The Securities and Exchange Commission yesterday announced the institution and simultaneous settlement of an enforcement action against Morgan Stanley DW Inc. (Morgan Stanley) for failing to provide customers important information relating to their purchases of mutual fund shares. As part of the settlement, Morgan Stanley will pay $50 million in disgorgement and penalties, all of which will be placed in a Fair Fund for distribution to certain Morgan Stanley customers.
Stemming from the SEC’s ongoing industry-wide investigation of mutual fund sales practices, this inquiry uncovered two distinct, firm-wide disclosure failures by Morgan Stanley. The first relates to Morgan Stanley’s “Partners Program” and its predecessor, in which a select group of mutual fund complexes paid Morgan Stanley substantial fees for preferred marketing of their funds. To incentives its sales force to recommend the purchase of shares in these “preferred” funds, Morgan Stanley paid increased compensation to individual registered representatives and branch managers on sales of those funds’ shares. The fund complexes paid these fees in cash or in the form of portfolio brokerage commissions.
Morgan Stanley also failed to adequately disclose at the point of sale the higher fees associated with large ($100,000 or greater) purchases of Class B shares of certain of its proprietary mutual funds. In connection with its recommendation to customers to purchase certain Class B shares, Morgan Stanley did not adequately inform customers at the point of sale that large purchases of such shares were subject to higher fees. Significantly, Morgan Stanley also failed to explain to customers that those fees could have a negative impact on customers’ investment returns. As with the sales of funds in the “preferred” programs, Morgan Stanley’s sales force stood to earn more on sales of Class B shares of its proprietary funds than on sales of Class A shares.
The Commission’s Order finds that this conduct violated Section 17(a)(2) of the Securities Act of 1933 and Rule 10b-10 under the Securities Exchange Act of 1934. Section 17(a)(2) prohibits the making of materially misleading statements or omissions in the offer and sale of securities. Rule 10b-10 requires broker dealers to disclose the source and amount of any remuneration received from third parties in connection with a securities transaction. The Order also finds that the conduct violated NASD Rule 2830(k), which prohibits NASD members from favoring the sale of mutual fund shares based on the receipt of brokerage commissions.
Stephen M. Cutler, Director of the Commission’s Division of Enforcement, said: “Unbeknownst to Morgan Stanley’s customers, Morgan Stanley received monetary incentives — in the form of “shelf space” payments — to sell particular mutual funds to its customers. When customers purchase mutual funds, they should understand the nature and extent of any conflicts of interest that may affect the transaction.”
Morgan Stanley has agreed to settle this matter, without admitting or denying the findings in the Commission’s Order. As part of the settlement, Morgan Stanley will pay $25 million in disgorgement and prejudgment interest. In addition, Morgan Stanley will pay civil penalties totaling $25 million. The entire $50 million payment will be placed in a Fair Fund for distribution to customers who purchased “preferred” fund shares from January 1, 2000 through the present.
In addition, Morgan Stanley has undertaken to, among other things, (1) place on its website disclosures regarding the Partners Program; (2) provide customers with a disclosure document that will disclose, among other things, specific information concerning the Partners Program, and the differences in fees and expenses connected with the purchase of different mutual fund share classes; (3) for those customers that bought certain Class B shares in amounts of $100,000 or more, offer to convert those customers’ Class B shares to A shares; (4) retain an independent consultant to conduct a review of, and to provide recommendations concerning, Morgan Stanley’s disclosures, policies and procedures and its plan to offer to convert Class B shares to A shares; and (5) adopt the recommendations of the independent consultant.
Finally, the Commission’s Order censures Morgan Stanley and orders it to cease-and-desist from committing or causing any violations of Section 17(a)(2) of the Securities Act of 1933 and Rule 10b-10 under the Securities Exchange Act of 1934.
“Morgan Stanley’s firm-wide failure to adequately disclose to customers at the point of sale the greater costs associated with large purchases of certain B shares and the potential greater returns associated with A shares made the brokers better off and their customers worse off,” said Arthur S. Gabinet, District Administrator of the Commission’s Philadelphia District Office. “Brokerage firms have a duty to ensure that the information they give their customers about different classes of mutual fund shares is complete and accurate, and that their recommendations are made for the benefit of customers, not themselves.”
The NASD also announced today a settled action against Morgan Stanley for violations of NASD Rule 2830(k) arising from the Partners Program and its predecessor.