UNITED STATES OF AMERICA
In the Matter of
MORGAN STANLEY DW INC.,
ORDER INSTITUTING ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933 AND SECTIONS 15(b) AND 21C OF THE SECURITIES EXCHANGE ACT OF 1934
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act"), and Sections 15(b) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Morgan Stanley DW Inc. ("Respondent").
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order Pursuant to Section 8A of the Securities Act of 1933, and Sections 15(b) and 21C of the Securities Exchange Act of 1934, ("Order"), as set forth below.
On the basis of this Order and Respondent's Offer, the Commission finds1 that:
1. Morgan Stanley DW, a broker-dealer registered with the Commission pursuant to Section 15 of the Exchange Act since 1968, is a subsidiary of the publicly traded entity Morgan Stanley. It is also a member of the National Association of Securities Dealers ("NASD"). Morgan Stanley DW's principal offices are located at 825 Third Avenue, New York, New York. It has approximately 500 branch offices, which provide retail brokerage services nationwide.
2. This matter arises from Morgan Stanley DW's failure to disclose adequately certain material facts to its customers in the offer and sale of mutual fund shares, thereby violating Section 17(a)(2) of the Securities Act and Rule 10b-10 under the Exchange Act. At issue in this matter are two distinct disclosure failures. The first relates to Morgan Stanley DW's operation of mutual fund marketing programs in which it collected from a select group of mutual fund complexes amounts in excess of standard sales loads and Rule 12b-1 trail payments.2 These programs were designed to specially promote the sale of those mutual funds with enhanced compensation to individual registered representatives, known as financial advisors ("FAs"), and branch managers as well as increased visibility in its extensive retail distribution network. The second disclosure failure related to Morgan Stanley DW's sales of Class B shares of its proprietary mutual funds in connection with sales in excess of $100,000. Morgan Stanley DW did not adequately disclose at the point of sale, in connection with its recommendations to purchase Class B shares, that such shares were subject to higher annual fees and that those fees could have a negative impact on the customers' investment return.
3. The selective marketing programs that Morgan Stanley DW operated, initially known as the Asset Retention Program and later as the Partners Program, created an undisclosed conflict of interest because Morgan Stanley DW was authorized to offer and sell shares of approximately 115 mutual fund complexes, but the firm and its FAs received additional compensation for the sale of the mutual funds of a select group of fund complexes. Morgan Stanley DW chose to rely on the disclosures that the fund companies made in their prospectuses and statements of additional information ("SAIs"), although most of those disclosures did not provide facts that would enable Morgan Stanley DW's customers to understand the conflict of interest.
4. As to the sale of Morgan Stanley Funds Class B mutual fund shares, at the point of sale, Morgan Stanley DW's FAs recommended Class B shares to customers without adequately disclosing the differences in share classes, including information about commissions and annual expenses and, importantly, that an equal investment in Class A shares at certain dollar levels could yield a higher return.
5. On January 1, 2000, Morgan Stanley DW implemented the Asset Retention Program to: (1) "[p]rovide quality mutual fund products for clients across various distribution channels;" (2) "[s]upport strategic long-term investment behavior by rewarding retention efforts;" and (3) "[m]aximize monetary value of the MS distribution channel in a uniform manner." The program was implemented and managed by the External Mutual Funds Group (the "EMF Group"), which is a department within Morgan Stanley DW.
6. Fourteen (14) mutual fund complexes out of the approximately 115 with which Morgan Stanley DW had distribution agreements participated in the Asset Retention Program. Two of the participating fund complexes were Morgan Stanley DW affiliated or proprietary fund complexes and twelve were external or non-proprietary fund complexes (the "Asset Retention Program Participants").
7. In exchange for participation in the program, the Asset Retention Program Participants paid Morgan Stanley DW: (i) 15 or 20 basis points ("bps") on gross sales of open-end, variable-priced mutual fund shares (the "gross sales payments") and (ii) 5 bps on aged assets (participating fund shares held over one year), which the firm then paid to the FAs responsible for the accounts holding these assets. These payments were in addition to existing payments such as commissions, 12b-1 fees, shareholder servicing fees and account maintenance fees.
