average monthly common equity from continuing operations is computed assuming a $1.5 billion equity allocation for the Company’s aircraft leasing business for all monthly periods through July 2005 and $0.4 billion for all monthly periods from August 2005 through November 2005. The decrease in equity allocated to this business primarily reflected the decrease in asset value as a result of a $0.5 billion pre-tax charge for discontinued operations (see “Discontinued Operations” herein). The Company views the pro forma return on average common equity as a relevant indicator of its operating performance for period-to-period comparisons as well as when comparing its operating results with other financial services firms.
(6) Amounts include assets under management or supervision associated with the Retail Brokerage business.
(7) Revenues and expenses associated with these assets are included in the Company’s Asset Management, Retail Brokerage and Institutional Securities segments.
(8) Source: Thomson Financial, data as of January 3, 2006—The data for fiscal 2005, fiscal 2004 and fiscal 2003 are for the periods from January 1 to December 31, 2005, January 1 to December 31, 2004 and January 1 to December 31, 2003, respectively, as Thomson Financial presents these data on a calendar-year basis.
(9) Percentages represent income from continuing operations before losses from unconsolidated investees, income taxes and net cumulative effect of accounting change as a percentage of net revenues.
(10) Amounts equal to Retail Brokerage net revenues divided by average global representative headcount.
(11) Bank deposits are held at the Company’s affiliated banks for the benefit of retail clients through their brokerage accounts.
(12) Source: Lipper, one-year performance excluding money market funds as of November 30, 2005, November 30, 2004 and November 30, 2003, respectively.
(13) Managed data include owned and securitized credit card loans. For an explanation of managed data and a reconciliation of credit card loan and asset quality data, see “Discover—Managed General Purpose Credit Card Loan Data” herein.

 

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Fiscal 2005 Performance.

 

Company Results.    The Company recorded net income of $4,939 million and diluted earnings per share of $4.57 in fiscal 2005, an increase of 10% and 13%, respectively, from the prior year. Net revenues (total revenues less interest expense and the provision for loan losses) rose 13% to $26.8 billion in fiscal 2005, and the return on average common equity was 17.3% compared with 16.8% in the prior year. Income from continuing operations was $5,192 million for the year, an increase of 13% from the prior year. Diluted earnings per share from continuing operations were $4.81 compared with $4.15 last year.

 

Non-interest expenses of $19.4 billion increased 15% from the prior year, primarily due to higher compensation expense and professional services expense associated with increased business activity and legal and consulting costs. Compensation and benefits expense in fiscal 2005 reflected higher compensation accruals associated with a higher level of net revenues, as well as charges for senior management severance and new hires of approximately $311 million (see “Senior Management Compensation Charges” herein). Other expenses included charges for certain legal matters, including those associated with the Coleman Litigation and the Parmalat settlement, as well as charges related to certain legal and regulatory matters in the Retail Brokerage business.

 

The Company’s effective income tax rate was 26.5% in fiscal 2005 compared with 28.8% in fiscal 2004. The decrease reflected an income tax benefit of $309 million resulting from the Company’s repatriation of approximately $4.0 billion of qualifying foreign earnings under the provisions of the American Jobs Creation Act of 2004 (the “American Jobs Creation Act”) (see “American Jobs Creation Act of 2004” herein). Excluding the impact of dividends repatriated under the American Jobs Creation Act, the Company’s effective income tax rate for fiscal 2005 would have increased to 30.8%, reflecting lower tax exempt income and higher tax rates applicable to non-U.S. earnings as compared with fiscal 2004.

 

On January 30, 2006, the Company announced that it had signed a definitive agreement under which it will sell its aircraft leasing business to Terra Firma, a European private equity group, for approximately $2.5 billion in cash and the assumption of liabilities. Based on the terms of the agreement and in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company revised its estimate of the fair value (less selling costs) of the aircraft leasing business and, as a result, in the fourth quarter reduced the pre-tax charge recorded in the third quarter of fiscal 2005 by approximately $1.1 billion. Full year results for fiscal 2005 reflected a charge of $509 million ($316 million after-tax). The sale is subject to customary regulatory approvals and closing conditions and is expected to close in the first half of 2006 (see “Discontinued Operations” herein).

 

At fiscal year-end, the Company had 53,218 employees worldwide compared with 53,284 at the prior year-end.

 

Institutional Securities.    Institutional Securities recorded income from continuing operations before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption of $4.8 billion, an 11% increase from a year ago. Net revenues rose 20% to $15.7 billion driven by record fixed income and higher equity sales and trading revenues, along with strong results in investment banking. Non-interest expenses increased 24% to $10.9 billion, reflecting higher compensation levels and costs associated with increased business activity and increased legal reserves. Legal reserves and costs associated with the Coleman Litigation and the Parmalat settlement totaled $535 million (see “Legal Proceedings” in Part I, Item 3). The increase in compensation and benefits expense included charges for senior management severance and new hires of approximately $193 million.

 

Investment banking advisory revenues rose 28% from last year to $1.5 billion, reflecting an increase in completed merger and acquisition transactions. Underwriting revenues rose 8% from last year to $2.0 billion with fixed income underwriting revenues driving the increase. Fixed income underwriting revenues increased 27%.

 

Fixed income sales and trading revenues were a record $6.8 billion, up 22% from a year ago. The increase was driven by a record year in interest rate and currency products and credit products, partially offset by lower

 

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revenues from commodities products. Interest rate and currency product revenues increased primarily due to higher revenues from interest rate cash and derivative products and higher revenues from emerging market fixed income securities. Credit products benefited from increased customer flows in securitized products and favorable trading conditions. Commodities revenues declined from last year’s record revenues as lower revenues in oil liquids were partially offset by record results in electricity and natural gas products. Equity sales and trading revenues rose 18% from last year to $4.8 billion and reached their highest annual level since fiscal 2000. The increase was driven by strong customer flows in derivatives, record revenues in prime brokerage, improved performance in principal trading strategies and higher revenues from equity cash products.

 

Principal transaction investment revenues were $656 million in fiscal 2005 compared with $364 million a year ago. Fiscal 2005’s results included gains from investments in IntercontinentalExchange, International Securities Exchange and Digital Globe Inc., while fiscal 2004’s results included a gain on the sale of the Company’s investment in TradeWeb.

 

Retail Brokerage.    Retail Brokerage recorded pre-tax income of $585 million, up 58% from the prior year. Fiscal 2004 was negatively affected by a change in the Company’s method of accounting for certain asset management and account fees that reduced pre-tax income by $80 million (see “Asset Management and Account Fees” herein). Excluding this change and Retail Brokerage’s share ($198 million) of the insurance settlement related to the events of September 11, 2001 (see “Insurance Settlement” herein), pre-tax income declined by 14%. Net revenues were $5.0 billion, a 9% increase over a year ago and the highest since fiscal 2000. Excluding the accounting methodology change, net revenues increased 6% from last year. Higher asset management, distribution and administration fees were driven primarily by an increase in client assets in fee-based accounts, which more than offset lower commissions resulting from a decline in transaction volumes. Total non-interest expenses were $4.4 billion, a 4% increase from a year ago. Excluding the insurance settlement, non-interest expenses rose 9% from a year ago, driven by higher compensation expense and higher professional services expense, including higher sub-advisory fees associated with increased asset and revenue growth, as well as higher legal and consulting costs. Total client assets increased to $617 billion, up 2% from the prior fiscal year-end. In addition, client assets in fee-based accounts increased 10% from a year ago to a record $173 billion and increased as a percentage of total client assets to 28% from last year’s 26%. At fiscal year-end, the number of global representatives was 9,526, a decline of 1,436 from a year ago, resulting largely from the sales force reduction completed during the year and the net loss of global representatives to competitors. The Company believes that legal and regulatory matters have adversely affected, and in the near term are likely to continue to affect adversely, the operating performance of Retail Brokerage.

 

Asset Management.    Asset Management recorded pre-tax income of $1.0 billion, a 22% increase from last year. The increase reflected a 6% increase in net revenues to $2.9 billion driven by higher investment gains and an increase in asset management fees. Non-interest expenses decreased 1% from the prior year to $1.9 billion as charges for senior management severance and new hires of approximately $41 million were offset by Asset Management’s share ($43 million) of the insurance settlement related to the events of September 11, 2001. Investment gains for the year were $326 million compared with $248 million a year ago, including gains associated with the Company’s holdings in Triana Energy Holdings, LLC and Aventine Renewable Energy Holding, LLC. Assets under management or supervision within Asset Management of $431 billion were up $7 billion, or 2%, from last year, primarily due to market appreciation, partially offset by net cash outflows associated with proprietary retail products and institutional separate accounts.

 

Discover.    Discover pre-tax income was $921 million, a decrease of 25% from last year. Net revenues of $3.5 billion were 2% lower than a year ago, primarily driven by lower servicing and securitization income, reflecting lower net interest cash flows partly resulting from rising short-term interest rates and a decrease in the fair value of the Company’s retained interests in securitized receivables. The decrease was partially offset by higher net interest income and a decline in the provision for loan losses, reflecting improved credit quality notwithstanding a spike in bankruptcy notices preceding new federal legislation effective October 2005. Non-interest expenses increased 9% from the prior year, partially resulting from the acquisition of PULSE, which the Company acquired on January 12, 2005 (see “Business Acquisitions and Sales” herein) and higher compensation costs,

 

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including costs associated with senior management changes of approximately $29 million. The managed credit card net principal charge-off rate decreased 77 basis points from a year ago to 5.23%, benefiting from the effect of the Company’s credit quality and collection initiatives and an industry-wide improvement in credit quality. The managed over 30-day delinquency rate decreased 57 basis points to 3.98% from a year ago, and the managed over 90-day delinquency rate was 43 basis points lower than a year ago at 1.75%. Managed credit card loans were $46.9 billion at year-end, a decrease of 3% from a year ago, primarily due to historically high cardmember payment rates.

 

Fiscal 2006 Performance Priorities.    During fiscal 2005, the Company made substantial changes to its senior management and effected certain organizational and strategic changes that the Company believes will improve its performance in future periods. The Company intends to pursue the following strategic initiatives in order to improve the Company’s net revenues, profit margins and return on common shareholders’ equity:

 

    Leverage global scale, franchise and integration across businesses

 

    Increase principal activity in order to strike a better balance between principal and customer activity

 

    Invest to optimize growth opportunities and achieve “best-in-class” status in all businesses

 

    Aggressively pursue new opportunities, including “bolt-on” acquisitions

 

    Improve operating margins by creating productivity and efficiency gains

 

    Create a cohesive “one-firm” culture

 

Institutional Securities will focus on identifying and pursuing what it believes will be high-growth areas, such as emerging markets, private equity and mortgage products; improving cross-divisional cooperation; taking advantage of opportunities for principal risk taking; and continuing to invest in product innovation and technology.

