Morgan Stanley & Co. LLC has been censured and fined $600,000 by the Financial Industry Regulatory Authority, or FINRA, for failure to supervise its stockbrokers to ensure compliance with its own guidelines regarding structured products.
As a result of this failure of supervision, the firm’s stockbrokers recommended a total of 14 unsuitable structured product investments to eight different customers. The risky and complex products were not appropriate given the customers’ financial situation and investment objectives.
The customers have since settled with Morgan Stanley, receiving about $329,000 in total.
FINRA Accepts AWC Submitted by Morgan Stanley to Settle Charges
On Jan. 5, FINRA accepted a Letter of Acceptance Waiver and Consent, or AWC, submitted by Morgan Stanley to settle the charges of failure to supervise. The firm agreed to the sanctions while neither admitting nor denying the findings, and agreed to the entry of the findings into its disciplinary record.
The failure-to-supervise action involved the Global Wealth Management Group of Morgan Stanley before the group merged with the Smith Barney division of Citigroup Global Market Inc. in 2009. Morgan Stanley is a full-service broker-dealer that has been a FINRA member since 1970.
The violations occurred between September 2006 and August 2008, the AWC said. Morgan Stanley did not have a suitability policy in place for structured products, but it had developed overall suitability guidelines over time that supervisors were supposed to consider when they reviewed securities purchases.
At first the guidelines came in the form of “selling memoranda” issued for each of its proprietary structured product offerings. Some of the memoranda stated that no more than 10 percent of a customer’s account should be concentrated in a specific issue, and that these structured products should not be recommended to customers with a net worth of less than $100,000.
In July 2007, the firm developed formal standard concentration and net worth guidelines using the parameters above and posted them to its structured products website, according to the AWC. Nonetheless, Morgan Stanley sold structured products at concentration levels higher than 10 percent and to customers who did not meet the firm’s minimum-net-worth requirement.
FINRA found that Morgan Stanley, despite the internal guidelines, failed to have a reasonable supervisory system and procedures in place to notify supervisors when structured product purchases did not comply with the guidelines. As a result, the firm failed to detect the 14 unsuitable structured product purchases.
Structured Products
Structured products are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance or a foreign currency, as described in the AWC. The underlying asset is called the reference asset and the structured products typically have two components—a note and a derivative that is often in the form of option.
Some structured products offer a guaranteed return of principal at maturity, subject to issuer credit risk. Some pay an interest or coupon rate well above the prevailing market rate. Structured products also frequently cap or limit upside participation in the reference asset, particularly if principal protection is offered or the security pays an above-market interest rate, the AWC said.
To receive a return of principal, the security must be held to maturity, which can take five or more years. This length increases the risk that an issuer may default. In addition, notes that guarantee a return of principal — called principal protected products — may yield no positive return if the reference asset fails to perform, the AWC said. This inherent issuer risk makes concentration policies or guidelines extremely important. Customers should invest only an appropriate amount of their assets in such products, given their risk.
Between September 2006 and August 2008, Morgan Stanley customers bought roughly 224,000 structured products, 90 percent of which were proprietary. The firm offered its customers structured products characterized as principal protected, leveraged exposure, yield enhancement, or access investments, the AWC said.
Principal protected products represented about 51 percent of Morgan Stanley’s commission revenue from structured products. Leveraged products represented 19 percent of revenue, and yield enhancement products accounted for 18 percent, the AWC said.
For example, during the period noted above Morgan Stanley sold “Protected Buy-Write Securities” that offered a return of principal at maturity plus variable, periodic income. These products invested assets in an equity component and allowed for the use of leverage to increase the equity component. The interest could turn out to be nothing and the chance for appreciation was limited.
Another example was a “RevCon,” or reverse convertible. These are interest bearing notes in which the repayment of principal is linked to a reference asset like a stock, according to the AWC. At maturity, if the value of the reference asset is below a certain level – called the trigger – the investor may receive less than a full return of principal. The return may come in the form of shares the investor is obligated to buy, or their cash equivalent.
FINRA Warned Members About Structured Products
FINRA warned it members in September 2005 regarding its concerns that broker dealers were not living up to their sales practice obligations when selling structured products, especially to retail customers, the AWC said. FINRA sent out a notice advising firms that some structured products present risks similar to those of options, and that they should develop procedures to ensure that the structured products match the particular investors’ stomach for risk. FINRA also reminded firms to perform a reasonable-basis suitability determination on a structured product before recommending it, as well as a customer-specific suitability determination.
Despite the notice, Morgan Stanley did not have a firm-wide structured product suitability policy in place at the time of its violations, the AWC said. The firm also failed to create reasonable systems or procedures to help supervisors determine whether structured product purchases complied with the firm’s own internal guidelines.
The firm left the responsibility to assess suitability with branch supervisors and had no required reports or other tools specific to structured products that would have led supervisors to detect over-concentrated structured product purchases, the AWC said.
As a result, among the structured product purchases made between September 2006 and August 2008, more than 28,000 were in concentrations exceeding 25 percent of the customer’s liquid net worth, despite a guideline of 10 percent, the AWC said. In addition, more than 2,600 of these purchases were made by customers with a stated net worth of less than $100,000, again in contravention of the guidelines.
Morgan Stanley’s Disciplinary History
Morgan Stanley has run afoul of FINRA’s supervision policy before. Most recently, the firm settled and consented to findings that it had failed to establish effective supervisory systems and procedures to ensure that brokers applied sales charge discounts to eligible unit investment trust purchases. The firm was censured and fined $100,000.
Guiliano Law Group
Our practice is limited to the representation of investors. We accept representation on a contingent fee basis, meaning there is no cost to you unless we make a recovery for you. There is never any charge for a consultation or an evaluation of your claim. For more information, contact us at (877) SEC-ATTY.
To learn more about FINRA Securities Arbitration, and the legal process, please visit us at securitiesarbitrations.com
