UNITED STATES OF AMERICA
In the Matter of
ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), against Morgan Stanley ("Company," or "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 Respondent and the subject matter of these proceedings, which Respondent admits, Respondent consents to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 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 as follows:
Respondent Morgan Stanley is a financial services firm incorporated under the laws of Delaware with its headquarters in New York City. Morgan Stanley's securities are registered with the Commission under Section 12(b) of the Exchange Act. Morgan Stanley reported its financial results using a fiscal year ended November 30.
Morgan Stanley valued certain aircraft in its aircraft leasing business in late 2001, late 2002, and early 2003 and certain bonds in its high-yield bond portfolio in late 2000 in a manner that violated financial reporting, recordkeeping, and internal controls provisions of the federal securities laws. Regarding its impaired aircraft, for the fourth quarter of fiscal year 2001 and for the third quarter of fiscal year 2002, Morgan Stanley used a valuation method not in compliance with Generally Accepted Accounting Principles ("GAAP") to determine the value of certain impaired aircraft in its aircraft leasing portfolio. GAAP requires that the value for these aircraft be recorded at "fair value." For the fourth quarter of fiscal year 2001, when there was a slump in the aircraft leasing business brought on by the terrorist attacks of September 11, 2001, and for the third quarter of fiscal year 2002, Morgan Stanley obtained independent appraisers' estimates of "base value" and used the average of their estimates of base value to establish the recorded value of a number of its aircraft. Base value, as described by Morgan Stanley, involved estimation of the value of an aircraft "presuming a transaction between an equally willing and informed buyer and seller, neither under compulsion to buy or sell, and with supply and demand for the aircraft in reasonable balance." Use of base value did not meet the GAAP requirement of fair value. Morgan Stanley should have considered current market conditions such as imbalances in supply and demand, and other factors that could be considered when looking at the then current market value of the aircraft. Had Morgan Stanley used market values to calculate a fair value for its impaired aircraft, it would have recorded significantly greater writedowns for the fourth quarter of fiscal year 2001 and for the third quarter of fiscal year 2002. In both of these quarters, Morgan Stanley's use of base value instead of an appropriate method of calculating fair value violated GAAP.
After the Commission staff questioned Morgan Stanley's use of base value and after a months long dialogue, Morgan Stanley agreed to use independent appraisers' market values as a basis for calculating fair value. In the first quarter of fiscal year 2003, Morgan Stanley recorded an impairment of certain aircraft as a catch-up adjustment for using base value in prior reporting periods. However, without an adequate basis under GAAP, and without creating adequate documentation of its valuation determination, Morgan Stanley used the highest portfolio market value in the range of appraisers' estimates it obtained as the fair value of aircraft. The Commission staff then questioned whether Morgan Stanley should have instead used the average of the appraisers' market valuations as it had for base valuations. Use of average market valuation would have resulted in a significantly greater writedown as the catch-up adjustment for prior reporting periods in the first quarter of 2003. After the staff's inquiry, Morgan Stanley then committed to use the average market valuation of aircraft to determine their fair value going forward. As a result of the above, Morgan Stanley's financial results for the fourth quarter of fiscal year 2001, third quarter of fiscal year 2002 and the first quarter of fiscal year 2003, as reported on filings made with the Commission, were misstated and not in conformity with GAAP. In addition, Morgan Stanley violated applicable recordkeeping and internal accounting control requirements.
Regarding its high-yield bond portfolio, Morgan Stanley overvalued certain bonds in the portfolio in 2000 by taking a "longer view" as to their value, which entailed discounting current market conditions such as imbalances in supply and demand. This reflected Morgan Stanley's view that its opinion about the value of the bonds was superior to the valuations of external pricing sources. Morgan Stanley's taking a "longer view of the market" was not in conformity with GAAP. The majority of the overvaluations occurred in the telecommunications sector, which in the fall of 2000 was experiencing significant business turmoil. Bonds in that sector declined significantly in value during that time period. By overvaluing those bonds, Morgan Stanley took less of a markdown than it would have had it complied with GAAP, thereby overstating its trading revenue for the fourth quarter of its fiscal year 2000. Because of this, Morgan Stanley's financial results for the fourth quarter of fiscal year 2000, as reported on filings made with the Commission, were misstated and not in conformity with GAAP. Morgan Stanley also failed to maintain sufficient underlying documentation supporting its bond valuations. Finally, Morgan Stanley's internal controls failed to ensure that it valued its bond positions in accordance with GAAP.