8. Although Morgan Stanley DW requested and preferred gross sales payments in the form of cash ("hard dollars"), the firm often accepted Asset Retention Program payments in the form of brokerage commissions on participants' portfolio transactions.3
9. Six of the fourteen participant fund complexes, including the Morgan Stanley DW affiliated funds, made their gross sales payment solely in hard dollars. The remaining eight paid either with portfolio brokerage commissions or a combination of hard dollars and brokerage commissions
10. All of the Asset Retention Program Participants, except one, paid the 5 bps on aged assets with hard dollars.
11. In return for their payments, program participants received a number of marketing benefits. First, Morgan Stanley DW included all Asset Retention Program Participants on its "preferred list," which was a list of fund complexes that FAs should look to first in making recommendations of mutual fund products. Second, it ensured that Asset Retention Program Participants had a "higher profile" in Morgan Stanley DW's sales system than non-participating fund complexes by, among other things, increasing the visibility of the Asset Retention Program Participants on its FAs' workstations. Third, the program participants were eligible to participate in the firm's 401(k) programs and to offer offshore fund products to Morgan Stanley DW's customers.
12. Morgan Stanley DW also provided "incentives designed to support long-term mutual fund asset retention goals." In particular, Morgan Stanley DW paid the 5bps component of the Asset Retention Program payment to FAs, thus incentivizing FAs to encourage their customers to make, and then retain over the specified time period, their investments in mutual fund complexes participating in the Asset Retention Program.
13. On December 1, 2002, Morgan Stanley DW replaced the Asset Retention Program with the Partners Program. The new program is similar to the Asset Retention Program, with a number of significant differences. Notably, the participants in the Partners Program ("Partners") receive greater access to Morgan Stanley DW's sales system, and have the prospect of greater sales as a result of compensation incentives that Morgan Stanley DW provides to the sales force on the sale of Partners' funds.
14. The Partners Program consists of sixteen mutual fund complexes, twelve of which had participated in the Asset Retention Program. Four new fund complexes joined the Partners Program, one Asset Retention Program Participant declined to join the Partners Program, and one Asset Retention Program Participant had dropped from the program in 2001.
15. Under the Partners Program, all fund complexes made the 5 bps aged asset payments in hard dollars. As in the Asset Retention Program, although Morgan Stanley DW requested and preferred gross sales payments in the form of hard dollars, some fund complexes paid the 15 or 20 bps gross sales payments with hard dollars, some paid with portfolio brokerage commissions, and some paid with a combination of hard dollars and brokerage commissions.
16. As mentioned above, one of the enhancements implemented in the Partners Program was greater access to FAs. This was achieved by affording Partners: (i) priority placement in queue for due diligence review of fund materials that will be distributed to Morgan Stanley DW's FAs; (ii) access to Morgan Stanley DW's branch system at the Branch Manager's discretion; (iii) access to FAs via training and customer seminars; (iv) inclusion in FA events; and (v) invitations to participate in "BTV" programs that are broadcast over Morgan Stanley DW's internal systems to its FAs. All of these benefits provide FAs with significantly more information on the Partners' funds than non-participating funds and provide Partners' funds with enhanced access to Morgan Stanley DW's FAs.
17. A second enhancement of the Partners Program is the increased incentives Morgan Stanley DW provided to its sales force. On December 1, 2002, Morgan Stanley DW adopted a new FA "Incentive Compensation" grid that, generally, provided greater compensation for "asset based products" versus "transaction based products." Partners' funds' shares are considered "asset based products," while non-participating funds' shares are considered either "transaction based products" or "asset based products," depending upon the type of account in which they were held. Under the new system, for instance, a broker whose annual production is over $1 million received 42% of the commissions on "asset based products" and 40% of the commissions on "transaction based products." Accordingly, under Morgan Stanley DW's current compensation grid, FAs generally receive a higher payout from the sale of Partners' funds than non-Partners' funds.
