DOB: Morgan Stanley Auction Rate Securities Consent Order

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IN THE MATTER OF:

MORGAN STANLEY & CO.
INCORPORATED

(CRD No. 8209)

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CONSENT ORDER

DOCKET NO. CO-10-7505-S

I. PRELIMINARY STATEMENT

WHEREAS, the Banking Commissioner (“Commissioner”) is charged with the administration of Chapter 672a of the General Statutes of Connecticut, the Connecticut Uniform Securities Act (“Act”), and Sections 36b-31-2 to 36b-31-33, inclusive, of the Regulations of Connecticut State Agencies promulgated under the Act (“Regulations”);
 
WHEREAS, Morgan Stanley & Co. Incorporated (“Morgan Stanley”) is a broker-dealer registered under the Act with its principal office at 1585 Broadway, New York, New York;
 
WHEREAS, the Commissioner, through the Securities and Business Investments Division of the Department of Banking (“Division”), conducted an investigation pursuant to Section 36b-26(a) of the Act into the activities of Morgan Stanley to determine whether it had violated, was violating or was about to violate any provisions of the Act or Regulations (“Investigation”);
 
WHEREAS, coordinated investigations into the activities of Morgan Stanley in connection with the marketing and sale of auction rate securities (“ARS”) have been conducted by a multistate task force composed of members of the North American Securities Administrators Association, Inc. (“NASAA”);
 
WHEREAS, Morgan Stanley has cooperated with regulators conducting the investigations by responding to inquiries, providing documentary evidence and other materials, and providing regulators with access to facts relating to the investigations;
 
WHEREAS, Morgan Stanley has advised regulators of its agreement to resolve the investigations relating to its marketing and sale of ARS to retail investors;
 
WHEREAS, Morgan Stanley has agreed, among other things, to reimburse certain purchasers of auction rate securities, implement certain changes with respect to its marketing and sale of ARS, and make certain payments;
 
WHEREAS, Section 36b-15(a) of the Act authorizes the Commissioner to revoke any registration if, inter alia, the commissioner finds that (1) the order is in the public interest, and (2) the registrant has engaged in fraudulent, dishonest or unethical practices in the securities business or if the registrant has failed to reasonably supervise its agents;
 
WHEREAS, Section 36b-27(a) of the Act authorizes the Commissioner to order any person who has violated, is violating or is about to violate any provision of the Act or any regulation, rule or order adopted or issued under the Act to cease and desist from such violation;
 
WHEREAS, Section 36b-27(d) of the Act authorizes the Commissioner to impose a fine of up to One Hundred Thousand Dollars ($100,000) per violation against any person who has violated any provision of the Act or any regulation, rule or order adopted or issued under the Act;
 
WHEREAS, Section 36b-31(a) of the Act provides, in relevant part, that “[t]he commissioner may from time to time make . . . such . . . orders as are necessary to carry out the provisions of sections 36b-2 to 36b-33, inclusive”;
 
WHEREAS, Section 36b-31(b) of the Act provides, in relevant part, that “[n]o . . . order may be made . . . unless the commissioner finds that the action is necessary or appropriate in the public interest or for the protection of investors and consistent with the purposes fairly intended by the policy and provisions of sections 36b-2 to 36b-33, inclusive”;
 
WHEREAS, an administrative proceeding initiated under Sections 36b-15 and 36b-27 of the Act would constitute a “contested case” within the meaning of Section 4-166(2) of the General Statutes of Connecticut;
 
WHEREAS, Section 4-177(c) of the General Statutes of Connecticut and Section 36a-1-55(a) of the Regulations of Connecticut State Agencies provide that a contested case may be resolved by consent order, unless precluded by law;

II. CONSENT TO WAIVER OF PROCEDURAL RIGHTS

WHEREAS, Morgan Stanley, through its execution of this Consent Order, voluntarily waives the following rights:

1.
To be afforded notice and an opportunity for a hearing within the meaning of Sections 36b-15(f), 36b-27(a) and 36b-27(d)(2) of the Act and Section 4-177(a) of the General Statutes of Connecticut;
2.
To present evidence and argument and to otherwise avail itself of Sections 36b-15(f), 36b-27(a) and 36b-27(d)(2) of the Act and Section 4-177c(a) of the General Statutes of Connecticut;
3. To present its position in a hearing in which it is represented by counsel;
4. To have a written record of the hearing made and a written decision issued by a hearing officer; and
5. To seek judicial review of, or otherwise challenge or contest the matters described herein, including the validity of this Consent Order;

NOW THEREFORE, the Commissioner, as administrator of the Act, hereby enters this Consent Order.