In fiscal year 2000, Morgan Stanley purchased Ansett Worldwide Aviation Services, an aircraft-leasing group that leases new and old commercial jet aircraft to airlines around the world. For the fourth quarter of fiscal year 2001, Morgan Stanley took an $87 million charge in financial statements filed with the Commission on Form 10-K to reflect the impairment of certain aircraft values as a result of the adverse impact the terrorist attacks of September 11, 2001, had on the global aviation industry, including its aircraft leasing business. Morgan Stanley calculated impairment charges for its aircraft using "base value," which Morgan Stanley described in its Form 10-Q for the third quarter of 2002 as "presuming a transaction between an equally willing and informed buyer and seller, neither under compulsion to buy or sell, and with supply and demand for the aircraft in reasonable balance." In consultation with its independent external auditors, Morgan Stanley used the average of several appraisers' estimates of base value to determine the reported value of its aircraft. Base value presumes supply and demand in a hypothetical balance, but GAAP defines fair value as the amount at which that asset could be bought or sold in a current transaction. By using base value to measure the impairment of aircraft, Morgan Stanley did not take into account fully the negative impact that the post September 11, 2001, overhang of unused aircraft and excess seat capacity had on aircraft valuations. In the third quarter of fiscal year 2002, Morgan Stanley took another $74 million impairment charge in financial statements filed with the Commission in its Form 10-Q to reflect declines in the value of its impaired aircraft. This impairment charge was also determined using the base value methodology described above.
Had Morgan Stanley used an appropriate market value method of determining fair value as required by GAAP to determine the impairment charges, it would have taken an additional $71 million charge in the fourth quarter of fiscal year 2001. This additional charge would have reduced pre-tax income for the quarter by 5.1%. Similarly, Morgan Stanley would have taken an additional $72 million charge in the third quarter of fiscal 2002, reducing pre-tax income for the quarter by 7.4%. Morgan Stanley believed that its use of base value was proper because the market for the purchase and sale of aircraft was "highly illiquid" at the time, making estimates of fair value based on current market conditions unreliable. After the use of this methodology was questioned by the Commission staff in a months long dialogue, on or about February 5, 2003, the Commission staff informed Morgan Stanley that its use of base value in determining the impairment charge was not in compliance with GAAP. Morgan Stanley ceased to use base value and began determining fair value using market values for the first fiscal quarter of 2003, ended February 28, 2003. It used market valuations from several appraisers to create a range of potential values. Then, Morgan Stanley used the valuation provided by the appraisal with the highest portfolio value as the reported value of aircraft, which resulted in a writedown of $36 million as a catch-up adjustment from prior reporting periods in financial statements filed with the Commission in its Form 10-Q for the first fiscal quarter of 2003. Morgan Stanley used its own internally generated cash flow projections for the aircraft in question as the justification for using the highest portfolio market value as fair value. However, the manner in which Morgan Stanley used its internal cash projections to select the highest appraiser's market valuation as fair value resulted in reporting that was not appropriate under GAAP. In addition, Morgan Stanley did not maintain contemporaneous documentation of its valuation determination. Had Morgan Stanley used the average of the market values provided by its appraisers, as it did with its base value methodology, Morgan Stanley would have written off an additional $138 million in the first fiscal quarter of 2003, or 10% of quarterly pre-tax income.
The Commission staff, in further dialogue with Morgan Stanley, questioned its use of the appraisal with the highest portfolio value as the basis for establishing fair value. Morgan Stanley then committed to use the average of the market values provided by its appraisers to determine the fair value of its aircraft.
