NASD Orders Morgan Stanley to Pay Over $6.1 Million for Fee-Based Account Violations
Washington, D.C. — NASD announced today that it has fined Morgan Stanley DW, Inc. $1.5 million and has ordered the firm to pay more than $4.6 million in restitution for failing to adequately supervise its fee-based brokerage business. More than 3,500 Morgan Stanley customers will be receiving restitution.
Fee-based brokerage accounts are an alternative to traditional commission-based accounts. In a fee-based account, a customer is charged an annual fee that is either fixed or a percentage of the assets in the account, rather than a commission for each transaction as in a traditional brokerage account.
"Fee-based accounts can be appropriate for a wide range of customers," said NASD Vice Chairman Mary L. Schapiro. "But firms have an obligation to their customers to periodically reassess whether a fee-based account, like that offered by Morgan Stanley, remains appropriate. Firms must have systems and procedures in place that adequately evaluate the continued appropriateness of these accounts for their customers."
The Securities and Exchange Commission issued a report (commonly known as the "Tully Report") in 1995, noting that fee-based accounts are appropriate for investors who are building assets in their accounts, and may be appropriate for investors with moderate trading activity. But it also noted that because of the imposed annual fee, small and low-trading-activity accounts would pay higher costs as a fee-based account than as a commission-based account.
The following year, Morgan Stanley began offering its customers a fee-based brokerage account program, called "Choice." NASD found that Morgan Stanley recognized and instructed its brokers, consistent with the Tully Report, that Choice accounts were not appropriate for certain categories of investors, including buy-and-hold customers and certain accounts that fall below $50,000. The firm typically required a minimum of $50,000 in eligible assets to open a Choice account and charged an annual fee based on the total amount and type of eligible assets held in the account.
NASD found that between 2001 and 2003, all Choice accounts, regardless of size, paid a minimum annual fee of $1,000. By the end of 2001, the firm had 129,630 Choice accounts, holding $19.8 billion in assets. By the end of 2002, there were 157,143 Choice accounts, holding over $21.2 billion in assets. Morgan Stanley had 176,274 Choice accounts holding $30.6 billion in assets by the end of 2003.
NASD's investigation showed that from January 2001 through December 2003, Morgan Stanley failed to establish and maintain a supervisory system reasonably designed to review and monitor its fee-based brokerage business to determine whether Choice accounts remained appropriate for its Choice customers. As a result of the firm's deficient system and procedures, Morgan Stanley allowed 3,549 of its customers to continue using Choice accounts without adequately reassessing whether the accounts remained appropriate for them. These customers, who either conducted no trades in their Choice accounts for at least two consecutive years or had Choice accounts whose assets averaged below $25,000 for at least one full year, or both, will be receiving restitution under the settlement announced today.
NASD found that Morgan Stanley's written procedures did not prescribe a system for ongoing supervisory review of the appropriateness of Choice accounts until June 2003. Beginning in December 2003, the firm's branch managers began receiving monthly exception reports based on a suppressed-commission-to-fee ratio for all Choice accounts with an anniversary date within that month. At that time, Morgan Stanley provided the branch managers with specific guidance on the review to be conducted and the specific actions to be taken with respect to accounts that appeared on the exception report. Although the firm improved its system and procedures, Morgan Stanley's system and procedures still were fundamentally flawed, in that the exception reports failed to capture any accounts that fell below $50,000 in assets.
NASD also found that between January 2001 and December 2003, there were 1,818 Choice customers whose billable asset level averaged below $25,000 for at least one full year. Morgan Stanley's supervisory system failed to capture these accounts, so the firm failed to conduct an adequate supervisory review to determine whether the accounts should remain in the Choice program. All of these customers paid at least the minimum annual fee of $1,000 applicable at the time, which represented at least four percent of the assets in their Choice accounts - well in excess of Morgan Stanley's stated maximum rate of 2.25 per cent. Those customers paid a total of $2.7 million in Choice fees.
In addition, NASD found that 2,062 customers conducted no trades in at least two consecutive Choice years. Although many of these customers had traded previously in their Choice accounts, after these customers went an entire Choice year without trading, the firm's system and procedures failed to determine whether these accounts remained appropriate for Choice. Consequently, without an adequate supervisory review of their particular circumstances, these 2,062 customers remained in Choice for at least an additional year, in which they incurred an additional $2.8 million in fees without conducting any trades.
In sanctioning Morgan Stanley, NASD took into account the firm's demonstrable steps, undertaken shortly after NASD's inquiry began, to enhance its system and procedures and which led to the firm's identification and removal of large numbers of accounts for which the Choice program was not appropriate.
In settling these matters, the firm neither admitted nor denied the charges, but consented to the entry of NASD's findings.
This case is part of NASD's continuing focus on fee-based brokerage accounts. In April, NASD fined Raymond James & Associates, Inc. $750,000 and ordered the firm to pay $138,000 in restitution for fee-based account violations. In November 2003, NASD issued Notice to Members 03-68, reminding firms that before opening a fee-based account they must have "reasonable grounds for believing that a fee-based program is appropriate for that particular customer" - taking into account the services provided, the projected cost to the customer, alternative fee structures available and the customer's fee structure preferences. In that notice, firms were also reminded that after a fee-based account has been opened, firms should implement procedures requiring a periodic review to determine whether the fee-based account remains appropriate for each of their customers.