III. JURISDICTION AND CONSENT TO ENTRY OF CONSENT ORDER

Morgan Stanley admits the jurisdiction of the Commissioner, neither admits nor denies the Findings of Fact and Conclusions of Law contained in this Consent Order, and consents to the entry of this Consent Order by the Commissioner, for the sole purpose of settling this matter prior to a hearing.

IV. FINDINGS OF FACT

Unethical Practices in the Offer and Sale of Auction Rate Securities

1. Auction rate securities are financial instruments that include auction preferred shares of closed-end funds, municipal auction rate bonds, and various asset-backed auction rate bonds (collectively referred to herein as “ARS”).  ARS are long-term instruments where the interest/dividend is reset weekly or monthly.
2.
Morgan Stanley participated in the marketing and sale of ARS.
3.
In certain instances, Morgan Stanley, through its salespeople, advised certain clients that ARS were safe, liquid investments, when in fact auction rate securities had significant liquidity risks associated with them.
4. Representatives of Morgan Stanley represented to certain customers of Morgan Stanley that ARS were short-term investments.  In fact, because ARS are bonds with long-term maturities, their short-term liquidity was dependent on the successful operation of a bidding process known as a Dutch auction.  Certain representatives of Morgan Stanley failed to disclose to certain customers with short-term liquidity needs that they might be unable to sell their ARS if the auction process failed.
5. In connection with the sale of ARS, certain Morgan Stanley salespeople told certain investors that ARS were “just like cash” and “liquid with seven days notice.”
6. Morgan Stanley marketed ARS to investors in a brochure entitled “Money Market Instruments.”  In this brochure, ARS were listed under the subsection “Other Short-Term Instruments.”
7. Since it began participating in the auction rate securities market, Morgan Stanley submitted support bids - purchase orders for the entirety of an auction rate security issue for which it acted as the sole or lead broker.  Support bids were Morgan Stanley proprietary orders that would be filled, in whole or in part, if there was otherwise insufficient demand in an auction.  When Morgan Stanley purchased auction rate securities through support bids, auction rate securities were then owned by Morgan Stanley, and the holdings were recorded on Morgan Stanley’s balance sheet.  For risk management purposes, Morgan Stanley imposed limits on the amounts of auction rate securities it could hold in inventory.
8.
Because many investors could not ascertain how much of an auction was filled through Morgan Stanley proprietary trades, they could not determine if auctions at Morgan Stanley were clearing because of normal marketplace demand, or because Morgan Stanley was making up for the lack of demand through support bids.  Generally, investors were also not aware that the liquidity of the auction rate securities as to which Morgan Stanley was the managing broker-dealer depended on Morgan Stanley’s continued use of support bids.  While Morgan Stanley could track its own inventory as a measure of the supply and demand for its auction rate securities, ordinary investors had no comparable ability to assess the operation of Morgan Stanley’s auctions.  There was no way for such investors to monitor supply and demand in the market or to assess when broker-dealers might decide to stop supporting the market, thereby causing its collapse.
9. Starting in August 2007, the credit crisis and other deteriorating market conditions strained the auction rate securities market.  Some institutional investors withdrew from the market, decreasing demand for auction rate securities.
10. The resulting market dislocation should have been evident to Morgan Stanley.  Morgan Stanley’s support bids filled the increasing gap in the demand in its auctions for auction rate securities, sustaining the impression that the demand for auction rate securities had not decreased.  As a result, Morgan Stanley’s auction rate securities inventory grew significantly, requiring Morgan Stanley to raise its risk management limits on its auction rate securities inventory.
11. From the Fall of 2007 through February of 2008, demand for auction rate securities continued to erode and Morgan Stanley’s auction rate securities inventory reached unprecedented levels.  Morgan Stanley eventually became aware of the increasing strains in the auction rate securities market, and recognized the potential for widespread market failure.  Morgan Stanley never disclosed these increasing risks of owning or purchasing auction rate securities to its customers.
12.
In February 2008, Morgan Stanley and other firms stopped supporting the auctions.  Without the benefit of support bids, the auction rate securities market collapsed, leaving investors who had been led to believe that these securities were cash alterative investments appropriate for managing short-term cash needs, holding long-term or perpetual securities that could not be sold at par value until and if the auctions cleared again.