As a result of the above, Morgan Stanley's financial results for the fourth quarter of fiscal year 2001, third quarter of fiscal year 2002 and the first quarter of fiscal year 2003, as reported on filings made with the Commission, were misstated and not in conformity with GAAP. Therefore, Morgan Stanley violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder. In addition, Morgan Stanley failed to comply with recordkeeping and internal accounting control requirements in violation of Section 13(b) of the Exchange Act.
On September 21, 2000, Morgan Stanley reported third quarter earnings below analysts' estimates due, in part, to a decline in trading revenues in its high-yield bond portfolio. On October 5, 2000, Morgan Stanley announced the retirement of the co-head of its high-yield bond department. The next day, representatives from the New York Stock Exchange informed Morgan Stanley that rumors about Morgan Stanley facing $1 billion in losses in its high-yield bond portfolio were circulating on the exchange floor. Public and private investors attributed these losses to bond holdings in the telecommunications industry, a sector experiencing significant business turmoil at the time. Between October 5 and October 10, 2000, Morgan Stanley's stock price dropped 19%, from $92 to $74.50, despite repeated assertions by Morgan Stanley that the rumors of losses were "greatly exaggerated." In response to market speculation regarding the amount of its high-yield bond losses, Morgan Stanley issued a press release on October 11, 2000, stating, among other things, that the effect of markdowns in its high-yield portfolio reduced third quarter earnings by less than $.04 per share, that markdowns in the fourth quarter were approximately the same magnitude, and that Morgan Stanley expected any additional markdowns for the quarter not to be material.
After its fourth quarter closed on November 30, 2000, Morgan Stanley reported fourth quarter results that were based, in part, on overvaluations of certain bonds in its high-yield bond portfolio. The majority of the overvaluations occurred with bonds in the telecommunications industry. For those bonds, Morgan Stanley believed that market conditions rendered third-party price quotations unreliable. In such market conditions, GAAP required Morgan Stanley to use its best efforts to determine the fair value of the bonds, which is the price at which a willing buyer and a willing seller would enter into a current exchange. Instead of following GAAP to determine the fair value for those bonds, Morgan Stanley valued those bonds by "taking a longer view of the market" and essentially put its subjective opinion about the value of the bonds ahead of prices quoted by external pricing sources. In effect, Morgan Stanley valued its positions at the price at which it thought a willing buyer and seller should enter into an exchange, rather than at the price at which a willing buyer and a willing seller would enter into a current exchange.
In using its own view of the value of certain high-yield bonds, Morgan Stanley almost always overvalued those particular bonds relative to other market participants. By contrast, Morgan Stanley rarely valued those bonds lower than other market participants, including Morgan Stanley's own mutual funds that held some of the same high-yield bonds. By the end of the fiscal year, Morgan Stanley had overvalued its high-yield bond portfolio by about $75 million, representing approximately 7% of its portfolio. Additionally, the magnitude of the overvaluation increased as the high-yield bond market deteriorated in the fourth quarter of 2000. Specifically, the amount by which Morgan Stanley overvalued certain bonds in its high-yield bond portfolio increased significantly from about $40 million by the end of the third quarter of fiscal year 2000 to approximately $75 million by the close of the fourth quarter of fiscal year 2000. Overall, Morgan Stanley's failure to follow GAAP caused it to overstate its fourth quarter principal transaction trading revenue by about $47 million, or 4.8%, and inflate quarterly earnings by 1.3%.
