Morgan Stanley, Complex Structured Products… and Nuns

Wall Street never ceases to amaze me. Financial News reported last week that two Catholic nunneries and more than 80 other investors, have filed a lawsuit in London against Morgan Stanley alleging the firm inappropriately managed a complex structured bond it sold them called a “constant maturity swap,” causing an estimated $6.5 million loss.

Specifically, the suit alleges that Morgan Stanley, in cooperation with Saturns, an Irish bank, neglected to redeem the bonds when a mandatory redemption was triggered after they were downgraded in late 2008 as the financial markets imploded. The suit further alleges that Morgan Stanley and Saturns may have deliberately waited to redeem the bonds several months later so that their firms could earn a fee that they otherwise would have lost if the bonds had been redeemed earlier.

In what could be a public relations nightmare, Morgan Stanley is apparently contesting the suit, claiming it sold the the product to Bloxham, an Irish brokerage firm that represented the nuns. However, the suit alleges that the delay Morgan Stanley ostensibly caused prevented Bloxham from hedging losses from the depreciated bonds and thus caused further losses.

While this case is especially shocking given the victims, it’s unfortunately, very common: Wall Street continues to put their own interests ahead of their clients by peddling structured products to retail investors at an alarming rate.

The structured product market is ballooning out of control and is poised to pop.  According to StructuredRetailProducts.com, Wall Street has sold an estimated $30 billion in structured products to retail investors so far this year. Chris Whalen, a risk expert and co-founder of Institutional Risk Analytics, calls structured products the “next investment bubble.”

I’ve advocated that before a structured product can be sold to a retail investor, parties must sign a simple, “plain English,” one-page agreement akin to what Wall Street uses when entering into a derivatives contract, the so-called “Master Agreement.” Obviously, this added measure alone will not solve the problem. The SEC and FINRA also need step up and enforce penalties to the fullest extent possible on those firms that inappropriately sell structured products to individual investors.

So long as the status quo remains intact, individual investors remain extremely vulnerable to Wall Street’s seemingly endless supply of structured products.

Did Morgan Stanley Opt for Fines Rather than Compliance with Conflict Rules?

Earlier this week FINRA announced that it fined Morgan Stanley $800,000 for failing to adequately disclose material conflicts of interest to investors. FINRA alleged that the firm didn’t make required disclosures in research reports about the securities holdings belonging to analysts. Disclosures were deficient in more than 6,500 research reports over a four year period.

As FINRA’s enforcement chief James Shorris put it, “This case strikes at the heart of FINRA’s research disclosure requirements.”

Perhaps, yet FINRA’s penalty amounts to about $120 per infraction–mere peanuts for Morgan Stanley.

Having played a role in the bubble-era investigation into Wall Street’s conflicted tech stock research, and seeing first hand the seedier side of Wall Street’s research, I believe there may be other forces at work. A greater motivation for Morgan Stanley may be that at the end of the day, its far cheaper to pay a measly fine for failing to make disclosures than it is to conduct its business in a conflict-free manner by separating its research from investment banking.

This is nothing new for Morgan Stanley. In 2006, FINRA’s predecessor, the NASD, alleged that Morgan Stanley failed to make analyst disclosures to investors in 22,000 reports. Morgan Stanley was only fined $200,000 for that infraction.

Until penalties are severe enough to be deterrents, Wall Street will continue to push the envelop. For serial infractions on such an important, high-profile issue, that “goes to the heart of FINRA’s research disclosure requirements,” you would think more than a wrist slap is warranted.

I say, throw the analysts involved and their supervisors out of the business and make Morgan Stanley pay an enormous fine. That would certainly make Wall Street think twice about whether to invest in compliance or regulatory fines.

The SEC and FINRA Need to Level the Playing Field in Structured Products

Before a derivatives dealer and its counterparty agree on a trade they must enter into a written contract called a “Master Agreement”. The European Union also has an agreement for derivatives trades called a Key Information Document (KID).

Derivatives and structured products are both complex financial instruments and can sometimes, nearly look alike. So, why are contracts similar to the “Master Agreement” not compulsory when Wall Street sells structured products to retail investors? The short answer is that Wall Street’s money isn’t at stake; it’s investors’ hard earned cash that’s at risk.

According to Stacy Marie Ishmael of the Financial Times, “The ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market.” The derivatives market couldn’t exist without the Master Agreement.

Yet the structured products market exists, nay thrives, without any such agreement.

