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State Files Morgan Stanley Complaint

Galvin charges company with hiding truth about fund-sale fees for brokers

Jul 15, 2003 | Boston Globe

Secretary of State William F. Galvin charged financial services giant Morgan Stanley yesterday with hiding the truth about how brokers and managers are compensated for mutual fund sales, and New York Attorney General Eliot Spitzer the lead prosecutor in regulators' $1.4 billion settlement with Wall Street firms this year applauded the move as an example of how state regulators protect individual investors.


Morgan Stanley issued a swift apology to Galvin and promised to cooperate with his ongoing investigation into its compensation practices for mutual fund sales.

The moves are set against the backdrop of a congressional battle over the role of state regulators in policing the securities industry. A House subcommittee approved a bill last week that would curtail the ability of state regulators like Galvin and Spitzer to reach settlements with securities firms. The industry, regulators, and consumer advocates are now squaring off over the bill as it goes to debate before the full Financial Services Committee.

"In dark of night, the securities industry is trying to take away crucial protection for investors," said Spitzer at a State House press conference. "They're trying to remove the cop from the beat."

Yesterday's one-two punch -- the civil charges filed against Morgan Stanley and the local appearance by the country's best-known securities regulator -- could be the first step in a larger campaign to thwart the proposed legislation, introduced by US Representative Richard H. Baker, Republican of Louisiana.

In an eight-page administrative complaint, Galvin's office said it was tipped off to the possible problems at Morgan Stanley's Back Bay office by an anonymous letter written by an employee. The employee alleged the manager of the branch put "inappropriate pressure" on brokers to sell the new Morgan Stanley Allocator fund, according to the complaint.

A lawyer from Galvin's office asked a Morgan Stanley lawyer whether brokers or managers received extra compensation for selling proprietary mutual funds, which are managed by Morgan Stanley, as opposed to shares in any of the thousands of other mutual funds. The lawyer responded: "There are no higher commission, fees, or other compensation paid to our financial advisers or branch managers for selling our proprietary or affiliated funds than our non-proprietary or non-affiliated funds," according to the complaint.

But shortly thereafter, an article in The Wall Street Journal highlighted Morgan Stanley's aggressive sales techniques for the in-house funds. The state investigator asked Morgan Stanley again, and this time received a different answer, according to the complaint. Morgan Stanley has two different pay "grids" for brokers. For sales of the in-house funds and 14 other "partner" fund groups, brokers receive a higher percentage of the overall commission.

The investigators also asked whether the Back Bay office sold more of the Allocator fund than other offices. Morgan Stanley responded that sales were "evenly spread" among branch offices, according to the complaint. But after the second inquiry, the firm once again changed its stance, and said the Back Bay office sold more than four times as much of the Allocator fund as the other office in Boston.

"Morgan Stanley has the utmost respect for the Massachusetts Securities Division and deeply regrets the errors made in one of our communications to the state investigators," said Bret Gallaway, a spokesman for the New York firm, in an interview. "We have endeavored to correct the information and rectify any misunderstanding."

Galvin said the difference in pay for the two groups of funds wasn't properly disclosed to investors, something he called a "significant material omission.

"Profit the profit of the broker, the profit of the branch manager, and the profit of the firm is being put ahead of the fiduciary duty to the customer," he said.

Spitzer said he is also investigating sales of mutual funds. "We have other significant issues with regard to the marketing of mutual funds that we think are intriguing," he said. Spitzer declined to elaborate on the ongoing investigation.

Some industry specialists were surprised that Morgan Stanley used the two-tiered payment system. "Higher payment on a proprietary product is something that's more or less gone by the wayside," said Matthew McGuinness, senior analyst at Cerulli Associates Inc., a financial services research and consulting firm in Boston. "I'm hard-pressed to believe that's still going on."

Spitzer issued a blunt challenge yesterday to William H. Donaldson, the new chairman of the US Securities and Exchange Commission, to "stand up and loudly reject" the bill that would limit the role of state regulators. "If you do not do that, I'll have to say you haven't learned the lessons of the last five years," said Spitzer.

US Representative Barney Frank, Democrat of Newton, also criticized the pending bill, called the Securities Fraud Deterrence and Investor Restitution Act of 2003. He criticized supporters who claim that individual state enforcement actions lead to "balkanization" of securities laws and an uneven playing field. "There have been zero examples of state regulators interfering with national regulators. The law already prevents that. They're raising a nonexistent problem."


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