Failure to Supervise

13.
Although ARS are complex products, Morgan Stanley did not provide its sales or marketing staff with the training necessary to adequately explain these products or the mechanics of the auction process to their customers.
14.
Morgan Stanley did not adequately train all of its brokers and financial advisers regarding the potential illiquidity of ARS, including the fact that Morgan Stanley might stop supporting the market.

V. CONCLUSIONS OF LAW

15. The Commissioner has jurisdiction over this matter pursuant to the Act.
16.
The Commissioner finds that Morgan Stanley failed to supervise its employees and engaged in dishonest or unethical practices in the securities business, that this conduct violates Sections 36b-4(b) of the Act and Section 36b-31-6f(b) of the Regulations, and forms the basis for a proceeding under Section 36b-15(a) of the Act.
17.
The Commissioner finds that this Consent Order and the following relief are appropriate, in the public interest, and consistent with the purposes fairly intended by the policies and provisions of the Act.

VI. CONDITIONS PRECEDENT TO ENTRY OF CONSENT ORDER

As conditions precedent to the entry of this Consent Order, Morgan Stanley represents, through its execution of this Consent Order, that it has or will comply with the following:

Definitions  For purposes of these Conditions Precedent and this Consent Order, the following terms shall have the meanings specified:

(a)   
“Eligible ARS” shall mean auction rate securities purchased at Morgan Stanley prior to February 13, 2008.
(b)
“Retail ARS Investors,” shall mean:  (1) Natural persons (including their IRA accounts, testamentary trust and estate accounts, custodian UGMA and UTMA accounts, and guardianship accounts) who purchased Eligible ARS at Morgan Stanley; (2) Charities and nonprofits with Internal Revenue Code Section 501(c)(3) status that purchased Eligible ARS at Morgan Stanley; and (3) Small Businesses that purchased Eligible ARS at Morgan Stanley.  For purposes of this provision, “Small Businesses” shall mean Morgan Stanley customers not otherwise covered in subparagraphs (1) and (2) of this paragraph (b) that had $10 million or less in assets in their accounts with Morgan Stanley, net of margin loans, as determined by the customer’s aggregate household position(s) at Morgan Stanley as of August 31, 2008, or, if the customer was not a customer of Morgan Stanley as of August 31, 2008, as of the date that the customer terminated its customer relationship with Morgan Stanley.  Notwithstanding any other provision, “Small Businesses” does not include broker-dealers or banks acting as conduits for their customers.