 

Retail Brokerage will focus on leveraging the Company’s institutional expertise to create new products for individual investors; increasing its relationships with client households in the $1 million and greater asset segment; developing, retaining and recruiting high-quality global representatives; and continuing to invest in infrastructure and technology.

 

Asset Management will focus on establishing a presence in high-growth global products; shifting its focus from profitability to asset growth while maintaining profitability with an emphasis on alternative investment products and other new, high-margin products; and continuing to improve investment performance.

 

Discover will focus on increasing card activity, usage and loan balances by building broader acceptance of the Discover Network, strengthening Discover’s brand, improving upon the client experience, and introducing new products and services. In addition, Discover will pursue growth opportunities through acquisitions and strategic partnerships, such as the acquisition of the Goldfish credit card business (“Goldfish”) in fiscal 2006 (see “Business Acquisitions and Sales” herein), and continue to grow its international presence.

 

Global Market and Economic Conditions in Fiscal 2005.

 

Global market and economic conditions were generally favorable for most of fiscal 2005, particularly in the U.S. Global capital markets activity was also higher than in fiscal 2004 despite concerns throughout much of the fiscal year about inflationary pressures, higher oil prices and geopolitical risk.

 

The U.S. economy remained generally strong during fiscal 2005, supported by productivity gains and consumer spending. Consumer confidence strengthened throughout most of fiscal 2005, although concerns about the economic impact of Hurricane Katrina and rising oil prices caused a decline during the fourth quarter. Crude oil prices rose to record levels during fiscal 2005, primarily driven by higher global demand and the disruption of energy supplies caused by Hurricane Katrina. Toward the end of fiscal 2005, however, crude oil prices had

 

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declined. Consumer spending and business investment improved, while the U.S. unemployment rate declined to 5.0% from 5.4% a year ago. The equity markets improved modestly during fiscal 2005 as improved corporate earnings and positive economic developments outweighed concerns over oil prices, inflation and the Federal Reserve Board’s (the “Fed”) monetary policy actions. During fiscal 2005, the Fed continued to tighten credit conditions by raising both the overnight lending rate and the discount rate on eight separate occasions by an aggregate of 2.0%. Long-term interest rates, however, declined as the yield curve flattened during most of fiscal 2005. Subsequent to fiscal 2005, the Fed raised both the overnight lending rate and the discount rate by an aggregate 0.50%.

 

In Europe, economic growth remained sluggish primarily due to the level of exports, although conditions improved modestly in the latter half of the year. The European Central Bank (the “ECB”) left the benchmark interest rate unchanged during fiscal 2005. In the U.K., economic growth was marginal as higher oil prices suppressed consumer demand and confidence. During fiscal 2005, the Bank of England lowered the benchmark interest rate by 0.25%. Subsequent to fiscal 2005, the ECB raised the benchmark interest rate by 0.25% in December 2005.

 

The Japanese economy continued to recover as business investment and corporate profits improved, and the jobless rate was near a seven-year low. The Japanese equity markets saw a historic rebound during fiscal 2005 as a result of strong growth in corporate earnings as well as signs of an economic recovery and an end to deflation. Economic growth elsewhere in Asia continued, including in China, driven by strength in domestic spending and exports.

 

Business Outlook.

 

As fiscal 2006 began, global economic and market conditions appeared generally stable, trading conditions remained favorable and consumer confidence in the U.S. rose to pre-Hurricane Katrina levels. However, investors remained concerned about, among other things, the pace of economic growth, global oil prices, inflation, the U.S. federal budget deficit and geopolitical risk.

 

In the beginning of fiscal 2006, Institutional Securities has experienced relatively strong transaction backlogs in investment banking and generally favorable trading conditions. However, the level of global transaction volumes, market volatility and the Company’s market share will continue to affect the results of this business.

 

The Retail Brokerage business will continue to invest in technology and infrastructure during fiscal 2006 that will impact non-interest expenses and its pre-tax profit margin. Retail Brokerage also expects that the number of financial advisors will decline to approximately 8,600 by the end of fiscal 2006, reflecting fewer new trainees and continued competition for experienced personnel.

 

Asset Management expects lower principal investment gains going forward as it continues to reduce its private equity business. Fiscal 2006’s results will be affected by the level of assets under management or supervision, net customer asset flows and the introduction of revenues from higher margin products.

 

Discover expects favorable trends in charge-offs in the first half of fiscal 2006 related to improved credit quality. In addition, the October 2005 spike in bankruptcy filings will be charged off primarily in December 2005 in accordance with Company policy. As the Company believes that the spike was, in part, an acceleration of losses that would have been incurred later in 2006, it expects to incur a lower level of bankruptcy losses in subsequent months. (See also “Discover—Provision for Consumer Loan Losses—Delinquencies and Charge-offs” herein). In fiscal 2006, the Company will be challenged by a slowing growth rate in the U.S. credit card industry, potential rising short-term interest rates and an increase in minimum payment requirements. Discover’s results for fiscal 2006 will also include the impact of the Goldfish credit card business after its acquisition is completed, which is expected in early 2006.

 

Business Segments.

 

The remainder of “Results of Operations” is presented on a business segment basis before discontinued operations. Substantially all of the operating revenues and operating expenses of the Company can be directly attributed to its business segments. Certain revenues and expenses have been allocated to each business segment, generally in proportion to its respective revenues or other relevant measures.

 

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As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an Intersegment Eliminations category to reconcile the segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations represents the effect of timing differences associated with the revenue and expense recognition of commissions paid by Asset Management to Retail Brokerage associated with sales of certain products and the related compensation costs paid to Retail Brokerage’s global representatives. Income before taxes recorded in Intersegment Eliminations was $94 million, $118 million and $121 million in fiscal 2005, fiscal 2004 and fiscal 2003, respectively.

 

Certain reclassifications have been made to prior-period segment amounts to conform to the current year’s presentation.

 

Beginning in the third quarter of fiscal 2005, the Company renamed three of its business segments. The Individual Investor Group was renamed “Retail Brokerage,” Investment Management was renamed “Asset Management” and Credit Services was renamed “Discover.” In addition, beginning in the third quarter of fiscal 2005, the principal components of the residential mortgage loan business previously included in the Discover business segment are managed by and included within the results of the Institutional Securities business segment. Prior periods have been restated to conform to the current year’s presentation.

 

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INSTITUTIONAL SECURITIES

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2005


   Fiscal
2004


   Fiscal
2003


     (dollars in millions)

Revenues:

                    

Investment banking

   $ 3,477    $ 3,008    $ 2,096

Principal transactions:

                    

Trading

     6,906      4,998      5,618

Investments

     656      364      87

Commissions

     2,160      1,998      1,748

Asset management, distribution and administration fees

     152      144      92

Interest and dividends

     25,455      16,395      13,420

Other

     301      190      86
    

  

  

Total revenues

     39,107      27,097      23,147

Interest expense

     23,434      13,984      11,846
    

  

  

Net revenues

     15,673      13,113      11,301
    

  

  

Total non-interest expenses

     10,919      8,832      7,235
    

  

  

Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change, net

     4,754      4,281      4,066

Losses from unconsolidated investees

     311      328      279

Provision for income taxes

     909      932      924

Dividends on preferred securities subject to mandatory redemption

     —        45      154
    

  

  

Income from continuing operations before cumulative effect of accounting change, net

   $ 3,534    $ 2,976    $ 2,709
    

  

  

 

Investment Banking.    Investment banking revenues are derived from the underwriting of securities offerings and fees from advisory services. Investment banking revenues were as follows:

 

     Fiscal
2005


   Fiscal
2004


   Fiscal
2003


     (dollars in millions)

Advisory fees from merger, acquisition and restructuring transactions

   $ 1,478    $ 1,156    $ 662

Equity underwriting revenues

     905      993      640

Fixed income underwriting revenues

       1,094           859           794
    

  

  

Total investment banking revenues

   $ 3,477    $ 3,008    $ 2,096
    

  

  

 

Investment banking revenues increased 16% in fiscal 2005. The increase was due to higher revenues from merger, acquisition and restructuring activities and fixed income underwriting transactions, partially offset by lower revenues from equity underwritings. In fiscal 2004, investment banking revenues increased 44%, primarily reflecting higher revenues from merger, acquisition and restructuring and equity underwriting transactions. Higher revenues from fixed income underwriting transactions also contributed to the increase.

 

In fiscal 2005, advisory fees from merger, acquisition and restructuring transactions increased 28% to $1,478 million. Conditions in the worldwide merger and acquisition markets were favorable throughout fiscal 2005, and the Company’s advisory revenues reached their highest level in five years. The increase in advisory fees reflected strong contributions from the real estate, energy and utilities, transportation and retail sectors. In fiscal 2004, advisory fees from merger, acquisition and restructuring transactions increased 75% to $1,156 million with sectors such as financial services, technology, media and telecommunications, manufacturing and healthcare making strong contributions to the results.

 

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Equity underwriting revenues decreased 9% in fiscal 2005, reflective of lower global industry-wide equity and equity-related activity. The Company’s equity underwriting revenues reflected lower revenues from the healthcare and manufacturing sectors, partially offset by higher revenues from the financial services sector. In fiscal 2004, equity underwriting revenues increased 55%, largely due to the resurgence of the initial public offerings market. The global equity markets experienced renewed investor demand for initial public offerings, particularly in the U.S., and the Company’s participation in these transactions more than outpaced the industry-wide increase in transaction volume. The Company’s equity underwriting revenues reflected increases from the financial services, healthcare, media and telecommunications, and technology sectors.

 

Fixed income underwriting revenues rose 27% in fiscal 2005 and 8% in fiscal 2004, primarily reflecting favorable conditions in the global fixed income markets. Although the Fed increased the overnight interest rate in both fiscal years, longer-term interest rates remained at relatively low levels. The attractive debt financing environment contributed to higher revenues as issuers continued to take advantage of low financing costs. The Company’s revenues from global high-yield and securitized fixed income transactions were higher in both periods. In fiscal 2005, acquisition-related financing resulting from a strong market for merger and acquisition activity also contributed to the increase.