Unfortunately, Wall Street has no interest in fixing something when it works perfectly well….for them. According to Bloomberg, Wall Street banks have sold a record $22 billion in structured products to retail investors so far this year and are expected to top the 2008 high of $38 billion by the end of the year.

To be sure, not all structured products are toxic and some do make sense for the right “accredited investors”. However, investors need to understand what to expect when they are on the other end of a trade. They need to understand that these products carry hidden risks and fees, and in many cases the upside is limited, while the downside isn’t. Before investors purchase a structured product they need a “plain english,” one-page document that clearly spells out the terms and risks of that particular product.

With so much money at stake, regulators desperately need to step in and require that investors truly understand what they are buying. FINRA and the SEC need to fix this issue because Wall Street most certainly will not.

More Half-Baked Justice from the SEC

Last year, Judge Jed Rakoff of the United States Southern District of New York struck a blow on behalf of all investors when he ordered the SEC and Bank of America back to the negotiating table. He deemed the settlement agreement the SEC submitted for Bank of America’s alleged failure to disclose billions of dollars of losses at Merrill Lynch as inadequate and poorly constructed. When the SEC and Bank of America went back to the drawing board and agreed to somewhat stricter terms, still without admission of guilt, Judge Rakoff reluctantly approved. But not without a last salvo.

Judge Rakoff proclaimed that the revised settlement represented “very modest punitive, compensatory, and remedial measures that are neither directed at the specific individuals responsible for the nondisclosures nor appear likely to have more than a very modest impact on corporate practices or victim compensation…While better than nothing, this is half-baked justice at best.”

The same “half-baked justice” Judge Rakoff described last year was evident in the SEC’s recent settlement with Citigroup. The SEC alleged Citigroup executives hid $40 billion in toxic mortgage industry assets from its shareholders. Citigroup paid a $75 million fine for what might be one of the biggest accounting scandals on record and managed to avoid using the word “fraud” to describe its actions. Carefully crafted by Citigroup’s attorneys, the terms of the settlement were clearly designed to protect executives from liability and undermine shareholder’s seeking to recover their losses.

Goldman Sachs executives similarly managed to escape blame stemming from the SEC’s accusation that the firm inappropriately constructed the ABACUS CDO transaction. To recall, Goldman created ABACUS so that its clients would unknowingly invest in securities design to fail. To avoid admitting fraud and spare the reputations of senior-level executives, Goldman paid a fine of over $500 million. The settlement was so favorable to Goldman Sachs that its stock price rose 5% percent.

The SEC’s lackluster enforcement record during the financial crisis stands in stark contrast to the country’s state regulators. Attorneys General and securities regulators from many states have done all the heavy lifting, and have extracted meaningful settlements along the way. Most notable is Massachusetts Secretary of State William Galvin. Among Mr. Galvin’s accomplishments is ordering Bear Stearns to pay back 100 percent of any losses suffered by Massachusetts residents who invested in the firm’s infamous, sub-prime laden, hedge funds that spectacularly collapsed in 2007. He also was among the earliest regulators to take action against Wall Street for misleading investors about auction rate securities and he has ordered the Madoff feeder-fund Fairfield Greenwich to pay its investors every penny they lost.

Another active state enforcement official is Mark Connolly, Director of Securities Regulation for New Hampshire, who has accused UBS of fraud for its sales practices related to Principal Protected Notes issued by Lehman Brothers. His case is especially notable because unlike the SEC, he isn’t afraid to use the word “fraud” to describe “misleading investors.”

I could write for hours about all of the significant cases filed by state regulators, but there is a common theme: state securities regulators help investors recover losses from fraudulent schemes and seek to deter it from happening again within their borders.

Unfortunately the same cannot be said of the SEC.

SEC Settlements Lack Personal Accountability

When a corporation commits fraud, should the S.E.C. just go after the corporation, or should corporate executives also be held personally accountable? That is a question the SEC is apparently struggling with.

After the SEC announced its $75 million settlement with Citigroup for failing to disclose $40 billion worth of toxic subprime mortgage investments to shareholders, SEC enforcement director Robert Khuzami touted that his settlement “sends a message within the company,” and “it sends a message to the industry.”

I disagree that company fines alone deter wrongdoing. I believe the SEC needs to hold high-ranking individuals liable.

