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Morgan Stanley Settles With SEC, NASD

Firm Accused of Failing to Disclose Funds' Payments

Nov 18, 2003 | Washington Post Investors who bought mutual funds from Morgan Stanley, the nation's second-largest securities firm, didn't know that the company was taking secret payments from some fund companies to promote their products, according to allegations that resulted in a $50 million settlement agreement yesterday with the Securities and Exchange Commission.

In many cases, those same investors were actually footing the bill, indirectly, for the slanted recommendations, the SEC said. Some of the 16 fund companies whose products were pushed by Morgan brokers paid for the marketing help by letting Morgan handle some of their stock and bond trading. The millions of dollars in commissions earned by Morgan on that trading came out of mutual fund share owners' profits, according to the SEC.

The settlement, focusing on yet another area of conflicts of interest, publicly opens a major new front in the investigation of abusive behavior in the $7 trillion mutual fund industry, which has been under fire since New York Attorney General Eliot L. Spitzer revealed Sept. 3 that four fund companies were secretly allowing wealthy customers to engage in predatory short-term trading at the expense of their ordinary investors.

Morgan also settled a separate complaint from the industry's self-regulatory body, NASD, in which the industry regulators alleged the firm violated an NASD rule against recommending funds in exchange for brokerage commissions.

Stephen M. Cutler, the SEC's chief of enforcement, said the commission is investigating both mutual fund companies that made payments to Morgan Stanley and 15 other brokerage houses that may have engaged in similar secret marketing deals. He called the practice "troubling" because "few things are more important to investors than receiving unbiased advice from their investment professionals or knowing that what they're getting may not be unbiased."

The fund companies under investigation for their deals with Morgan include many of the industry's biggest names, including several that had previously gone unscathed in the investigation into trading abuses.

Morgan said yesterday that companies in its "Partners Program" included AIM Management Group Inc., Alliance Capital Management LP, American Funds, BlackRock Funds, Davis Funds, Dreyfus Corp., Eaton Vance Corp., Evergreen Investments, Fidelity Investments, Franklin Templeton Investments, MFS Investment Management, Morgan Stanley Funds, Pimco Funds, Putnam Investments, Scudder Investments and Van Kampen Investments. Several fund company representatives declined to comment. A Fidelity spokesman said the firm believed it had made the proper disclosures.

Still, SEC officials cautioned that the disclosure standards for fund companies in this area are lower than for brokers so a violation by Morgan does not necessarily translate into a violation for the fund company.

"The investigation just grows and grows. It's like a worm. You really have to wonder where the safe haven is," said Duke University law professor James D. Cox.

Long seen as the best investment vehicle for middle-class Americans, mutual funds are now under fire from several directions. Spitzer started out looking at two trading practices known as "late trading" and "market timing." What he found surprised even the SEC. As the investigation continued, it led to firings at more than a dozen top fund companies and brokerage houses and allegations that several fund companies allowed insiders to profit from personal trades at the expense of investors. Most recently, Wall Street giant Bear Stearns & Co. acknowledged firing four brokers and two assistants for improper trading in mutual fund shares, according to a regulatory filing, and Janus Capital Group Inc. said that Richard Garland, chief executive of its international business, had resigned. Garland had been implicated in Spitzer's probe of market-timing agreements.

Even before Spitzer filed his initial charges, the SEC, Massachusetts state regulators and the NASD had been looking at several areas involving brokers' sales commissions. They are focused in an area that has been of public concern for years: whether customers are being given enough information about why their brokers are pushing particular funds.

"It's not per se illegal, as long as the customer knows about it," said Merri Jo Gillette, the associate director of the SEC's Philadelphia office, which handled the Morgan case. "Brokers have an obligation to disclose outside payments."

It all adds up to the biggest scandal in the mutual fund industry in more than 60 years. The third congressional committee in as many weeks is scheduled to start hearings on the industry today, and preliminary money flow statistics suggest that the country's 95 million mutual fund investors are becoming increasingly worried. Putnam Investments, the fund hardest hit by the scandal so far, reported yesterday that it lost another $7 billion in assets last week for a total of $21 billion since state and federal regulators announced civil fraud charges against the company for failing to prevent abusive trading by employees.

Yesterday's settlement "goes to show that the mutual fund managers as well as broker dealers have too often viewed mutual fund shareholders as sheep to be sheared," said Sen. Peter Fitzgerald (R-Ill.), who is investigating the industry. "Congress has to figure out the variety of ways people are being sheared so that we can stop it."

The Morgan settlement focuses on "shelf-space payments" in which fund companies pay brokerage houses extra compensation on top of ordinary broker's commissions for inclusion in a stable of preferred funds. Such deals have become "commonplace" in recent years, said University of Mississippi law professor Mercer Bullard.

The SEC complaint alleges that Morgan failed to make the necessary disclosures about the existence of its Partners Program. The SEC settlement also covers allegations that the firm's brokers improperly steered customers into a particular kind of high-commission "Class B" mutual fund shares without disclosing that the class carried higher fees for the customer.

Morgan neither admitted nor denied liability, as is customary in SEC and NASD settlements, but it agreed to disgorge $25 million in profits and interest and pay an additional $25 million in fines. All the money will be put in a restitution fund for investors who bought the funds Morgan was promoting from January 2000 to the present. Customers who were improperly pushed into Class B shares will be offered the chance to convert to lower-fee Class A shares.

"I regret that some of our sales and disclosure practices have been found inadequate," Philip J. Purcell, Morgan Stanley's chairman and chief executive, said in a statement yesterday. "We take this most seriously because it strains the bonds we have with our clients and our financial advisers."

Morgan is the second big financial services institution to settle with the SEC over mutual fund issues in the past week. Boston-based Putnam, which was charged with civil fraud for allowing portfolio managers to trade in the funds they managed, agreed to a partial deal that required it to make governance changes and left the financial penalty for a later date.

That deal drew heavy criticism from Spitzer and Massachusetts Secretary of the Commonwealth William F. Galvin, who argued that the Putnam settlement failed to address the issue of fees and brokerage commissions.

But Cutler said yesterday that the SEC prefers to focus its settlements specifically on the misbehavior cited in the complaint. "We don't think an enforcement issue X should be the forum for a wish list people are considering for the industry at large," Cutler said.

Spitzer declined to comment on the Morgan deal.

Galvin, who still has open civil fraud complaints filed against Putnam and Morgan Stanley, said in a statement, "While I am pleased that the Securities and Exchange Commission has taken action against Morgan Stanley. I regret that Morgan Stanley was not compelled to admit its wrongdoing. Our investigation into the Morgan Stanley abuses is continuing."

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