18. At the same time, Morgan Stanley DW implemented a system under which Branch Managers stood to earn a higher bonus for the sale of shares of Partners' funds than for the sale of non-Partners' funds. Branch Manager compensation consists of three components: salary, "Management Incentive Compensation" and a "Discretionary Challenge Bonus." Management Incentive Compensation, which is based on the profitability of the branch, includes an expense allocation based on product type: (i) 10% of revenues is charged on proprietary mutual funds for overhead; (ii) 20% of revenues is charged on Partners' funds for overhead; and (iii) 40% of revenues is charged on non-Partners' funds for overhead.4 Thus, branches are more profitable and the managers' incentive compensation is greater if they sell more Partners' funds as compared to non-Partners' funds.
19. In addition, in early 2003, Morgan Stanley DW enhanced the sales efforts for the Partners' funds by replacing the head of the EMF Group with an individual who had previously been responsible for encouraging FAs to sell the firm's proprietary products and, thus, had experience focusing Morgan Stanley DW's sales system to increase sales of specific, targeted products.
20. Periodically, the Asset Retention Program Participants and the Partners provided sales figures to the EMF Group. The EMF Group in turn calculated the payments owed based on those sales figures and billed those amounts to the participants. The participants then either sent a check or sent trades with sufficient brokerage commissions to satisfy payment. Most of the participants that paid via brokerage commissions executed portfolio trades on Morgan Stanley DW's trading desk until January 2002 and, thereafter, on the trading desk of Morgan Stanley & Co., an affiliate, which then earmarked a portion of the commission for payment to Morgan Stanley DW.
21. The Asset Retention Program Participants and Partners that paid via brokerage commissions were required to pay in portfolio commissions a negotiated multiple of the amount they would have paid via hard dollars. The trading desk retained one-third of the commission to cover its expenses, while the remaining two-thirds was directed to Morgan Stanley DW. Thus, for a program participant that agreed to pay 15 bps on gross sales via brokerage commissions with a multiplier of 1.5, generated a revenue stream of 22.5 bps on gross sales with one-third, or 7.5 bps, being retained by the trading desk, and 15 bps directed to Morgan Stanley DW.
22. When Asset Retention Program Participants and Partners called in the trades to Morgan Stanley & Co. that they intended to use for program payments, they typically "flagged" those trades as "for the benefit of DW."
23. Morgan Stanley DW discloses information to customers concerning mutual fund purchases primarily through its FAs' direct contacts with customers and by supplying customers with the prospectuses and if requested, the SAIs issued by the mutual funds.5 Morgan Stanley DW has never had policies and procedures requiring FAs to disclose the above-discussed aspects of the Asset Retention or Partners Programs to customers when discussing customers' purchases of mutual fund shares.
24. Although Morgan Stanley DW relied on the disclosures in the participating funds' prospectuses and SAIs to fulfill its disclosure obligations, it made no effort until 2003 to review the funds' prospectuses and SAIs to ascertain the content of the funds' disclosures regarding the fund complexes' payments and the enhanced marketing treatment provided to the participating funds.
25. Although the Asset Retention Program and Partners funds' prospectuses and SAIs contain various disclosures concerning payments to the broker-dealers distributing their funds, none adequately disclose the preferred programs as such, nor do most provide sufficient facts about the preferred programs for investors to appreciate the dimension of the conflicts of interest inherent in them. For example, none of the prospectuses specifically discloses that Morgan Stanley DW receives payments from the fund complexes, that the fund complexes send portfolio brokerage commissions to Morgan Stanley DW or Morgan Stanley & Co. in exchange for enhanced sales and marketing, nor do they describe for investors the various marketing advantages provided through the programs.
26. Based on the above-described conduct, Morgan Stanley DW willfully6 violated:
Neither Section 17(a)(2) nor Rule 10b-10 require a showing of scienter.7
By virtue of the portfolio brokerage commission payments, as described above, Morgan Stanley DW also contravened the dictates of Rule 2830(k) of the NASD, which essentially prohibits NASD members from favoring the sale of mutual fund shares based on the receipt of brokerage commissions.
28. Since 2000, Morgan Stanley DW has sold more than sixty individual funds offered by Morgan Stanley Funds. The funds are offered in different classes of shares, representing interests in the same mutual fund assets. Each share class (A, B, C and D) has different features, including differences in sales loads8 to purchase the shares, annual fees, and considerations to determine whether a particular class of shares may be more appropriate for certain customers.