Requirement to Repurchase ARS from Retail ARS Investors

1. Morgan Stanley shall have provided liquidity to Retail ARS Investors by buying back, at par, in the manner described below, Eligible ARS that were not clearing as of September 30, 2008.
2. Morgan Stanley represents through its execution of this Consent Order that (a) it has offered or will offer to purchase, at par plus accrued and unpaid dividends/interest, from Retail ARS Investors their Eligible ARS that were not clearing as of September 30, 2008 (“Buyback Offer”), and (b) that it explained or will explain to such Retail ARS Investors what they would have to do to accept, in whole or in part, the Buyback Offer.  The Buyback Offer would remain open until at least January 11, 2009 (“Offer Period”).  Morgan Stanley retained sole discretion to extend the Offer Period beyond such date.
3. By October 20, 2008, Morgan Stanley used its best efforts to identify and provide notice of the Buyback Offer described in these Conditions Precedent to Retail ARS Investors who invested in Eligible ARS that were not clearing as of September 30, 2008.
4. Retail ARS Investors could accept the Buyback Offer by notifying Morgan Stanley at any time before midnight, Eastern Time, January 11, 2009, subject to Morgan Stanley’s ability, in its sole discretion, to extend the Offer Period beyond such date.  For Retail ARS Investors who accepted the Buyback Offer prior to December 11, 2008, Morgan Stanley shall have purchased their Eligible ARS by December 15, 2008.  Morgan Stanley shall have purchased the Eligible ARS of all other Retail ARS Investors who accepted the Buyback Offer within the Offer Period, on or before January 16, 2009.
5. Morgan Stanley shall have purchased the Eligible ARS of any Retail ARS Investor (a) who did not accept the Buyback Offer because such Retail ARS Investor did not receive notice of the Buyback Offer prior to January 11, 2009, and (b) who at any time between January 12, 2009 and December 31, 2009 contacted Morgan Stanley and affirmed that such Retail ARS Investor did not receive notice of the Buyback Offer prior to January 11, 2009.
6. No later than October 20, 2008 and continuing through December 31, 2009, Morgan Stanley shall have established and would maintain:  (a) a dedicated toll-free telephone assistance line, with appropriate staffing, to provide information and to respond to questions concerning the terms of the Buyback Offer; and (b) a public Internet page on its corporate web site(s), with a prominent link to that page appearing on Morgan Stanley’s relevant homepage(s), to provide information concerning the terms of the Buyback Offer and, via reasonable means, to respond to questions concerning such Buyback Offer.

Relief for Investors Who Sold Below Par

7.   
No later than December 11, 2008, Morgan Stanley shall have paid any Retail ARS Investor that Morgan Stanley could reasonably identify who sold Eligible ARS below par between February 13, 2008 and August 13, 2008 the difference between par and the price at which the Retail ARS Investor sold the Eligible ARS.


Claims for Consequential Damages

8.   
For any investor pursuing a claim related exclusively to consequential damages in connection with the sale of auction rate securities, Morgan Stanley has provided or will provide such investor with the option of proceeding in arbitration according to the following provisions:
 
(a)
The arbitrations would be conducted by a single public arbitrator in accordance with FINRA’s special arbitration procedures for claims of consequential damages filed by Retail ARS Investors;
(b) Morgan Stanley would pay all applicable FINRA forum and FINRA filing fees;
(c) Any Morgan Stanley Retail ARS Investors who chose or choose to pursue such claims would bear the burden of proving that they suffered consequential damages, and that such damages were caused by the investors’ inability to access funds consisting of Eligible ARS holdings purchased at Morgan Stanley; and
(d) Morgan Stanley would be able to defend itself against such claims; provided, however, that Morgan Stanley would not contest liability related to the sale of auction rate securities, and provided further that Morgan Stanley would not be able to use as part of its defense a Morgan Stanley Retail ARS Investor’s decision not to borrow money from Morgan Stanley.
9.
Retail ARS Investors electing to use the special arbitration process described in these Conditions Precedent would not be eligible for punitive damages.
10. Retail ARS Investors electing to utilize the special arbitration process described in these Conditions Precedent would be limited to the remedies available in that process, and would not be able to bring or pursue a claim against Morgan Stanley or in any case where Morgan Stanley is or was underwriter relating to Eligible ARS in another forum.