Morgan Stanley also violated Section 13(b)(2)(A) of the Exchange Act and deviated from the requirement in paragraphs 7.10 and 7.12 of the American Institute of Certified Public Accountants' audit and accounting guide Brokers and Dealers in Securities when it failed to maintain documentation that supported certain bond valuations. Specifically, Morgan Stanley was unable to produce sufficient contemporaneous documentation to support its bond valuations. The documentation provided by Morgan Stanley after the fact merely represented the type of analysis that it undertook to value certain bond positions, rather than support the actual accounting. Furthermore, Morgan Stanley's internal controls were inadequate under Section 13(b)(2)(B) of the Exchange Act as they failed to ensure that the company value its high-yield bond positions in accordance with GAAP. Morgan Stanley's internal controls only were able to identify possibly overvalued positions through a variance analysis. Once identified, however, the inadequate internal controls operated to further Morgan Stanley's GAAP violations by allowing subjectivity to lead to the overvaluation of the bonds. Morgan Stanley's failure to follow GAAP when valuing its bond portfolio and its lax internal controls caused it to include inaccurate financial results for the fourth quarter of its fiscal year 2000 on a Form 8-K filed on December 19, 2000 with the Commission in violation of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-11.
Section 13(a) of the Exchange Act requires issuers of registered securities to file periodic reports with the Commission containing information prescribed by specific Commission rules. Rules 13a-1, 13a-11, and 13a-13 require, respectively, the filing of Forms 10-K, 8-K, and 10-Q. Rule 12b-20 requires, in addition to information required in periodic reports by Commission rules, such further information as may be necessary to make the required statements not misleading. Among other things, Morgan Stanley is required to comply with GAAP in its financial statements filed with the Commission. Morgan Stanley failed to do so in the following respects.
As discussed above, regarding its aircraft impairment valuations, Morgan Stanley's improper use of base value to determine fair value caused Morgan Stanley to overstate the fair value of certain aircraft in its leasing portfolio and, as a consequence, take a smaller impairment charge for those aircraft than it should have taken for the fourth fiscal quarter of 2001 and for the third fiscal quarter of 2002. In addition, its inappropriate use of the value provided by the appraisal with the highest portfolio value to determine fair value for the first fiscal quarter of 2003 resulted in further underreporting of the catch-up impairments of its aircraft for prior reporting periods that it recorded in that quarter.
Morgan Stanley also valued certain positions in its high-yield portfolio without giving sufficient weight to objective external criteria and instead used an unsupported internal analysis to give its valuations an upward bias. Morgan Stanley's valuations exceeded those that GAAP would have allowed. Morgan Stanley's overvaluations resulted in it overstating its trading revenue and earnings in a filing with the Commission disclosing financial results for the fourth quarter of fiscal year 2000. These misstatements were of particular significance because of Morgan Stanley's October 11, 2000 press release stating that bond losses were "greatly exaggerated," which heightened the importance of its valuation of these bonds.
As a result of the above-described aircraft impairment valuations and high-yield bond portfolio valuations, Morgan Stanley filed financial statements for the fourth quarter of fiscal year 2000, the fourth quarter of fiscal year 2001, the third quarter of fiscal year 2002 and the first fiscal quarter of 2003, which did not comply with GAAP. Accordingly, Morgan Stanley violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11 and 13a-13.
Section 13(b)(2)(A) of the Exchange Act requires issuers to "make and keep books, records, and accounts, which in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer." Additionally, Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain accountability for assets. As described above, Morgan Stanley's use of base value for certain of its aircraft and its subsequent use of the highest portfolio market valuations inflated the value of the aircraft on its balance sheet and reduced the impairment charges reflected in Morgan Stanley's income statement. Similarly, Morgan Stanley failed to value certain bond positions in accordance with GAAP and thus inaccurately stated the value of those positions in its books and records. Additionally, Morgan Stanley failed to maintain sufficient documentation that supported its bond valuations. Morgan Stanley's internal controls were not adequate to ensure that Morgan Stanley valued either its bond positions or its aircraft in accordance with GAAP. Accordingly, Morgan Stanley violated Sections 13(b)(2)(A) and (B) of the Exchange Act.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent's Offer.
ACCORDINGLY, THE COMMISSION HEREBY ORDERS THAT, pursuant to Section 21C of the Exchange Act, Morgan Stanley cease and desist from committing or causing any violations of, and committing or causing any future violations of, Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Exchange Act Rules 12b-20, 13a-1, 13a-11, and 13a-13.
By the Commission.
Jonathan G. Katz
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