 

At the end of fiscal 2005, the backlog of merger, acquisition and restructuring transactions was higher as compared with the end of fiscal 2004, reflecting improved global market and economic conditions. The backlog for equity underwriting transactions was also higher as compared with the end of the prior fiscal year, reflecting increases across all global regions. The backlog of both merger, acquisition and restructuring transactions as well as equity underwriting transactions is subject to the risk that transactions may not be completed due to unforeseen economic and market conditions, adverse developments regarding one of the parties to the transaction, a failure to obtain required regulatory approval or a decision on the part of the parties involved not to pursue a transaction.

 

Sales and Trading Revenues.    Sales and trading revenues are composed of principal transaction trading revenues, commissions and net interest revenues. In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions and net interest revenues in the aggregate. In addition, decisions relating to principal transactions in securities are based on an overall review of aggregate revenues and costs associated with each transaction or series of transactions. This review includes, among other things, an assessment of the potential gain or loss associated with a trade, including any associated commissions, dividends, the interest income or expense associated with financing or hedging the Company’s positions and other related expenses.

 

The components of the Company’s sales and trading revenues are described below:

 

Principal Transactions–Trading.    Principal transaction trading revenues include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s positions. The Company also engages in proprietary trading activities for its own account.

 

Prior to fiscal 2005, certain investments made by the Company for business facilitation and principal investment purposes were recorded in Financial instruments owned, and gains and losses on such investments were recorded in Principal transaction trading revenues (see “Investments” herein). Amounts related to these investments are now recorded in Other assets and Principal transaction investment revenues in order to reflect the nature of these positions. Prior periods have been reclassified to conform to the current year presentation. For fiscal 2004 and fiscal 2003, $95 million and $24 million, respectively, have been reclassified to Principal transaction investment revenues, and $554 million as of November 30, 2004 has been reclassified to Other assets.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and options.

 

Net Interest.    Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including financial instruments owned and financial instruments sold, not yet purchased,

 

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reverse repurchase and repurchase agreements, trading strategies, customer activity in the Company’s prime brokerage business, and the prevailing level, term structure and volatility of interest rates. Reverse repurchase and repurchase agreements and securities borrowed and securities loaned transactions may be entered into with different customers using the same underlying securities, thereby generating a spread between the interest revenue on the reverse repurchase agreements or securities borrowed transactions and the interest expense on the repurchase agreements or securities loaned transactions.

 

Total sales and trading revenues increased 18% in fiscal 2005 and 5% in fiscal 2004, reflecting higher equity and fixed income sales and trading revenues.

 

Sales and trading revenues include the following:

 

     Fiscal
2005


   Fiscal
2004(1)


   Fiscal
2003(1)


     (dollars in millions)

Equities

   $ 4,804    $ 4,067    $ 3,591

Fixed income(2)

     6,782      5,567      5,462

(1) Certain reclassifications have been made to prior-year amounts to conform to the current presentation.
(2) Amounts include interest rate and currency products, credit products and commodities. Amounts exclude revenues from corporate lending activities.

 

Equity sales and trading revenues increased 18% in fiscal 2005 to the highest annual level since fiscal 2000. The increase was broad based and included increased customer flows in derivatives, record revenues in prime brokerage, improved performance in principal trading strategies and higher revenues from equity cash products. Derivative revenues increased due to strong customer flows despite continued low levels of volatility in the equity markets. Record revenues in prime brokerage were driven by robust growth in client balances. Global equity market indices generally trended higher and created favorable trading opportunities for principal trading strategies. Revenue from equity cash products rose on higher market volumes, particularly in the European and Asian markets.

 

Equity sales and trading revenues increased 13% in fiscal 2004 driven by record revenues in the prime brokerage business and higher revenues from cash and derivative products. The prime brokerage business experienced significant growth in global customer balances, which resulted in then-record annual revenues. Revenues from equity cash products rose, in part, due to increased cash flows into U.S. equity mutual funds. Revenues from equity derivatives increased modestly despite low levels of volatility in the equity markets. Commission revenues continued to be affected by intense competition and a continued shift toward electronic trading.

 

Fixed income sales and trading revenues increased 22% to a record level in fiscal 2005, primarily due to record revenues from interest rate and currency and credit products, partially offset by lower revenues from commodities products. Interest rate and currency product revenues increased 41% primarily due to higher revenues from interest rate cash and derivative products and higher revenues from emerging market fixed income securities, partially offset by lower revenues from foreign exchange products. Interest rate and currency product revenues benefited from strong new client transaction activity and favorable positioning results. The 19% increase in credit product revenues was primarily due to increased customer flows in securitized products and favorable trading conditions. Commodities revenues decreased 8% from last year’s record levels as lower revenues in oil liquids were partially offset by record results in electricity and natural gas products. In fiscal 2005 and fiscal 2004, 47% and 63% of fixed income sales and trading revenues were recorded in the first half of each respective fiscal year. In fiscal 2005, client activity, market volatility and improved risk taking efficiency resulted in improved second half results as compared with the prior year.

 

Fixed income sales and trading revenues increased 2% to a then-record level in fiscal 2004 driven by higher revenues from commodities and credit products, partially offset by lower revenues from interest rate and currency products. Commodities revenues increased 20% to record levels, primarily associated with activities in

 

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the energy sector where tight oil supplies, growing demand and global political instability drove energy prices and volatilities higher. Credit product revenues, which increased 1%, reflected record revenues from securitized products as the Company benefited from increased securitization flows in commercial and residential whole loans and favorable trading conditions. Lower revenues from investment grade products partially offset the increase. Interest rate and currency product revenues decreased 7% from fiscal 2003’s record levels due to lower revenues from cash and derivative products. In addition, in the second half of fiscal 2004, mixed U.S. economic data coupled with higher global energy prices and concerns about the strength of economic growth resulted in market conditions that the Company did not take advantage of, which adversely affected revenues from certain interest rate products. These decreases were partially offset by record results in foreign exchange and emerging markets, reflecting higher volatility and strong customer volume.

 

In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues include the net revenues from the Company’s corporate lending activities. In fiscal 2005, revenues from corporate lending activities decreased by approximately $240 million, reflecting the impact of mark-to-market valuations on a significantly higher level of new loans made in fiscal 2005. In fiscal 2004, revenues from corporate lending activities had increased by approximately $110 million, reflecting growth in the loan portfolio amidst improving conditions in the commercial lending market, which largely offset the mark-to-market valuation impact from new loans.

 

Principal Transactions-Investments.    Principal transaction net investment revenue aggregating $656 million was recognized in fiscal 2005 as compared with $364 million in fiscal 2004 and $87 million in fiscal 2003. Fiscal 2005’s results included gains from investments in IntercontinentalExchange, International Securities Exchange and Digital Globe Inc. Fiscal 2004’s results included a gain on the sale of an investment in TradeWeb, an electronic trading platform.

 

Principal investments generally are held for appreciation and are not readily marketable. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, estimates of the fair value of the investments involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions. The Company intends to make additional investments over time to bring the level of principal investments to approximately $2.5 billion (see “Investments” herein).

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include revenues from asset management services, primarily fees associated with the Company’s real estate fund investment activities.

 

Asset management, distribution and administration fees increased 6% in fiscal 2005 and 57% in fiscal 2004. The increase in fiscal 2004 was due to higher fees associated with real estate investment and advisory activities, primarily due to the acquisition of a majority of the U.S. real estate equity investment management business of Lend Lease Corporation in November 2003 (see “Business Acquisitions and Sales” herein).

 

Other.    Other revenues consist primarily of revenues from providing benchmark indices and risk management analytics associated with Morgan Stanley Capital International Inc. (“MSCI”) and Barra, Inc. (“Barra”) (see “Business Acquisitions and Sales” herein).

 

Other revenues increased 58% in fiscal 2005 and 121% in fiscal 2004. The increase in both periods was primarily attributable to Barra, which was acquired on June 3, 2004.

 

Non-Interest Expenses.    Non-interest expenses increased 24% in fiscal 2005. Compensation and benefits expense increased 21%, reflecting higher incentive-based compensation costs due to higher net revenues and Institutional Securities’ share ($193 million) of the costs associated with senior management changes (see “Senior Management Compensation Charges” herein). Excluding compensation and benefits expense, non-interest expenses increased 29%. Occupancy and equipment expense increased 41%, reflecting higher rental

 

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costs, primarily in North America. The increase also included a $71 million charge for the correction in the method of accounting for certain real estate leases (see “Lease Adjustment” herein). Brokerage, clearing and exchange fees increased 14%, primarily reflecting increased trading activity. Information processing and communications expense increased 11%, primarily due to higher telecommunications, market data and data processing costs. Professional services expense increased 31%, primarily due to higher consulting and legal costs, including costs of $55 million related to the matters below. Other expenses increased 71%, reflecting legal accruals of $360 million related to the Coleman Litigation, approximately $120 million related to the Parmalat settlement and $50 million related to the IPO Allocation Matters, while the prior year included legal accruals of $110 million related to the Parmalat settlement and IPO Allocation Matters (see Note 9 to the consolidated financial statements and “Legal Proceedings” in Part I, Item 3).

 

Fiscal 2004’s total non-interest expenses increased 22%. Compensation and benefits expense increased 22% due to higher incentive-based compensation resulting from higher net revenues and higher amortization expense related to equity-based awards (see “Stock-Based Compensation” herein). Excluding compensation and benefits expense, non-interest expenses increased 21%. Occupancy and equipment expense increased 16%, primarily due to higher rental costs, primarily in London. Brokerage, clearing and exchange fees increased 16%, primarily reflecting increased trading activity. Professional services expense increased 42%, primarily due to higher consulting costs, including the implementation of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”) and the Consolidated Supervised Entities Rule (the “CSE Rule”) (see “Regulatory Developments” herein). Legal and employee recruitment costs increased due to higher business activity. Costs for outside legal counsel increased due to certain regulatory and litigation matters. Marketing and business development expense increased 25% due to higher travel and entertainment costs. Other expenses increased 17% and included approximately $25 million relating to Institutional Securities’ share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the New York Stock Exchange, Inc. (the “NYSE”) relating to the prospectus delivery requirements, operational deficiencies, employee defalcations and other matters. In addition, other expenses included legal accruals of approximately $110 million related to the Parmalat settlement and IPO Allocation Matters (see “Legal Proceedings” in Part I, Item 3).