29. The different share classes and their respective features are described in Morgan Stanley Funds prospectuses. In particular, Class A shares of equity funds are subject to a front-end load of 5.25% at the time of purchase for purchases of $25,000 and less. The front-end load is decreased for larger purchases at specified investment increments or "breakpoints."9 For instance, amounts between $25,000 and $49,999 are subject to an initial sales charge of 4.75%. An investment between $50,000 and $99,999 reduces the sales charge to 4%; between $100,000 and $249,999 reduces the sales charges to 3%; between $250,000 and $499,999 reduces the sales charge to 2.5%; between $500,000 and $999,999 reduces the sales charge to 2%; and there is no sales charge for an investment of $1 million or more.10
30. In contrast, investors who purchase Class B shares pay no front-end load. Rather, Class B shares become subject to the CDSC, only if they are redeemed before the end of a six-year holding period. The amount of the CDSC declines as a percentage of the account's value over the six-year holding period (5%, 4%, 3%, 2%, 2%, and 1%). Class B shares automatically convert to Class A shares in the month following the ten-year anniversary of their purchase. In contrast to Class A shares, breakpoint discounts are not available for purchases of Class B shares, regardless of the size of the investments, and the annual 12b-1 fee is significantly higher: a maximum of 1% for Class B shares as compared to .25% for Class A equity funds.
31. The prospectuses of Morgan Stanley Funds contain two tables that illustrate the impact of costs on the investment. These tables compare the costs of all classes of shares over one year, three years, five years and ten years, assuming a hypothetical investment of $10,000 and return of 5% per year and a hypothetical investment decision to either hold or sell the investment at the end of each period. The 2001 Information Fund prospectus, for example, demonstrates generally that, based on these assumptions, for a $10,000 investment, where the investor sold the shares at the end of each period, Class A shares had lower total costs than Class B shares.
32. The compensation that FAs receive for the sale of Class B shares is higher than for Class A shares. Specifically, for Class B shares, Morgan Stanley DW FAs received gross sales credits at the time of purchase of 5% for all amounts, until a March 2002 policy and procedures change described below, thereby making it more lucrative for the FAs to sell Class B, rather than Class A, shares. For Class A shares, the FAs' compensation decreases similar to the breakpoint discounts, with the FAs receiving a gross sales credit at the time of sale of equity funds of 5% for purchases of less than $25,000; 4.5% for purchases between $25,000 - $49,999; 3.75% for purchases between $50,000 - $99,999; 2.75% for purchases between $100,000 - $249,999; 2.25% for purchases between $250,000 - $499,999; 1.8% for purchases between $500,000 - $999,999; and 1% for purchases of $1 million and above.11
33. Morgan Stanley DW did not have a policy restricting large purchases of Class B shares by its customers until October 1, 2001. At that time, the firm implemented a policy whereby "[t]he Morgan Stanley Funds generally will not accept purchase orders for Class B shares in amounts of $100,000 or greater. Purchases of $100,000 or greater but less than $1 million generally can be made only in Class A or Class C shares." Moreover, according to the Morgan Stanley Funds Multi-Class Manual, also dated October 1, 2001,12 "[a]ggregate purchases of $100,000 or greater in Class B shares of Morgan Stanley Funds require the Branch Manager to first discuss the intended investment with the prospective investor to ensure that the investor understands the relative fees, expenses and features of the different classes."
34. The Multi-Class Manual summarized the considerations relating to sales of mutual funds that have multi-classes as follows:
You should consider, among other things, sales charges and ongoing expenses in estimating the costs of investing in a particular class of shares before making an investment recommendation. Although Class B and C shares do not pay front-end sales charges, the 12b-1 distribution fees payable on Class B and Class C shares may over time cost more than the sales charges and 12b-1 distribution fees imposed on the same amount investment in Class A shares. Class B shares are subject to higher annual distribution fees than Class A shares for a period of ten (10) years, after which they convert to Class A shares, whereas Class C shares do not convert to Class A shares, so they continue to have higher ongoing annual expenses.
