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Two subsidiaries of Morgan Stanley were fined by the Financial Industry Regulatory Authority (FINRA) earlier this month for negligently making material misrepresentations to investors regarding the call price and yield of certain fixed-income securities, as well as negligently failing to disclose that these securities were interest-only.

The misrepresentations were the result of incomplete information that was entered into Morgan Stanley’s master database.

The Two Morgan Stanley Subsidiaries

The two subsidiary firms are Morgan Stanley & Co. LLC and Morgan Stanley Smith Barney LLC. They jointly submitted a Letter of Acceptance, Waiver and Consent (AWC) through which they consented to an entry of findings by FINRA without admitting or denying the findings. FINRA accepted the AWC on May 16.

Morgan Stanley & Co. became a member of FINRA in 1970. Most of the misconduct dealt with in the AWC occurred at Morgan Stanley DW Inc., which became a member of FINRA or its predecessors in 1936 and merged into Morgan Stanley & Co. in April 2007.

Morgan Stanley Smith Barney became a member of FINRA in 2009. The firm was created as a joint venture to combine the wealth management businesses of Morgan Stanley and Citigroup. It is majority owned by Morgan Stanley through direct and indirect subsidiaries, including Morgan Stanley & Co.

Both Firms Censured & Fined

The firms agreed to be censured and fined. Morgan Stanley & Co. agreed to pay $175,000. Morgan Stanley Smith Barney agreed to pay $25,000 jointly and severally with Morgan Stanley & Co., so that the total fine equals $175,000.

Before the FINRA disciplinary action was filed, the firms learned about the misrepresentations through a customer complaint. Upon investigation, the firms learned that the same bad information had been disseminated to every person who bought the securities known as Structured Asset Trust Unit Repackagings (SATURNS).


SATURNS are part of a Morgan Stanley proprietary program for issuing ownership interests in repackaged fixed-income securities. They are linked to Verizon bonds and were referred to in the AWC as VZ Class B Units. Morgan Stanley DW Inc. began selling them in 2001.

When the firms learned that bad information had gone out regarding the VZ Class B Units, they voluntarily paid remediation totaling about $473,000. They also consented to pay roughly $220,000 more in remediation to additional customers identified by FINRA, the AWC said.

The FINRA-ordered remediation equals $84.50 per VZ Class B Unit owned by uncompensated customers on the call date. This amount represents the difference between the actual call price, and the call price negligently disseminated by Morgan Stanley.

In addition, the firms agreed to complete the remediation process within 120 days, to submit a schedule of payments to FINRA, and, in the event a customer cannot be located, to forward the person’s restitution and interest to the unclaimed or abandoned property fund for the state in which the customer last resided, the AWC said.

Incomplete Call Price Data Entered Caused Misrepresentations

The problem sales of VZ Class B Units occurred at Morgan Stanley DW Inc. and Morgan Stanley & Co. from January 2004 through May 2009. The AWC said that when the units were entered into the database in January 2004, the data used to calculate the call price was incomplete.

This caused the database to incorrectly calculate the call price and yield information so that the prices that appeared were misleading. The database also failed to indicate that the VZ Class B Units were an interest-only, amortized security, the AWC said.

As a result, Morgan Stanley DW Inc. and Morgan Stanley & Co. negligently made material misrepresentations to investors concerning the call price and yield of the VZ Class B Units and negligently failed to disclose to investors who purchased in the secondary market that the VZ Class B Units were interest-only, the AWC said.

After June 2009, the VZ Class B Units were sold by Morgan Stanley Smith Barney. The firm sold these securities through August 2010, during which time it made negligent material misrepresentations to investors stemming from the same botched database set up that affected the other Morgan Stanley companies.

The trade confirmations and account statements sent to Morgan Stanley customers in connection with sales of VZ Class B Units contained inaccurate information on the call price and yield, the AWC said. The most recent call price to appear on the confirmations and statements was the equivalent of $906.50 per $1000 invested when the actual call price of the VZ Class B Units at the time they were called by the warrant holders in August 2010 was about $822 per $1000 invested.

Morgan Stanley & Co. also negligently provided inaccurate information about the call price of the VZ Class B Units for publication by Bloomberg.

Complete and accurate information was available, however. The true call price, yield and the fact that the securities were interest-only were disclosed in a publicly available prospectus supplement filed with the SEC in January 2004.

From January 2004 through May 2009, Morgan Stanley DW Inc. and Morgan Stanley & Co. sold more than $16 million in VZ Class B Units to about 675 customers. From June 2009 through August 2010, Morgan Stanley Smith Barney sold $3.6 million in VZ Class B Units to about 57 customers.

As a result of the database error, the firms violated National Association of Securities Dealers Conduct Rule 2110 and FINRA Rule 2010. Both rules concern negligent misrepresentations, standards of commercial honor and equitable principles of trade. The two firms also violated Section 10(b) of the Securities and Exchange Act of 1934, and Rule 10b-10 thereunder, by providing inaccurate information on call prices and yield on trade confirmations.

Morgan Stanley DW Inc. was once subject to a similar action by FINRA, the AWC said. In November 2004, FINRA found that the firm had failed to disclose on trade confirmations that certain bonds were callable. The flawed transactions occurred from 1997 through 2002.

The firm was censured, fined $100,000, and required to offer to rescind bonds that had not yet been called.

Then, in October 2007, the Securities and Exchange Commission (SEC) filed a cease-and-desist proceeding against Morgan Stanley & Co. for violating Rule 10b-10, among other provisions and rules.

The SEC said that Morgan Stanley & Co., and its predecessor Morgan Stanley DW Inc., failed to provide customers with accurate and complete trade confirmations for certain fixed income securities over a five-year period beginning in 2000. The firm was ordered to pay a civil penalty of $7.5 million.

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