 

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RETAIL BROKERAGE

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2005


    Fiscal
2004


    Fiscal
2003


     (dollars in millions)

Revenues:

                      

Investment banking

   $ 320     $ 290     $ 305

Principal transactions:

                      

Trading

     464       518       651

Investments

     (1 )     (5 )     4

Commissions

     1,228       1,327       1,231

Asset management, distribution and administration fees

     2,517       2,099       1,696

Interest and dividends

     662       409       370

Other

     167       133       134
    


 


 

Total revenues

     5,357       4,771       4,391

Interest expense

     338       156       149
    


 


 

Net revenues

     5,019       4,615       4,242
    


 


 

Total non-interest expenses

     4,434       4,244       3,778
    


 


 

Income before taxes and cumulative effect of accounting change, net

     585       371       464

Provision for income taxes

     197       120       194
    


 


 

Income before cumulative effect of accounting change, net

   $ 388     $ 251     $ 270
    


 


 

 

Investment Banking.    Retail Brokerage investment banking revenues derive from its distribution of equity and fixed income securities underwritten by the Institutional Securities business, as well as underwritings of unit investment trust products. Investment banking revenues increased 10% in fiscal 2005 and decreased 5% in fiscal 2004. The increase in fiscal 2005 was primarily due to higher revenues from equity underwritings and unit investment trust products, partially offset by lower revenues from fixed income underwritings. The decrease in fiscal 2004 was primarily due to lower revenues from fixed income underwritings, partially offset by higher revenues from underwriting unit investment trust products.

 

Principal Transactions—Trading.    Principal transactions include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s inventory positions held, primarily to facilitate customer transactions. Principal transaction trading revenues decreased 10% and 20% in fiscal 2005 and fiscal 2004, respectively, primarily due to lower customer transaction activity in corporate, government and municipal fixed income securities.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and OTC equity securities and sales of mutual funds, futures, insurance products and options. Commission revenues decreased 7% in fiscal 2005 and increased 8% in fiscal 2004. The decrease in fiscal 2005 was primarily due to lower transaction volumes reflecting lower individual investor participation in the equity markets as compared with the prior year, as well as the continued growth of fee-based accounts. The increase in fiscal 2004 reflected higher customer trading volumes as compared with fiscal 2003 due to improved equity market conditions.

 

Net Interest.    Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including customer margin loans and securities borrowed and securities loaned transactions. Net interest revenues increased 28% and 14% in fiscal 2005 and fiscal 2004, respectively, primarily due to growth in customer margin balances.

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include revenues from individual investors electing a fee-based pricing arrangement and fees for investment management, account services and administration. The Company also receives fees for services it provides in distributing certain open-ended mutual funds and other products. Mutual fund distribution fees are based on

 

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either the average daily fund net asset balances or average daily aggregate net fund sales and are affected by changes in the overall level and mix of assets under management or supervision.

 

Asset management, distribution and administration fees increased 20% in fiscal 2005 and 24% in fiscal 2004. In both fiscal years, the increase was driven by higher client asset balances in fee-based accounts, including separately managed and Morgan Stanley ChoiceSM accounts. In addition, the fiscal 2004 results included a $107 million reduction in revenues for a change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein).

 

In fiscal 2005, client asset balances increased to $617 billion at November 30, 2005 from $602 billion at November 30, 2004. The increase was primarily due to market appreciation, reflecting improvement in the global financial markets. Client assets in fee-based accounts rose 10% to $173 billion at November 30, 2005 and increased as a percentage of total client assets to 28% from 26% in the prior year. Client assets in fee-based accounts rose 21% to $157 billion at November 30, 2004 and increased as a percentage of total client assets to 26% from 23% as of November 30, 2003.

 

Other.    Other revenues primarily include customer account transaction fees and other service fees. Other revenues increased 26% in fiscal 2005 and decreased 1% in fiscal 2004. In fiscal 2005, the increase was primarily due to higher customer account transaction fees.

 

Non-Interest Expenses.    Non-interest expenses increased 4% in fiscal 2005 and included Retail Brokerage’s share ($198 million) of the insurance settlement related to the events of September 11, 2001 (see “Insurance Settlement” herein). Excluding the insurance settlement, non-interest expenses increased 9%. Compensation and benefits expense increased 5%, reflecting higher incentive-based compensation costs and Retail Brokerage’s share ($48 million) of the costs associated with senior management changes (see “Senior Management Compensation Charges” herein). In addition, fiscal 2004 included a reduction in compensation expense of $27 million associated with the change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein). Excluding compensation and benefits expense, non-interest expenses increased 3%. Occupancy and equipment expense increased 11% primarily due to a $29 million charge recorded in the first quarter of fiscal 2005 for the correction in the method of accounting for certain real estate leases (see “Lease Adjustment” herein). Information processing and communications expense increased 9% primarily due to higher telecommunications costs within the branch network. Professional services expense increased 31%, largely due to higher sub-advisory fees associated with increased client fee-based assets and revenue growth, as well as higher outside legal counsel and consulting costs. Other expenses increased 16% primarily due to costs associated with branch closings and higher legal and regulatory costs. In fiscal 2005, the Company recorded legal and regulatory expenses of approximately $170 million, primarily related to employment matters and certain regulatory and branch litigation matters (see “Legal Proceedings” in Part I, Item 3).

 

Non-interest expenses increased 12% in fiscal 2004. The increase was primarily due to higher compensation and benefits expense, which increased 9%. The increase reflected higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Stock-Based Compensation” herein). This increase was partially offset by the reduction in compensation expense of $27 million mentioned above. Excluding compensation and benefits expense, non-interest expenses increased 19%. Marketing and business development expense increased 20% due to an increase in advertising costs. Professional services expense increased 48%, largely due to higher sub-advisory fees associated with increased client fee-based assets and revenue growth, as well as higher consulting and legal fees resulting from the implementation of SOX 404 and the CSE Rule and an increase in costs for outside legal counsel due to regulatory and litigation matters. Information processing and communications expense decreased 11% due to lower data processing costs. Other expenses increased 46%, primarily resulting from an increase in legal and regulatory expenses, including approximately $25 million relating to Retail Brokerage’s share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the NYSE relating to the prospectus delivery requirements, operational deficiencies, employee defalcations and other matters.

 

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ASSET MANAGEMENT

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2005


   Fiscal
2004


   Fiscal
2003


     (dollars in millions)

Revenues:

                    

Investment banking

   $ 50    $ 43    $ 39

Principal transactions:

                    

Investments

     326      248      19

Commissions

     29      27      18

Asset management, distribution and administration fees

     2,460      2,390      2,177

Interest and dividends

     23      8      —  

Other

     30      28      29
    

  

  

Total revenues

     2,918      2,744      2,282

Interest expense

     11      6      6
    

  

  

Net revenues

     2,907      2,738      2,276
    

  

  

Total non-interest expenses

     1,900      1,911      1,794
    

  

  

Income before taxes and cumulative effect of accounting change, net

     1,007      827      482

Provision for income taxes

     378      318      161
    

  

  

Income before cumulative effect of accounting change, net

   $ 629    $ 509    $ 321
    

  

  

 

Investment Banking.    Asset Management generates investment banking revenues primarily from the underwriting of Unit Investment Trust products. Investment banking revenues increased 16% in fiscal 2005 and 10% in fiscal 2004. The increase in both periods was primarily due to a higher volume of Unit Investment Trust sales. Unit Investment Trust sales volume increased 11% to $6.1 billion in fiscal 2005 and increased 28% to $5.5 billion in fiscal 2004.

 

Principal Transactions.    Asset Management principal transaction revenues consist primarily of gains and losses on investments associated with the Company’s private equity activities and capital investments in certain of the Company’s investment funds.

 

Principal transaction net investment gains aggregating $326 million were recognized in fiscal 2005 as compared with gains of $248 million in fiscal 2004. Fiscal 2005’s results primarily reflected net gains on certain investments in the Company’s private equity portfolio, including Triana Energy Holdings, LLC and Aventine Renewable Energy Holding, LLC. Fiscal 2004’s results also primarily reflected net gains on certain investments in the Company’s private equity portfolio, including Vanguard Health Systems, Inc. and Ping An Insurance (Group) Company of China, Ltd.

 

Lower investment gains are expected going forward as Asset Management continues to reduce its private equity business.

 

Private equity investments generally are held for appreciation and are not readily marketable. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, estimates of the fair value of the investments involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions (see “Investments” herein).

 

Commissions.    Asset Management primarily generates commission revenues from dealer and distribution concessions on sales of certain funds. Commission revenues increased 7% in fiscal 2005 and 50% in fiscal 2004. The increase in both periods reflected an increase in commissionable sales of certain fund products.

 

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Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees primarily include revenues from the management and supervision of assets, including fees for distributing certain open-ended mutual funds, shareholder servicing fees and management fees associated with the Company’s private equity activities. These fees arise from investment management services the Company provides to investment vehicles pursuant to various contractual arrangements. The Company receives fees primarily based upon mutual fund daily average net assets or quarterly assets for other vehicles.

 

Asset Management’s period-end and average customer assets under management or supervision were as follows:

 

     At November 30,

   Average for

     2005

   2004(1)

   2003(1)

   Fiscal
2005


   Fiscal
2004(1)


   Fiscal
2003(1)


     (dollars in billions)

Assets under management or supervision by distribution channel:

                                         

Retail

   $ 199    $ 200    $ 191    $ 202    $ 199    $ 184

Institutional

     232      224      166      223      191      154
    

  

  

  

  

  

Total assets under management or supervision

   $ 431    $ 424    $ 357    $ 425    $ 390    $ 338
    

  

  

  

  

  

Assets under management or supervision by asset class:

                                         

Equity

   $ 218    $ 198    $ 168    $ 207    $ 183    $ 144

Fixed income

     91      104      97      96      103      103

Money market

     79      83      60      82      69      62

Alternative investment vehicles

     19      19      16      19      18      14

Real estate

     12      9      6      10      7      5
    

  

  

  

  

  

Total assets under management

     419      413      347      414      380      328

Unit investment trusts

     12      11      10      11      10      10
    

  

  

  

  

  

Total assets under management or supervision

   $ 431    $ 424    $ 357    $ 425    $ 390    $ 338
    

  

  

  

  

  


(1) Certain prior-year information has been reclassified to conform to the current year’s presentation.

 

Activity in Asset Management’s customer assets under management or supervision during fiscal 2005 and fiscal 2004 were as follows (dollars in billions):

 

Balance at November 30, 2003

   $ 357  

Net flows excluding money markets

     8  

Net flows from money markets

     21  

Net market appreciation

     38  
    


Total net increase

     67  
    


Balance at November 30, 2004

     424  

Net flows excluding money markets

     (15 )

Net flows from money markets

     (4 )

Net market appreciation

     26  
    


Total net increase

     7  
    


Balance at November 30, 2005

   $ 431  
    


 

Net outflows (excluding money markets) in fiscal 2005 were primarily associated with both the Company’s institutional separate account and proprietary retail mutual fund products, partially offset by positive flows from non-proprietary retail and institutional mutual fund products.