Institutional Investors

11.   
Morgan Stanley would endeavor to work with issuers and other interested parties, including regulatory and governmental entities, to expeditiously provide liquidity solutions for institutional investors that purchased auction rate securities not covered by the Retail ARS Investor repurchase provisions described in these Conditions Precedent.
12. Beginning December 11, 2008, and within 45 days of the end of each quarter thereafter, Morgan Stanley submitted and shall submit a written report to a representative specified by NASAA, outlining the efforts in which Morgan Stanley has engaged, and the results of those efforts, with respect to Morgan Stanley institutional investors’ holdings in Eligible ARS.  Morgan Stanley would, at the option of the representative specified by NASAA, confer with such representative no less frequently than quarterly to discuss Morgan Stanley’s progress.  Such quarterly meetings would continue until no later than December 2009.  Following each quarterly meeting, the representative would advise Morgan Stanley of any concerns and, in response, Morgan Stanley would detail the steps that Morgan Stanley planned or plans to implement to address such concerns.  The reporting or meeting deadlines in this paragraph would be subject to amendment upon Morgan Stanley’s request if written permission were received from the representative specified by NASAA.

Relief for Municipal Issuers

13.   
Morgan Stanley would promptly refund to municipal issuers refinancing fees that issuers paid to Morgan Stanley for the refinancing of their auction rate securities, where such refinancing occurred between February 11, 2008 and the date of this Consent Order and where Morgan Stanley acted as underwriter for the primary offering of the auction rate securities between August 1, 2007 and February 11, 2008.

Review of Customer Accounts

14.   
Morgan Stanley represents and undertakes, through its execution of this Consent Order, that, for a period of two years following the entry of this Consent Order by the Commissioner, upon request from any firm that is repurchasing auction rate securities, Morgan Stanley shall take reasonable steps to provide notice of that firm’s offer to repurchase auction rate securities to Morgan Stanley customers that Morgan Stanley can reasonably identify that hold such auction rate securities subject to the other firm’s repurchase.

VII. CONSENT ORDER

On the basis of the Findings of Fact, Conclusions of Law, and Morgan Stanley’s consent to the entry of this Consent Order,

IT IS HEREBY ORDERED THAT:

1.
This Consent Order concludes the investigation by the Division and any other action that the Commissioner could commence under the Act on behalf of Connecticut as it relates to Morgan Stanley’s marketing and sale of auction rate securities to Morgan Stanley’s Retail ARS Investors as defined herein.  Specifically excluded from and not covered by this paragraph are any claims by the Commissioner arising from or relating to the Consent Order provisions herein contained;
2.
This Consent Order is entered into solely for the purpose of resolving the investigation into Morgan Stanley’s marketing and sale of auction rate securities to Morgan Stanley Retail ARS Investors, and is not intended to be used for any other purpose;
3.
Morgan Stanley shall CEASE AND DESIST from violating the Act or any regulation or order under the Act, and shall comply with the Act, its regulations and any order under the Act;
4.
Within ten (10) days after the entry of this Consent Order by the Commissioner, Morgan Stanley shall pay to the “Treasurer, State of Connecticut”, by electronic funds transfer or wire transfer, the sum of Nine Hundred Nine Thousand Ninety Four and 71/100 Dollars ($909,094.71) as a fine.  If Morgan Stanley fails to make the payment described in this paragraph, the Commissioner may, at the Commissioner’s sole discretion, pursue any legal remedies, including but not limited to initiating an action to enforce this Consent Order, revoking Morgan Stanley’s registration under the Act or vacating this Consent Order;
5.
In the event another state securities regulator determines not to accept Morgan Stanley’s settlement offer, the total amount of the payment to the State of Connecticut shall not be affected, and shall remain at Nine Hundred Nine Thousand Ninety Four and 71/100 Dollars ($909,094.71);
6.
To the extent that Morgan Stanley agrees to any subsequent settlement with any NASAA jurisdiction arising out of the above-referenced coordinated investigations pertaining to Morgan Stanley’s marketing and Sale of Eligible ARS to Retail ARS Investors as described herein, which includes a term or terms analogous to the terms herein which are more favorable to Retail ARS Investors in such NASAA jurisdiction than those terms identified herein, the subsequent more favorable settlement term or terms shall, upon the Commissioner’s request, be incorporated by reference into this Consent Order and become equally applicable to Connecticut Retail ARS Investors;
7. Nothing herein shall preclude Connecticut, its departments, agencies, boards, commissions, authorities, political subdivisions and corporations, other than the Commissioner and only to the extent set forth in paragraph 1 above, (collectively, “State Entities”) and the officers, agents or employees of State Entities from asserting any claims, causes of action, or applications for compensatory, nominal and/or punitive damages, administrative, civil, criminal, or injunctive relief against Morgan Stanley in connection with auction rate securities practices at Morgan Stanley;
8. This Consent Order shall not disqualify Morgan Stanley or any of its affiliates or current or former employees from any business that they otherwise are qualified or licensed to perform under applicable state law, and this Consent Order is not intended to form the basis for any disqualification;
9. This Consent Order shall not operate to disqualify Morgan Stanley, its affiliates or current or former employees, from relying, to the extent applicable, upon the registration exemptions or registration safe harbor provisions contained in the federal securities laws, the rules and regulations thereunder, the rules and regulations of self regulatory organizations or any states’ or U.S. Territories’ securities laws.  In addition, this Consent Order is not intended to form the basis for any such disqualification, nor is it intended to form the basis of a statutory disqualification under Section 3(a)(39) of the Securities Exchange Act of 1934;
10. For any person or entity not a party to this Consent Order, this Consent Order does not limit or create any private rights or remedies against Morgan Stanley, nor does it limit or create liability of Morgan Stanley, or limit or create defenses of Morgan Stanley;
11. This Consent Order and any dispute related thereto shall be governed and construed in accordance with the laws of the State of Connecticut without regard to any choice of law principles; and
12. This Consent Order shall be binding upon Morgan Stanley and its successors and assigns as well as the successors and assigns of relevant affiliates with respect to all conduct subject to the provisions herein and all future obligations, responsibilities, undertakings, commitments, limitations, restrictions, events and conditions.

