Morgan, Merrill Face Lawsuits Over Annuities

by Neil Weinberg, Forbes, Jan 21, 2005

NEW YORK - Morgan Stanley received secret  payments and offered its brokers undisclosed  incentives to sell variable annuities, according  to a class action filed against the firm earlier  today. Merrill Lynch is expected to face a  class action later in the day making similar  allegations.

The suit against Morgan Stanley was filed  in the Southern District of California in  San Diego in the name of William Dornan, a  San Marcos, Calif. resident and former Morgan  Stanley client, who made similar allegations  in a December complaint filed with the National  Association of Securities Dealers. His attorney,  Ronald Marron, said he plans to file a class  action charging Merrill Lynch with similar  wrongdoing. Marron also has a complaint pending  with the NASD in which Charles Schwab is accused  of wrongful variable annuity sales practices  and abuse of elderly clients.

A Morgan Stanley spokeswoman said the suit  is without merit and that it believes its  variable annuity sales practices are "appropriate  and have been properly disclosed." The  company also maintains a variable annuity  client bill of rights outlining the complex  products and designed to protect investors,  she added. Merrill Lynch spokesman Mark Herr  said the company had not seen the suit and  declined comment.

Variable annuities are a form of life insurance  that includes a lump-sum death benefit and  tax-deferred investments, often mutual funds,  which are supposed to provide income during  a client's lifetime. They can be particularly  lucrative for insurers because of high upfront  commissions, plus ongoing "trailer"  commissions and the underlying fees for the  mutual funds included in them.

Dornan's class action alleges that at least  since 1990 variable annuity underwriters and  Morgan Stanley maintained "secret contingent  fee sharing arrangements" in which a  portion of commission revenue was paid to  the brokerage firm as an incentive to sell the  product. Morgan Stanley has also limited its  variable annuity sales to underwriters who  participated in fee-sharing deals, it adds.  The suit further claims that Morgan Stanley  brokers received bonuses based on sales volume. 

Under its fee-sharing arrangements, Morgan  Stanely has received 10% of first-year commissions  back from underwriters as contained in an  "override addendum" on variable  annuity policies, according to information  Marron says he received from Morgan Stanley  during the discovery process for Dornan's  NASD complaint. That is in addition to half  the 7% first-year commission on such policies,  he said. Morgan Stanley brokers further received  volume bonuses entitling them to up to 15%  of first-year commissions for booking over  $100,000 in "eligible production"  on variable life insurance products, Marron  said. The attorney further charges that the  prospectuses Morgan Stanley provided clients  included "misreprentations and omissions"  of its financial interests.

Revenue-sharing by underwriters and brokerage firms  is legal if properly disclosed. However, the  class action claims the arrangements enabled  Morgan Stanley to "receive a higher amount  of compensation from the annuity transaction  than disclosed to the client in the annuitiy's  prospectus and related materials."

"Morgan Stanley entered into secret  revenue-sharing agreements with insurers,"  Marron said.

The class actions come amid rapidly mounting  scrutiny of variable annuity sales practices  by the NASD and others. Two days ago, Forbes  first reported that Morgan Stanley had been  served earlier with a subpoena by Massachusetts  Secretary of the Commonwealth William Galvin  seeking details of its variable annuity sales,  including revenue-sharing arrangements, compensation,  whether the products receive preferred sales  treatment, commission schedules, prospectuses  and documents for internal use only (see:  "Morgan  Stanley Subpoenaed Over Annuity Sales"). 

Galvin said he has subpoenaed other financial  institutions over variable annuity sales but  declined to name them. The Hartford, one of  the underwriters whose variable annuities  Morgan Stanley sells disclosed in November  that it has received subpoenas from attorneys  general in California and Florida.

The lawsuits come at a particularly sensitive  time for Morgan Stanley and the brokerage  industry which recently came through a separate  pay-to-play scandal involving mutual funds.  Only 14 months ago Morgan Stanley agreed to  pay $50 million in a Securities and Exchange  Commission settlement charging it with failing  to disclose to its mutual fund clients that  its brokers were receiving extra payments  to sell certain products.

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