 

Asset management, distribution and administration fees increased 3% in fiscal 2005 and 10% in fiscal 2004. In fiscal 2005, higher fund management and administration fees associated with a 9% increase in average assets

 

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under management were partially offset by lower distribution fees. In addition, although average equity assets under management increased 13%, a greater proportion of these assets was in products generating lower fees as compared with the prior-year period. The increase in fiscal 2004 reflected higher fund management and administration fees associated with a 15% increase in average assets under management or supervision. The increase in revenues in fiscal 2004 also reflected a more favorable average asset mix, including a greater percentage of equity assets under management, partially offset by an increase in institutional fixed income and liquidity fund products, which generate lower fees than equity products.

 

Non-Interest Expenses.    Non-interest expenses decreased 1% in fiscal 2005, including Asset Management’s share ($43 million) of the insurance settlement related to the events of September 11, 2001 (see “Insurance Settlement” herein). Excluding the insurance settlement, non-interest expenses increased 2%. Compensation and benefits expense increased 9%, primarily reflecting higher incentive-based compensation costs due to higher net revenues and Asset Management’s share ($41 million) of the costs associated with senior management changes (see “Senior Management Compensation Charges” herein). Brokerage, clearing and exchange fees decreased 7%, primarily reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in recent periods due to a decrease in sales of certain open-ended funds. Marketing and business development expenses increased 19% primarily due to higher promotional costs associated with the Company’s Van Kampen products. Professional services expense increased 6% due to higher sub-advisory fees, partially offset by lower legal and consulting fees. Other expenses decreased 20%, primarily due to a reduction in legal reserves resulting from the resolution of certain legal matters, partially offset by higher insurance expense.

 

Fiscal 2004’s total non-interest expenses increased 7%. Compensation and benefits expense increased 21%, primarily reflecting higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Stock-Based Compensation” herein). Excluding compensation and benefits expense, non-interest expenses were relatively unchanged from fiscal 2003. Professional services expense increased 45%, primarily reflecting an increase in sub-advisory, legal and consulting fees, including costs associated with the establishment of the independent private equity firm that manages Morgan Stanley Capital Partners funds in a long-term sub-advisory capacity. Marketing and business development expense decreased 22%, primarily due to lower promotional costs. Brokerage, clearing and exchange fees decreased 7%, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in recent periods due to a decrease in sales of certain open-ended funds.

 

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DISCOVER

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2005


   Fiscal
2004


   Fiscal
2003


 
     (dollars in millions)  

Merchant, cardmember and other fees

   $ 1,323    $ 1,317    $ 1,377  

Servicing and securitization income

     1,609      1,921      1,922  

Other

     5      10      14  
    

  

  


Total non-interest revenues

     2,937      3,248      3,313  
    

  

  


Interest revenue

     2,174      1,859      2,046  

Interest expense

     781      648      790  
    

  

  


Net interest income

     1,393      1,211      1,256  

Provision for consumer loan losses

     878      926      1,266  
    

  

  


Net credit income

     515      285      (10 )
    

  

  


Net revenues

     3,452      3,533      3,303  
    

  

  


Total non-interest expenses

     2,531      2,312      2,276  
    

  

  


Income before taxes and cumulative effect of accounting change, net

     921      1,221      1,027  

Provision for income taxes

     340      443      378  
    

  

  


Income before cumulative effect of accounting change, net

   $ 581    $ 778    $ 649  
    

  

  


 

Merchant, Cardmember and Other Fees.    Merchant, cardmember and other fees include revenues from fees charged to merchants on credit card sales (net of interchange fees paid to banks that issue cards on the Company’s merchant and cash access network), transaction processing fees on debit card transactions as well as charges to cardmembers for late payment fees, overlimit fees, balance transfer fees, credit protection fees and cash advance fees, net of cardmember rewards. Cardmember rewards include various reward programs, including the Cashback Bonus® reward program, pursuant to which the Company pays certain cardmembers a percentage of their purchase amounts based upon a cardmember’s level and type of purchases.

 

In fiscal 2005, merchant, cardmember and other fees were relatively unchanged as higher transaction processing revenues were offset by higher net cardmember rewards. The increase in transaction processing revenues was related to the acquisition of PULSE on January 12, 2005 (see “Business Acquisitions and Sales” herein). The increase in net cardmember rewards reflected record sales volume and the impact of promotional programs.

 

Merchant, cardmember and other fees decreased 4% in fiscal 2004. The decrease was due to lower cardmember fees and higher net cardmember rewards, partially offset by higher balance transfer fees and merchant discount revenues. The decline in cardmember fees was due to lower late payment and overlimit fees, reflecting fewer late fee occurrences and a decline in the number of accounts charged an overlimit fee, partially offset by lower charge-offs of such fees. Late fee occurrences were lower primarily due to a decline during fiscal 2004 in the over 30-day delinquency rates. Overlimit fees declined due to fewer overlimit accounts and the Company’s modification of its overlimit fee policies and procedures in response to industry-wide regulatory guidance. The increase in net cardmember rewards reflected the impact of promotional programs and higher sales volume. Balance transfer fees increased as a result of the Company’s continued focus on improving balance transfer profitability. The increase in merchant discount revenue was due to higher sales volume.

 

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Servicing and Securitization Income.    Servicing and securitization income is revenue derived from consumer loans that have been sold to investors through asset securitizations. Cash flows from the interest yield and cardmember fees generated by securitized general purpose credit card loans as well as interchange fees for certain securitization transactions are used to pay investors in these loans a predetermined fixed or floating rate of return on their investment, to reimburse investors for losses of principal resulting from charged-off loans and to pay the Company a fee for servicing the loans (“servicing rights”). Any excess cash flows remaining (“excess servicing rights”) are paid to the Company. The sale of general purpose credit card loans through asset securitizations, therefore, has the effect of converting portions of net credit income and fee income to servicing and securitization income.

 

Included in servicing and securitization income are revenues from servicing rights, excess servicing rights and gains or losses on general purpose credit card asset securitizations as well as the change in the fair value of the Company’s retained interests in general purpose credit card asset securitizations.

 

The table below presents the components of servicing and securitization income:

 

     Fiscal
2005


    Fiscal
2004


    Fiscal
2003


     (dollars in millions)

Merchant, cardmember and other fees

   $ 694     $ 650     $ 727

Other revenue

     (78 )     (8 )     30
    


 


 

Total non-interest revenues

     616       642       757
    


 


 

Interest revenue

     3,530       3,842       4,114

Interest expense

     1,025       692       771
    


 


 

Net interest income

     2,505       3,150       3,343

Provision for consumer loan losses

     1,512       1,871       2,178
    


 


 

Net credit income

     993       1,279       1,165
    


 


 

Servicing and securitization income

   $ 1,609     $ 1,921     $ 1,922
    


 


 

 

Servicing and securitization income is affected by the level of securitized loans, the spread between the net interest yield on the securitized loans and the yield paid to the investors, the rate of credit losses on securitized loans and the level of merchant, cardmember and other fees earned. Servicing and securitization income decreased 16% in fiscal 2005, reflecting lower net interest cash flows and other revenue, partially offset by a lower provision for consumer loan losses and higher merchant, cardmember and other fees. The decrease in net interest cash flows was attributable to a lower level of average securitized general purpose credit card loans and a higher weighted average coupon rate paid to investors associated with the higher short-term interest rate environment. The interest yield was relatively unchanged from the prior year as the impact of the increase in the prime rate was offset by a decline in higher rate loans due to improved credit quality and various pricing initiatives. The lower provision for consumer loan losses was primarily attributable to a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio and a lower level of average securitized general purpose credit card loans, partially offset by an increase in bankruptcy charge-offs. The increase in merchant, cardmember and other fees reflected the allocation of interchange revenue to certain securitization transactions and lower fee net charge-offs, partially offset by lower assessed late payment and overlimit fees.

 

In fiscal 2004, servicing and securitization income was relatively unchanged as lower cardmember fees, net interest cash flows and other revenue were partially offset by a lower provision for consumer loan losses. Cardmember fees declined due to lower late payment and overlimit fees, partially offset by higher balance transfer fees and lower fee net charge-offs. The decrease in net interest cash flows was largely attributable to a lower level of average securitized general purpose credit card loans. The decrease in the provision for consumer loan losses was attributable to a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio and a lower level of average securitized general purpose credit card loans.

 

The Other revenue component of servicing and securitization income, which includes net securitization gains and losses on general purpose credit card loans and the change in the fair value of the Company’s retained interests in

 

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general purpose credit card asset securitizations, decreased $70 million in fiscal 2005 and $38 million in fiscal 2004. The decrease in fiscal 2005 was primarily due to a lower level of securitized receivables and a decline in the fair value of the Company’s retained interests in securitized receivables as a result of an increase in bankruptcy notifications and its impact on future charge-offs. The decrease in such revenue in fiscal 2004 was attributable to a lower level of average general purpose credit card securitization transactions and higher net gain amortization related to prior securitization transactions.

 

The net proceeds received from general purpose credit card asset securitizations were $7,240 million in fiscal 2005 and $3,714 million in fiscal 2004. The credit card asset securitization transactions completed in fiscal 2005 have expected maturities ranging from approximately three to five years from the date of issuance.

 

Net Interest Income.    Net interest income represents the difference between interest revenue derived from consumer loans and short-term investment assets and interest expense incurred to finance those loans and assets. Assets, consisting primarily of consumer loans, currently earn interest revenue at both fixed rates and market-indexed variable rates. The Company incurs interest expense at fixed and floating rates. Interest expense also includes the effects of any interest rate contracts entered into by the Company as part of its interest rate risk management program. This program is designed to reduce the volatility of earnings resulting from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules of consumer loans as well as the Company’s right, with notice to cardmembers, to reprice certain fixed rate consumer loans to a new interest rate in the future.

 

Net interest income increased 15% in fiscal 2005 due to an increase in interest revenue, partially offset by an increase in interest expense. The increase in interest revenue was primarily due to an increase in average general purpose credit card loans, which was partly attributable to a higher level of securitization maturities and the deferment of new securitization transactions due to the exploration of the potential spin-off of Discover (see “Board Approval to Retain Discover” herein). The increase in interest expense was largely due to a higher level of average interest bearing liabilities, primarily to support the increase in average general purpose credit card loans.

