For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Morgan Stanley & Co. LLC submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Morgan Stanley & Co. LLC,Respondent (AWC 20090181611, May 1, 2012).
Morgan Stanley & Co. Incorporated was a FINRA-regulated broker-dealer since 1936. Effective June 1, 2009, Morgan Stanley's Global Wealth Management Group combined with the Smith Barney Division of Citigroup Global Markets,Inc. to become Morgan Stanley Smith Barney Holdings LLC, a new joint venture that directly owns Morgan Stanley Smith Barney LLC. As of June 2011, Morgan Stanley & Co. Incorporated converted to a limited liability company and changed its name to Morgan Stanley & Co. LLC.
July 2009 FINRA ETF Notice
As described in "Non-Traditional ETFs: FINRA Reminds Firms of Sales Practice ObligationsRelating to Leveraged and Inverse Exchange-Traded Funds" (FINRA Regulatory Notice 09-31, June 2009), ETFs are typically registered unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index.
Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Some Non-Traditional ETFs are "inverse" or "short" funds (or combinations of both), meaning that they seek to deliver the opposite of the performance of the index or benchmark they track. Such objectives are achieved through the use swaps, futures contracts and other derivative instruments.
The AWC asserts that Non-Traditional ETFs generally "reset" daily, and such a factor can have significant ramifications that distort the performance of the subject ETF and its underlying index or benchmark. For example, the AWC notes that the Dow Jones U.S. Oil & Gas Index, between December 1, 2008 and April 30, 2009, gained two percent, while an ETF seeking to deliver twice the index's daily return fell six percent, and the related ETF seeking to deliver twice the inverse of the index's daily return fell 26 percent.
Despite the risks associated with holding Non-Traditional ETFs for longer periods, the AWC alleges that certain Morgan Stanley customers held Non-Traditional ETFs for extended time periods during the relevant period of January 2008 through June 2009. In fact, certain Morgan Stanley customers with a primary investment objective of income held Non-Traditional ETFs for periods of several months. The AWC offers these examples:
- A 74-year old customer with a primary investment objective of income and a net worth under $300,000 allocated over 25% of the account to a single Non-Traditional ETF that was purchased on a solicited basis and held for 128 trading days, sustaining losses of over $13,000; and
- An 89-year old customer with a primary investment objective of income and a net worth under $200,000 allocated over 59% of the account to a single Non-Traditional ETF that was purchased on a solicited basis and held for 39 trading days, sustaining losses of over $10,000.
During the relevant period from January 2008 through June 2009, FINRA alleged that Morgan Stanley failed to establish and maintain a supervisory system, including written procedures, reasonably designed to achieve compliance with applicable NASD and/or FINRA rules in connection with the sale of leveraged, inverse, and inverse-leveraged Exchange-Traded Funds ("Non-Traditional ETFs"). The AWC alleges that Morgan Stanley supervised Non-Traditional ETFs the same way it supervised traditional ETFs. Thus, Morgan Stanley failed to establish a reasonable supervisory system and written procedures to monitor the sale of Non-Traditional ETFs.
The AWC further alleges that Morgan Stanley also failed to establish adequate formal training regarding Non-Traditional ETFs during the Relevant Period.
In addition, certain Morgan Stanley registered representatives allegedly did not have an adequate understanding of Non-Traditional ETFs before recommending these products to retail brokerage customers. Certain Morgan Stanley registered representatives also made unsuitable recommendations of Non-Traditional ETFs to certain customers with a primary investment objective of income.
As such, the AWC alleged that Morgan Stanley violated NASD Rules 3010, 2310, and 2110 and FINRA Rule 2010, and, according to the terms of the AWC, FINRA imposed sanctions of a Censure, a $1.75 million fine, and $604,584 in restitution.