Additionally, the Multi-Class Manual identified the following as important factors to be considered prior to recommending a share class for investment: the investment amount, the expected term of the investment, the fees and expenses associated with each class of shares, and the investor's personal and financial circumstances and investment objectives, in addition to the suitability of the investment. Moreover, for Class B shares, the manual identified client profiles and practice considerations for each share class. The Class B share client profile describes the investors as: (1) investors who do not qualify for reduced sales charges on purchases of Class A; (2) investors who may benefit from the Class B CDSC waivers when considered in view of the higher ongoing 12b-1 distribution expenses; and (3) small investors who prefer to spread the cost of investing over several years. The manual states that "it should be pointed out that they will bear higher on-going 12b-1 distribution expenses in the first ten (10) years and, if they qualify for reduced Class A sales charges, will generally have lower returns than if the investment were made in Class A shares."
36. On or about March 6, 2002, Morgan Stanley DW further modified its Class B share policy by increasing the restrictions on its Class B share sales to impose a limit on Class B share sales of $100,000 over a rolling 45-day period, rather than a single purchase limitation. The limit applied to the total amount invested in a single fund, fund family and across fund families (including both internal and external funds). Moreover, in the event a purchase is made above these limits, even at the customer's insistence, the policy reduced the FA's payout to the Class A payout for the sales in the amount of $100,000 or greater.
37. The disclosures made by Morgan Stanley DW FAs to customers about the relative costs and expenses associated with different Morgan Stanley mutual funds share classes differed. In some instances, the FAs discussed with their customers the various share classes and features, and the customers chose to purchase Class B shares, nonetheless. As to other customers, in some instances the customers followed the recommendations of their FAs to purchase Class B shares, but did so without being informed by Morgan Stanley DW FAs that other classes of shares existed or what the differences between them were. Still others purchased Class B shares, but did not know this fact until they saw their confirmations or monthly account statements.
38. Morgan Stanley DW FAs also were inconsistent in disclosing the other features that may make Class A shares more attractive to some customers, including breakpoint discounts, rights of accumulation and letters of intent.
39. During the time period from January 1, 2000 through July 31, 2003, Morgan Stanley DW executed over 7,000 transactions in which customers purchased Class B shares in amounts of $100,000 or greater. After the Class B share policy was implemented in October 2001, the number of such transactions decreased substantially.
40. According to Morgan Stanley DW's Multi-Class Manual, branch managers are required to contact customers prior to their purchases of Class B shares in amounts of $100,000 or greater to confirm the transaction. However, this policy is not always followed and there is no requirement that the branch manager document the mandated customer contact. Although Morgan Stanley DW's Class B Share Policy Statement of March 2002 contains a form letter (stating the differences in sales charges and 12b-1 fees between Class A and B shares and that Class A shares would be the more appropriate choice for their investments) that a branch manager may use to confirm a Class B share transaction of $100,000 or greater, there is no specific requirement that the letter be used. Moreover, in practice, it appears that FAs, instead of branch managers, are sometimes sending these letters to customers.
41. Since at least February 2002, the compliance department at Morgan Stanley DW also has been reviewing large purchases of Class B shares by contacting the branches and asking for explanations and confirmations that the customer did, in fact, decide to make the purchase after the necessary disclosures were made. The firm's procedures, however, do not require that the firm, through its compliance department or otherwise, review the branches' contacts with customers relating to Class B share purchases that are covered by the Class B share policy.
42. Based on the above-described conduct, Morgan Stanley DW willfully violated Section 17(a)(2) of the Securities Act. Section 17(a)(2) does not require a showing of scienter.
43. Morgan Stanley DW undertakes the following:
In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions specified in the Offer submitted by Morgan Stanley DW.
Accordingly, it is hereby ORDERED that:
A. Morgan Stanley DW is censured.
B. Morgan Stanley DW shall cease and desist from committing or causing any violations and any future violations of Section 17(a)(2) of the Securities Act and Rule 10b-10 under the Exchange Act.
C. Morgan Stanley DW shall pay, in accordance with the provisions of the Distribution Plan, the amount of $50 million, consisting of disgorgement plus prejudgment interest in the amount of $25 million and a civil monetary penalty in the amount of $25 million (pursuant to Section 308 of the Sarbanes-Oxley Act of 2002).
D.. Morgan Stanley DW shall comply with the undertakings enumerated in Section III.43.
By the Commission.
Jonathan G. Katz
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