 

Net interest income decreased 4% in fiscal 2004 due to a decline in interest revenue that was partially offset by lower interest expense. The decline in interest revenue was primarily due to a decrease in average general purpose credit card loans. The decrease in interest expense was primarily due to a lower level of average interest bearing liabilities and a decrease in the Company’s average cost of borrowings. The Company’s average cost of borrowings was 4.13% for fiscal 2004 as compared with 4.49% for fiscal 2003. The decline in the average cost of borrowings reflected the favorable impact of replacing certain maturing fixed rate debt with lower cost financing.

 

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The following tables present analyses of Discover’s average balance sheets and interest rates in fiscal 2005, fiscal 2004 and fiscal 2003 and changes in net interest income during those fiscal years:

 

Average Balance Sheet Analysis.

 

    Fiscal 2005

    Fiscal 2004

    Fiscal 2003

 
    Average
Balance


    Rate

    Interest

    Average
Balance


    Rate

    Interest

    Average
Balance


    Rate

    Interest

 
    (dollars in millions)  

ASSETS

                                                                 

Interest earning assets:

                                                                 

General purpose credit card loans

  $ 19,931     10.12 %   $ 2,017     $ 17,608     10.05 %   $ 1,770     $ 19,531     10.02 %   $ 1,956  

Other consumer loans

    364     7.64       28       427     8.14       35       457     8.29       38  

Investment securities

    52     1.86       1       40     1.92       1       23     2.75       1  

Other

    3,427     3.74       128       2,526     2.11       53       2,650     1.92       51  
   


       


 


       


 


       


Total interest earning assets

    23,774     9.15       2,174       20,601     9.02       1,859       22,661     9.03       2,046  

Allowance for loan losses

    (864 )                   (972 )                   (967 )              

Non-interest earning assets

    2,479                     2,343                     2,317                
   


               


               


             

Total assets

  $ 25,389                   $ 21,972                   $ 24,011                
   


               


               


             

LIABILITIES AND SHAREHOLDER’S EQUITY

                                                                 

Interest bearing liabilities:

                                                                 

Interest bearing deposits:

                                                                 

Savings

  $ 691     2.89 %   $ 20     $ 688     1.05 %   $ 7     $ 810     1.01 %   $ 8  

Brokered

    11,639     4.38       510       8,601     5.07       436       10,523     5.28       556  

Other time

    2,190     3.71       81       2,154     3.33       72       1,620     4.38       71  
   


       


 


       


 


       


Total interest bearing deposits

    14,520     4.21       611       11,443     4.50       515       12,953     4.90       635  

Other borrowings

    4,131     4.10       170       4,247     3.14       133       4,642     3.35       155  
   


       


 


       


 


       


Total interest bearing liabilities

    18,651     4.19       781       15,690     4.13       648       17,595     4.49       790  

Shareholder’s equity/other liabilities

    6,738                     6,282                     6,416                
   


               


               


             

Total liabilities and shareholder’s equity

  $ 25,389                   $ 21,972                   $ 24,011                
   


               


               


             

Net interest income

                $ 1,393                   $ 1,211                   $ 1,256  
                 


               


               


Net interest margin(1)

                  5.86 %                   5.88 %                   5.54 %

Interest rate spread(2)

          4.96 %                   4.89 %                   4.54 %        

(1) Net interest margin represents net interest income as a percentage of total interest earning assets.
(2) Interest rate spread represents the difference between the rate on total interest earning assets and the rate on total interest bearing liabilities.

 

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Rate/Volume Analysis.

 

     Fiscal 2005 vs. Fiscal 2004

    Fiscal 2004 vs. Fiscal 2003

 

Increase/(Decrease) due to Changes in:


    Volume 

     Rate 

     Total 

     Volume 

     Rate 

     Total 

 
     (dollars in millions)  

Interest Revenue

                                                

General purpose credit card loans

   $ 233     $ 14     $ 247     $ (192 )   $ 6     $ (186 )

Other consumer loans

     (5 )     (2 )     (7 )     (2 )     (1 )     (3 )

Other

     19       56       75       (3 )     5       2  
                    


                 


Total interest revenue

     285       30       315       (186 )     (1 )     (187 )
                    


                 


Interest Expense

                                                

Interest bearing deposits:

                                                

Savings

     —         13       13       (1 )     —         (1 )

Brokered

     154       (80 )     74       (102 )     (18 )     (120 )

Other time

     1       8       9       23       (22 )     1  
                    


                 


Total interest bearing deposits

     138       (42 )     96       (74 )     (46 )     (120 )

Other borrowings

     (3 )     40       37       (13 )     (9 )     (22 )
                    


                 


Total interest expense

     122       11       133       (86 )     (56 )     (142 )
                    


                 


Net interest income

   $ 163     $ 19     $ 182     $ (100 )   $ 55     $ (45 )
    


 


 


 


 


 


 

In response to industry-wide regulatory guidance, the Company has increased minimum payment requirements on certain general purpose credit card loans and will implement further minimum payment increases beginning in the second quarter of fiscal 2006. The Company expects this increase in minimum payment requirements to impact negatively future levels of general purpose credit card loans and related interest and fee revenue and charge-offs.

 

During fiscal 2005, the Company implemented a relief plan to assist certain cardmembers affected by Hurricane Katrina. The relief plan included temporarily suspending minimum payment requirements, temporarily waiving penalty fees and charging 0% interest on purchases for six months after the cardmember requested to be covered by the relief plan. As of November 30, 2005, approximately 1% of the Company’s managed general purpose credit card loans were made to cardmembers in the affected Gulf Coast region and were therefore subject to this relief plan. While the Company has taken steps to mitigate the risks associated with its cardmember relief plan and the other effects of Hurricane Katrina on its business, future levels of general purpose credit card loans, related interest and fee revenue, and charge-offs may still be negatively affected.

 

Provision for Consumer Loan Losses.    The provision for consumer loan losses is the amount necessary to establish the allowance for consumer loan losses at a level that the Company believes is adequate to absorb estimated losses in its consumer loan portfolio at the balance sheet date. The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is primarily applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy and is established through a charge to the provision for consumer loan losses. In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. This process starts with a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

 

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The Company’s provision for consumer loan losses was $878 million, $926 million and $1,266 million for fiscal 2005, fiscal 2004 and fiscal 2003, respectively. The Company’s allowance for consumer loan losses was $838 million at November 30, 2005 and $943 million at November 30, 2004.

 

The provision for consumer loan losses decreased 5% in fiscal 2005. The decrease reflected a higher net release of reserves and lower net charge-offs as compared with the prior-year period due to improvement in credit quality in the Company’s consumer loan portfolio, partially offset by the impact of higher bankruptcy filings in advance of the new U.S. bankruptcy legislation that became effective in October 2005. The net reduction in reserves in fiscal 2005 totaled approximately $100 million as compared with a net reduction of approximately $60 million in the prior-year period. The Company believes that the spike in bankruptcy filings in October 2005 was, in part, an acceleration of losses that would have been incurred later in 2006. In determining the allowance for loan losses as of November 30, 2005, the Company considered the impact of the current trends in bankruptcy filings. The peak filing month was October 2005, which will be recognized as charge-offs (in accordance with the Company’s accounting policy) in December 2005. The allowance for loan losses has provided for these charge-offs, in addition to other impacts of the change in bankruptcy legislation that were known or highly certain to the Company at November 30, 2005.

 

In fiscal 2004, the provision for consumer loan losses decreased 27%, primarily due to lower net principal charge-offs resulting from an improvement in credit quality, including lower bankruptcy charge-offs driven by a decline in U.S. personal bankruptcy filings. The decrease was also due to a lower level of average general purpose credit card loans. The Company reduced the allowance for consumer loan losses by approximately $60 million in fiscal 2004 as compared with an increase of approximately $70 million in fiscal 2003 due to improvement in credit quality, including lower delinquency rates and dollars.

 

Delinquencies and Charge-offs.    General purpose credit card loans are considered delinquent when contractual payments become 30 days past due. General purpose credit card loans generally are charged off at the end of the month during which an account becomes 180 days contractually past due, except in the case of cardmember bankruptcies, probate accounts and fraudulent transactions. Cardmember bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day contractual time frame. Fraudulent transactions are reported in consumer loans at their net realizable value upon receipt of notification of the fraud through a charge to operating expenses and are subsequently written off at the end of the month 90 days following notification but not later than the contractual 180-day time frame. Loan delinquencies and charge-offs are affected by changes in economic conditions, account collection management and policy changes and may vary throughout the year due to seasonal consumer spending and payment behaviors.

 

Delinquency rates in both the over 30- and over 90-day categories and net principal charge-off rates were lower for both the owned and managed portfolios in fiscal 2005, reflecting improvements in portfolio credit quality (see “Managed General Purpose Credit Card Loan Data” herein). The improvement in net principal charge-off rates was partially offset by an increase in bankruptcy charge-offs related to consumers filing for bankruptcy in advance of the new U.S. bankruptcy legislation that became effective in October 2005.

 

In fiscal 2004, net principal charge-off rates decreased in both the owned and managed portfolios as compared with fiscal 2003, reflecting improvements in portfolio credit quality and a lower level of bankruptcy filings. Delinquency rates in both the over 30- and over 90-day categories were lower in both the owned and managed portfolios at November 30, 2004 as compared with November 30, 2003, also reflecting improvements in portfolio credit quality.

 

The Company’s future charge-off rates and credit quality are subject to uncertainties that could cause actual results to differ materially from what has been discussed above. Factors that influence the provision for consumer loan losses include the level and direction of general purpose credit card loan delinquencies and charge-offs, changes in consumer spending and payment behaviors, new laws and regulations and interpretations thereof,

 

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bankruptcy trends, the seasoning of the Company’s general purpose credit card loan portfolio, interest rate movements and their impact on consumer behavior, and the rate and magnitude of changes in the Company’s general purpose credit card loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio.

 

Non-Interest Expenses.    Non-interest expenses increased 9% in fiscal 2005, partially resulting from the acquisition of PULSE (see “Business Acquisitions and Sales” herein). Compensation and benefits expense increased 15%, including Discover’s share ($29 million) of the costs associated with senior management changes (see “Senior Management Compensation Charges” herein), as well as an increase in personnel costs, including salaries and benefits. Excluding compensation and benefits expense, non-interest expenses increased 7%. Marketing and business development expense increased 2% due to increased marketing and advertising costs. Professional services expense increased 12% due to higher consulting fees partially related to the exploration of the potential spin-off of Discover (see “Board Approval to Retain Discover” herein) and an increase in legal and account collection fees. Other expenses increased 16%, primarily reflecting an increase in certain operating expenses, including accruals for losses associated with cardmember fraud and higher legal accruals.