NOW THEREFORE, the Commissioner enters the following:

1. The Findings of Fact, Conclusions of Law and Consent Order set forth above, be and are hereby entered;
2. Entry of this Consent Order by the Commissioner is without prejudice to the right of the Commissioner to take enforcement action against Morgan Stanley based upon a violation of this Consent Order or the matters underlying its entry, if the Commissioner determines that compliance with the terms herein is not being observed or if any representations made by Morgan Stanley and reflected herein are subsequently discovered to be untrue; and
3. This Consent Order shall become final when entered.


 
So ordered at Hartford, Connecticut      _______/s/_________
this 7th day of July 2010.      Howard F. Pitkin 
    Banking Commissioner 


CONSENT TO ENTRY OF ORDER

I, Eric Grossman, state on behalf of Morgan Stanley & Co. Incorporated, that I have read the foregoing Consent Order; that I know and fully understand its contents; that I am authorized to execute this Consent Order on behalf of Morgan Stanley & Co. Incorporated; that Morgan Stanley & Co. Incorporated agrees freely and without threat or coercion of any kind to comply with the terms and conditions stated herein; and that Morgan Stanley & Co. Incorporated voluntarily consents to the entry of this Consent Order, expressly waiving any right to a hearing on the matters described herein.  Morgan Stanley & Co. Incorporated further agrees that it shall not claim, assert, or apply for a tax deduction or tax credit with regard to any state, federal or local tax for any administrative monetary penalty that Morgan Stanley & Co. Incorporated shall pay pursuant to the foregoing Consent Order.     

 
     Morgan Stanley & Co. Incorporated
  
           
By: ______/s/__________________
Eric Grossman
  General Counsel of the Americas 

 
State of:  New York

County of:  New York

On this the 2nd day of July, 2010, before me, the undersigned officer, personally appeared Eric Grossman, who acknowledged himself to be the General Counsel of the Americas of Morgan Stanley & Co. Incorporated, a corporation, and that he, as such General Counsel of the Americas, being authorized to do so, executed the foregoing instrument for the purposes therein contained, by signing the name of the corporation by himself as General Counsel of the Americas.
 
In witness whereof I hereunto set my hand.
 

_____/s/_____________________
Notary Public
Date Commission Expires:  7/9/11

  

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