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U.S. Securities and Exchange Commission

before the

Release No. 7841 \ April 6, 2000

Release No. 42642 \ April 6, 2000

File No. 3-10181

In the Matter of




The Commission deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 15(b)(4) of the Securities Exchange Act of 1934 ("Exchange Act") against Morgan Stanley & Co. Incorporated ("Morgan Stanley").

In anticipation of the institution of these proceedings, Morgan Stanley has submitted an offer of settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. 201.100 et seq., Morgan Stanley, without admitting or denying the findings contained herein, except that it admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the entry of the findings, the issuance of the cease-and-desist order, and the imposition of the remedial sanctions set forth below.


Based on the foregoing, the Commission finds as follows:


Morgan Stanley is a Delaware corporation with its principal place of business in New York. At all relevant times, Morgan Stanley was registered with the Commission as a broker-dealer pursuant to Section 15(b) of the Exchange Act.


This is a municipal finance case involving Morgan Stanley's sale of U.S. Treasury securities to municipal bond issuers at excessive, undisclosed markups in connection with certain advance refunding transactions.

When interest rates fall, state and local governments often seek to reduce their borrowing costs by paying off outstanding bonds through the issuance of new bonds at lower interest rates. When the old bonds cannot be paid off until a future call date, the municipality can still obtain a benefit from lower interest rates through an advance refunding. An advance refunding can lock in current interest rates and ensure that the municipality will realize debt service savings over the life of the new bonds. In an advance refunding, the municipality issues new "refunding" bonds and immediately invests the proceeds in a portfolio of U.S. Treasury or agency securities structured to pay the principal and interest obligations on the old bonds until the call date and then to pay off the outstanding principal and any call premium. The portfolio of government securities is normally placed in a defeasance escrow to guarantee repayment of the old bonds.

Defeasance escrow portfolios are subject to Internal Revenue Code provisions and Treasury regulations that prohibit the issuer of tax-exempt refunding bonds from earning tax arbitrage (that is, a profit from the rate differential between the taxable and tax-exempt markets). I.R.C. § 148; Treas. Reg. § § 1.148-0 et seq. The regulations provide that the issuer cannot receive a yield on the securities held in escrow that exceeds the yield it pays on the refunding bonds. In addition, to prevent an issuer from diverting tax arbitrage to the seller of the escrow securities by paying artificially high prices, the regulations provide, in effect, that the price paid by refunding bond issuers for escrow securities purchased in the secondary market (known as "open market securities") cannot exceed the fair market value or market price of the securities as defined in those regulations.

When the yield on the investments in the escrow, if purchased at fair market value, would exceed the yield on the refunding bonds, the transaction is said to be in "positive arbitrage." Overcharging by dealers for open market escrow securities in positive arbitrage situations diverts tax arbitrage to the dealers at the expense of the U.S. Treasury. This diversion of money-known colloquially as "yield burning"-violates IRS regulations. If yield burning occurs, the IRS can declare interest paid on the refunding bonds taxable. See Harbor Bancorp & Subsidiaries v. Commissioner, 115 F.3d 722 (9th Cir. 1997), cert. denied, 118 S. Ct. 1035 (1998).


Before 1995, Morgan Stanley sold portfolios of U.S. Treasury securities for defeasance escrows at excessive, undisclosed markups to certain municipalities in connection with advance refundings. For example, in 1994, Morgan Stanley sold a portfolio of $41.8 million in Treasury securities to a municipality. Morgan Stanley's markup and carry on that portfolio was .45 percent of the prevailing interdealer market prices of the Treasury securities sold to the municipality.1 At the time, dealers generally charged materially lower markups on escrow securities when the prices were determined through competition or bona fide arm's length negotiation.

Morgan Stanley violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by effecting defeasance escrow transactions with municipalities at prices not reasonably related to the current wholesale market prices for the securities under the particular facts and circumstances, including the pertinent tax regulations. Based on all the relevant facts and circumstances, Morgan Stanley knew or should have known that the prices it charged were not reasonably related to the prevailing wholesale market prices of the securities. The excessive markups also violated Sections 17(a)(2) and 17(a)(3) of the Securities Act because the excessive markups jeopardized the tax-exempt status of those municipalities' refunding bonds and diverted money from the U.S. Treasury to Morgan Stanley.


By reason of the foregoing, Morgan Stanley willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act.


Accordingly, IT IS ORDERED, pursuant to Section 8A of the Securities Act and Section 15(b)(4) of the Exchange Act, that:

A. Morgan Stanley is censured;

B. Morgan Stanley shall cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act;

C. Morgan Stanley shall comply with its undertaking to pay $2,453,219.92 to the United States Treasury under an agreement simultaneously entered into among Morgan Stanley, the Internal Revenue Service and the United States Attorney for the Southern District of New York; and

D. At the time the payment is made to the United States Treasury as described in sub-paragraph C above, a copy of the payment and any cover letter accompanying it shall be sent by Morgan Stanley to Lawrence A. West, Assistant Director, Division of Enforcement, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0807.

By the Commission.

Jonathan G. Katz



1 Profit on open market escrow securities generally has two components: markup and carry. Markup is the difference between the price that the dealer charges the issuer and the prevailing wholesale market price. In re Lehman Bros. Inc., Exchange Act Release No. 37673 (Sept. 12, 1996). Carry is the difference between (a) the interest and accretion produced by the escrow securities between the sale date and closing date and (b) the cost of financing those securities during that period. See Board of Governors of the Federal Reserve System, Trading Activities Manual, Part 2 at 2-8 (March 1994).