 

Fiscal 2004’s total non-interest expenses increased 2% from fiscal 2003. Compensation and benefits expense decreased 5% due to lower employee benefit costs, as well as lower salaries resulting from lower employment levels due, in part, to workforce reductions conducted during the fourth quarter of fiscal 2003. Excluding compensation and benefits expense, non-interest expenses increased 5%. Marketing and business development expense increased 20% due to increased marketing costs associated with account acquisition, merchant initiatives and advertising. Other expenses decreased 8%, primarily reflecting a decrease in certain operating expenses, including lower losses associated with cardmember fraud.

 

Seasonal Factors.    Discover’s activities are affected by seasonal patterns of retail purchasing. Historically, a substantial percentage of general purpose credit card loan growth occurs in the fourth calendar quarter, followed by a flattening or decline of these loans in the following calendar quarter. Merchant fees, therefore, historically have tended to increase in the first fiscal quarter, reflecting higher sales activity in the month of December. Additionally, higher cardmember rewards incentives historically have been accrued for as a reduction of merchant and cardmember fee revenues in the first fiscal quarter, reflecting seasonal growth in retail sales volume.

 

Managed General Purpose Credit Card Loan Data.    The Company analyzes its financial performance on both a “managed” loan basis and as reported under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) (“owned” loan basis). Managed loan data assume that the Company’s securitized loan receivables have not been sold and present the results of the securitized loan receivables in the same manner as the Company’s owned loans. The Company operates its Discover business and analyzes its financial performance on a managed basis. Accordingly, underwriting and servicing standards are comparable for both owned and securitized loans. The Company believes that managed loan information is useful to investors because it provides information regarding the quality of loan origination and credit performance of the entire managed portfolio and allows investors to understand the related credit risks inherent in owned loans and retained interests in securitizations. In addition, investors often request information on a managed basis, which provides a more meaningful comparison with industry competitors.

 

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The following table provides a reconciliation of owned and managed average loan balances, returns on receivables, interest yields and interest rate spreads for the periods indicated:

 

Reconciliation of General Purpose Credit Card Loan Data (dollars in millions)

 

    Fiscal 2005

    Fiscal 2004

    Fiscal 2003

 
    Average
Balance


 

Return on

Receivables(1)


    Interest
Yield


    Interest
Rate
Spread


    Average
Balance


 

Return on

Receivables(1)


    Interest
Yield


    Interest
Rate
Spread


    Average
Balance


 

Return on

Receivables(1)


    Interest
Yield


    Interest
Rate
Spread


 

General Purpose Credit Card Loans:

                                                                       

Owned

  $ 19,932   2.92 %   10.12 %   5.94 %   $ 17,608   4.43 %   10.05 %   5.92 %   $ 19,531   3.32 %   10.02 %   5.53 %

Securitized

    27,398   2.12 %   12.88 %   9.16 %     29,779   2.62 %   12.90 %   10.56 %     31,333   2.07 %   13.13 %   10.64 %
   

                   

                   

                 

Managed

  $ 47,330   1.23 %   11.72 %   7.81 %   $ 47,387   1.65 %   11.84 %   8.88 %   $ 50,864   1.28 %   11.93 %   8.71 %
   

                   

                   

                 

(1) Return on receivables is equal to Discover income divided by average owned, securitized or managed credit card receivables, as applicable.

 

The following tables present a reconciliation of owned and managed general purpose credit card loans and delinquency and net charge-off rates:

 

Reconciliation of General Purpose Credit Card Loan Asset Quality Data (dollars in millions)

 

     Fiscal 2005

    Fiscal 2004

    Fiscal 2003

 
          Delinquency
Rates


         Delinquency
Rates


         Delinquency
Rates


 
     Period-
End
Loans


   Over
30
Days


    Over
90
Days


    Period-
End
Loans


   Over
30
Days


    Over
90
Days


    Period-
End
Loans


   Over
30
Days


    Over
90
Days


 

General Purpose Credit Card Loans:

                                                         

Owned

   $ 22,496    3.69 %   1.62 %   $ 19,724    4.08 %   1.97 %   $ 18,930    5.36 %   2.53 %

Securitized

     24,440    4.24 %   1.87 %     28,537    4.87 %   2.34 %     29,428    6.36 %   3.01 %
    

              

              

            

Managed

   $ 46,936    3.98 %   1.75 %   $ 48,261    4.55 %   2.18 %   $ 48,358    5.97 %   2.82 %
    

              

              

            

 

     Fiscal 2005

    Fiscal 2004

    Fiscal 2003

 

Net Principal Charge-offs:

                  

Owned

   4.84 %   5.53 %   6.05 %

Securitized

   5.52 %   6.28 %   6.95 %

Managed

   5.23 %   6.00 %   6.60 %
     Fiscal 2005

    Fiscal 2004

    Fiscal 2003

 

Net Total Charge-offs (inclusive of interest and fees):

                  

Owned

   6.59 %   7.68 %   8.33 %

Securitized

   7.72 %   9.01 %   9.75 %

Managed

   7.25 %   8.51 %   9.20 %

 

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Other Items.

 

Board Approval to Retain Discover.

 

On April 4, 2005, the Company announced that its Board of Directors had authorized management to pursue a spin-off of Discover Financial Services. On August 17, 2005, the Company announced that its Board of Directors had determined that it is in the best interest of shareholders to retain Discover Financial Services and to no longer pursue a spin-off.

 

Discontinued Operations.

 

As described in Note 18 to the consolidated financial statements, on August 17, 2005, the Company announced that its Board of Directors had approved management’s recommendation to sell the Company’s non-core aircraft leasing business. In connection with this action, the aircraft leasing business was classified as “held for sale” under the provisions of SFAS No. 144, and reported as discontinued operations in the Company’s consolidated financial statements. In addition, in the third quarter of fiscal 2005, the Company recognized a charge of approximately $1.7 billion ($1.0 billion after-tax) to reflect the write-down of the aircraft leasing business to its estimated fair value of approximately $2.0 billion. In determining the charge that was recorded in the third quarter of fiscal 2005, the Company estimated the value to be realized in selling the aircraft leasing business as a whole. The estimated value of the business was based on the appraised values of the aircraft portfolio, an evaluation of then current market conditions, recent transactions involving the sales of similar aircraft leasing businesses, a detailed assessment of the portfolio and additional valuation analyses.

 

On January 30, 2006, the Company announced that it had signed a definitive agreement under which it will sell its aircraft leasing business to Terra Firma, a European private equity group, for approximately $2.5 billion in cash and the assumption of liabilities. Based on the terms of the agreement and in accordance with SFAS No. 144, the Company revised its estimate of the fair value (less selling costs) of the aircraft leasing business and, as a result, in the fourth quarter reduced the pre-tax charge recorded in the third quarter of fiscal 2005 by approximately $1.1 billion. Full year results for fiscal 2005 reflected a charge of $509 million ($316 million after-tax).

 

The sale is subject to customary regulatory approvals and closing conditions and is expected to close in the first half of fiscal 2006.

 

In the third quarter of fiscal 2004, the Company entered into agreements for the sale of certain aircraft. Accordingly, the Company designated such aircraft as “held for sale” and recorded a $42 million pre-tax loss related to the write-down of these aircraft to fair value in accordance with SFAS No. 144. As of February 3, 2005, all of these aircraft were sold. In addition, during fiscal 2004 and fiscal 2003, the Company recorded aircraft impairment charges in accordance with SFAS No. 144 (see Note 18 to the consolidated financial statements).

 

The table below provides information regarding the pre-tax loss on discontinued operations and the aircraft impairment charges that are included in these amounts (dollars in millions):

 

     Fiscal Year

     2005

   2004

   2003

Pre-tax loss from discontinued operations

   $ 486    $ 172    $ 393

Aircraft impairment charges

     —        109      287

 

The pre-tax loss on discontinued operations for fiscal 2003 also included a $36 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 18 to the consolidated financial statements).

 

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Senior Management Compensation Charges.

 

Compensation and benefits expense in fiscal 2005 included charges for certain members of senior management related to severance and new hires, which increased non-interest expenses by approximately $311 million. These compensation charges were allocated to the Company’s business segments as follows: Institutional Securities ($193 million), Retail Brokerage ($48 million), Asset Management ($41 million) and Discover ($29 million).

 

Coleman Litigation.

 

On May 8, 2003, Coleman (Parent) Holdings Inc. (“CPH”) filed a complaint against the Company in the Circuit Court of the Fifteenth Judicial Circuit for Palm Beach County. The complaint relates to the merger between The Coleman Company, Inc. (“Coleman”) and Sunbeam, Inc. (“Sunbeam”) in 1998. The complaint, as amended, alleges that CPH was induced to agree to the transaction with Sunbeam based on certain financial misrepresentations, and it asserts claims against the Company for aiding and abetting fraud, conspiracy and punitive damages. Shortly before trial, which commenced in April 2005, the trial court granted, in part, a motion for entry of a default judgment against the Company and ordered that portions of CPH’s complaint, including those setting forth CPH’s primary allegations against the Company, be read to the jury and deemed established for all purposes in the action. In May 2005, the jury returned a verdict in favor of CPH and awarded CPH $604 million in compensatory damages and $850 million in punitive damages. On June 23, 2005, the trial court issued a final judgment in favor of CPH in the amount of $1,578 million, which includes prejudgment interest and excludes certain payments received by CPH in settlement of related claims against others. On June 27, 2005, the Company filed a notice of appeal with the District Court of Appeal for the Fourth District of Florida and posted a supersedeas bond, which automatically stayed execution of the judgment pending appeal. Included in cash and securities deposited with clearing organizations or segregated under federal and other regulations or requirements in the consolidated statement of financial condition is $1,863 million of commercial paper and other securities which have been pledged to obtain the bond which was posted in this matter. The Company filed its initial brief in support of its appeal on December 7, 2005. The Company’s appeal seeks to reverse the judgment of the trial court on several grounds and asks that the case be remanded for entry of a judgment in favor of the Company or, in the alternative, for a new trial.

 

The Company believes, after consultation with outside counsel, that it is probable that the compensatory and punitive damages awards will be overturned on appeal and the case remanded for a new trial. Taking into account the advice of outside counsel, the Company is maintaining a reserve of $360 million for the Coleman litigation, which it believes to be a reasonable estimate, under SFAS No. 5, “Accounting for Contingencies,” of the low end of the range of its probable exposure in the event the judgment is overturned and the case remanded for a new trial. If the compensatory and/or punitive awards are ultimately upheld on appeal, in whole or in part, the Company may incur an additional expense equal to the difference between the amount affirmed on appeal (and post-judgment interest thereon) and the amount of the reserve. While the Company cannot predict with certainty the amount of such additional expense, such additional expense could have a material adverse effect on the consolidated financial condition of the Company and/or the Company’s or Institutional Securities operating results for a particular future period, and the upper end of the range could exceed $1.2 billion. For further information, see Note 9 to the consolidated financial statements.

 

Parmalat.

 

On July 18, 2005, the Italian government approved the settlement agreement that the Company and its subsidiaries, Morgan Stanley & Co. International Ltd. and Morgan Stanley Bank International Ltd., had entered into with the administrator of Parmalat pursuant to which the Company agreed to pay €155 million to Parmalat as part of a settlement of all existing and potential claims between the Company and Parmalat. For further information, see Note 9 to the consolidated financial statements.

 

Business Acquisitions and Sales.

 

On December 20, 2005, the Company announced that it had entered into a definitive agreement to acquire the Goldfish credit card business from Lloyds TSB for approximately £1 billion. The acquisition of Goldfish will add approximately 800,000 accounts and approximately £0.8 billion of receivables to the Company’s existing U.K. credit card business. The Company currently expects the transaction to be completed in February 2006. The results of Goldfish will be included within the Discover business segment as of the date of acquisition.

 

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On January 12, 2005, the Company completed the acquisition of PULSE, a U.S.-based automated teller machine/debit and electronic funds transfer network currently serving banks, credit unions, and savings and other financial institutions. The Company believes that the combination of the PULSE and Discover Networks will create a leading electronic payments company offering a full range of products and services for financial institutions, consumers and merchants. As of the date of acquisition, the results of PULSE are included within the Discover business segment. The Company recorded goodwill and other intangible assets of $329 million in connection with the acquisition (see Note 23 to the consolidated financial statements).

 

On June 3, 2004, the Company completed the acquisition of Barra, a global leader in delivering risk management systems and services to managers of portfolio and firm-wide investment risk. The Company believes that the combination of MSCI, a majority-owned subsidiary of the Company, and Barra created a leading global provider of benchmark indices and risk management analytics. Since the date of acquisition, the results of Barra have been included within the Institutional Securities business segment. In February 2005, the Company sold its 50% interest in POSIT, an equity crossing system that matches institutional buyers and sellers, to Investment Technology Group, Inc. The Company acquired the POSIT interest as part of its acquisition of Barra. As a result of the sale, the net carrying amount of intangible assets decreased by approximately $75 million (see Note 23 to the consolidated financial statements).

 

In fiscal 2003, the Company acquired selected components of the U.S. real estate equity advisory businesses of Lend Lease Corporation, an Australia-based company. The financial statement impact of this acquisition, which is included in the Company’s Institutional Securities segment, was not significant.

 

Insurance Settlement.

 

On September 11, 2001, the U.S. experienced terrorist attacks targeted against New York City and Washington, D.C. The attacks in New York resulted in the destruction of the World Trade Center complex, where approximately 3,700 of the Company’s employees were located, and the temporary closing of the debt and equity financial markets in the U.S. Through the implementation of its business recovery plans, the Company relocated its displaced employees to other facilities.

 

In the first quarter of fiscal 2005, the Company settled its claim with its insurance carriers related to the events of September 11, 2001. The Company recorded a pre-tax gain of $251 million as the insurance recovery was in excess of previously recognized costs related to the terrorist attacks (primarily write-offs of leasehold improvements and destroyed technology and telecommunications equipment in the World Trade Center complex, employee relocation and certain other employee-related expenditures).

 

The pre-tax gain, which was recorded as a reduction to non-interest expenses, is included within the Retail Brokerage ($198 million), Asset Management ($43 million) and Institutional Securities ($10 million) segments. The insurance settlement was allocated to the respective segments in accordance with the relative damages sustained by each segment.

 

Stock-Based Compensation.

 

In fiscal 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123,” using the prospective adoption method for both deferred stock and stock options. In fiscal 2005, the Company early adopted SFAS No. 123R, which revised the fair value based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarified SFAS No. 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to service periods. SFAS No. 123R also amended SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits be reported as financing cash inflows rather than as a reduction of taxes paid, which is included within operating cash flows.

 

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Upon adoption of SFAS 123R using the modified prospective approach, the Company recognized an $80 million gain ($49 million after-tax) as a cumulative effect of a change in accounting principle in the first quarter of fiscal 2005 resulting from the requirement to estimate forfeitures at the date of grant instead of recognizing them as incurred. The cumulative effect gain increased both basic and diluted earnings per share by $0.05.

 

In accordance with SFAS 123R, fiscal 2005 compensation expense included the amortization of fiscal 2003 and fiscal 2004 equity-based awards but did not include any amortization for fiscal 2005 year-end awards. This had the effect of reducing compensation expense in fiscal 2005. If SFAS No. 123R were not in effect, fiscal 2005’s compensation expense would have included three years of amortization (i.e., for awards granted in fiscal 2003, fiscal 2004 and fiscal 2005). In addition, the fiscal 2005 year-end awards, which were granted in December 2005 and which will begin to be amortized in fiscal 2006, will be amortized over a shorter period (primarily two and three years) as compared with awards granted in fiscal 2004 and fiscal 2003 (primarily three and four years). The shorter amortization period will have the effect of increasing compensation expense in fiscal 2006. In addition, fiscal 2006 compensation expense will include the amortization of fiscal 2003, fiscal 2004 and fiscal 2005 equity-based awards.

 

For stock-based awards issued prior to the adoption of SFAS 123R, the Company’s accounting policy for such awards granted to retirement-eligible employees was to recognize compensation cost over the service period specified in the award terms. The Company accelerates any unrecognized compensation cost if and when a retirement-eligible employee leaves the Company. For stock-based awards made to retirement-eligible employees after the adoption of SFAS 123R on December 1, 2004, the Company’s accounting policy is to treat such awards as fully vested on the date of grant unless other provisions of the award terms operate as substantive service conditions. For awards granted to retirement-eligible employees during fiscal 2005, the Company recognized compensation expense for such awards on the date of grant. The Company modified certain terms of the fiscal 2005 year-end awards, which were granted in December 2005. As a result of such changes, the Company is in the process of evaluating the accounting treatment for fiscal 2005 year-end awards that were granted to retirement-eligible employees. If it is determined that the compensation expense for such awards should be recognized at the date of grant instead of over the relevant service period, incremental compensation expense of approximately $300 million will be recognized in the first quarter of fiscal 2006.

 

Lease Adjustment.

 

Prior to the first quarter of fiscal 2005, the Company did not record the effects of scheduled rent increases and rent-free periods for certain real estate leases on a straight-line basis. In addition, the Company had been accounting for certain tenant improvement allowances as reductions to the related leasehold improvements instead of recording funds received as deferred rent and amortizing them as reductions to lease expense over the lease term. In the first quarter of fiscal 2005, the Company changed its method of accounting for these rent escalation clauses, rent-free periods and tenant improvement allowances to properly reflect lease expense over the lease term on a straight-line basis. The cumulative effect of this correction resulted in the Company recording $109 million of additional rent expense in the first quarter of fiscal 2005. The impact of this change was included within non-interest expenses and reduced income before taxes within the Institutional Securities ($71 million), Retail Brokerage ($29 million), Asset Management ($5 million) and Discover ($4 million) segments. The impact of this correction was not material for all periods presented to the pre-tax income of each of the segments or to the Company.

 

Income Tax Examinations.

 

The Company is under continuous examination by the Internal Revenue Service (the “IRS”) and other tax authorities in certain countries, such as Japan and the U.K., and states in which the Company has significant business operations, such as New York. The tax years under examination vary by jurisdiction; for example, the current IRS examination, which recently began, covers 1999-2004. The Company has filed an appeal with respect to unresolved issues relative to the IRS examination of years 1994-1998. The Company believes that the settlement of the IRS examination of years 1994-1998 will not have a material negative impact on the consolidated statement of income of the Company. The Company regularly assesses the likelihood of additional assessments in each of the taxing jurisdictions resulting from these and subsequent years’ examinations. The

 

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Company has established tax reserves that the Company believes are adequate in relation to the potential for additional assessments. Once established, the Company adjusts tax reserves only when more information is available or when an event occurs necessitating a change to the reserves. The Company believes that the resolution of tax matters will not have a material effect on the consolidated financial condition of the Company, although a resolution could have a material impact on the Company’s consolidated statement of income for a particular future period and on the Company’s effective income tax rate for any period in which such resolution occurs.

 

American Jobs Creation Act of 2004.

 

The American Jobs Creation Act, adopted on October 22, 2004, provided for a special one-time tax deduction, or dividend received deduction, of 85% of qualifying foreign earnings that are repatriated in either a company’s last tax year that began before the enactment date or the first tax year that begins during the one-year period beginning on the enactment date. In the fourth quarter of fiscal 2005, the Company recorded an income tax benefit of $309 million, or $0.29 per diluted share, resulting from the Company’s repatriation of approximately $4.0 billion of qualifying foreign earnings under the provisions of the American Jobs Creation Act. The $309 million tax benefit resulted from the reversal of net deferred tax liabilities previously provided under SFAS No. 109, “Accounting for Income Taxes,” net of additional taxes associated with these qualifying earnings.

 

Asset Management and Account Fees.

 

Prior to the fourth quarter of fiscal 2004, the Company was improperly recognizing certain management fees, account fees and related compensation expense paid at the beginning of the relevant contract periods, which is when such fees were billed. In the fourth quarter of fiscal 2004, the Company changed its method of accounting for such fees to properly recognize such fees and related expenses over the relevant contract period, generally quarterly or annually. As a result of the change, the Company’s results in the fourth quarter of fiscal 2004 included an adjustment to reflect the cumulative impact of the deferral of certain management fees, account fees and related compensation expense paid to representatives. The impact of this change reduced net revenues by $107 million, non-interest expenses by $27 million and income before taxes by $80 million, at both the Company and the Retail Brokerage segment in the fourth quarter of fiscal 2004. Such adjustment reduced net income by approximately $50 million and basic and diluted earnings per share by $0.05. If the above-referenced fees and expenses had been recognized over the relevant contract period in the past, pre-tax income for the Company and the Retail Brokerage segment would have been lower by the following amounts:

 

   

Decrease in

Pre-tax Income


 
    (dollars in
millions)
 

Quarter ended:

       

February 28, 2003

  $ (5.2 )

May 31, 2003

    (1.3 )

August 31, 2003

    (4.2 )

November 30, 2003