Just a few days before the Citigroup settlement was announced, the SEC announced it had reached a $100 million settlement with Dell for overstating its earnings. Michael Dell and Kevin Rollins, the current and former CEO, were each fined $4 million, and James Schneider, Dell’s CFO, was fined $3 million. In announcing the settlement, Mr. Khuzami’s stated that, “Accuracy and completeness are the touchstones of public company disclosure under the federal securities laws. Michael Dell and other senior Dell executives fell short of that standard repeatedly over many years, and today they are held accountable.”

Though Mr. Dell and his cronies probably got off easy, at least they were asked to pony up more than a few thousand bucks. The only Citigroup executives that were fined were the CFO and the IR executive, who paid a paltry $180,000 collectively.

A great example of how personal liability can send shockwaves throughout an industry is the WorldCom class action case, which was led by former plaintiff’s attorney and current candidate for New York Attorney General Sean Coffey. He recovered $6 billion for shareholders and forced WorldCom’s directors and officers to contribute $24.75 million, which was 20 percent of their net worths.

Commenting about Mr. Coffey’s settlement, the CEO of Glass Lewis said, “This may be one of the most important steps toward reinforcing the importance of performing the directorship duties with fidelity toward shareholders. It’s going to be very sobering to board members around the country.”

Corporate executives, especially on Wall Street, could use a similarly sobering moment after operating with impunity for years.

Making a Mockery of Financial Reform

According to a recent New York Times report, the very same people that allowed investors to be exploited over the past decade at the SEC are being rehired by Wall Street to carve out loopholes in the Dodd-Frank financial industry reform bill. It’s what’s known as the “revolving door.”

Their objective is to water down the approximately 243 financial rules and 150 “studies” the bill calls for. Of course, this comes after the devastating influence Wall Street lobbyists have had on shaping the bill from its inception. It’s a one-two, knockout punch for investors.

A “fiduciary duty” standard for brokers probably doesn’t stand a chance even though its the one Dodd-Frank provision that affects nearly every investor. Dodd-Frank calls for the SEC to “study” what effect a broad application of the fiduciary standard for brokers would have. You can bet Wall Street lobbyists will work their former colleagues behind the scenes so that the new standard will only be applied in special circumstances, making it effectively meaningless.

The battle between financial regulators and Wall Street over Dodd-Frank will be a David versus Goliath story. Unfortunately, because of the revolving door, Goliath is getting bigger every day.

Annuities and the Avoidance of the Fiduciary Standard

There’s a saying on Wall Street: “Structured products are never bought, only sold”. The same could be said of annuities.

Selling annuities is an extremely lucrative and virtually risk-free business, which is one of the reasons why insurance companies and some Wall Street firms are aggressively lobbying Congress not to require brokers and other purveyors of financial products to adhere to a so-called “fiduciary standard.” Under the proposed standard, brokers and insurance salesmen would be required to put their clients’ interests ahead of their own, likely forgoing high-commission annuities for other, more appropriate investments.

Not surprisingly, Morgan Stanley has voiced concerns that the fiduciary standard would cut into its business. Morgan Stanley has good reason to worry: The firm earned $37 million from selling annuities in the first quarter of 2009 alone, or 1.22 percent of its noninterest income, according to a report by the American Bankers Insurance Association (ABIA). A Morgan Stanley spokesman recently told Bloomberg that expanding the fiduciary standard to include brokers would impinge upon the firm’s ability “to provide clients with products and services they want.” Or, perhaps more accurately, don’t want.

Some annuities are suitable products for investors, however, more times than not, they come with hidden costs and penalties (commissions can be as high as 7-10%) that vastly diminish their value.  Even FINRA has acknowledged the problem.  Richard G. Ketchum, the head of FINRA, recently acknowledged in the New York Times that there “had long been problems with how brokers disclosed their conflicts and how they pushed products.” Last year FINRA fined Fifth Third Securities $1.75 million for what they declared to be 250 unsuitable variable annuity transactions and five other broker-dealers were fined a total of $1.65 million for unsuitable sales of annuities, mostly to elderly investors with conservative investment objectives.

The securities industry likes to say it supports a broad fiduciary standard, but that’s far from the truth.  SIFMA, Wall Street’s lobbyist, has publicly supported a proposal by the House of Representatives which would create a new, “limited” fiduciary standard for brokers only when they are giving “personalized investment advice” to their retail clients.  In other words, brokers would have the discretion to decide when they are providing financial advice and when they are selling snake-oil. FINRA also supports the House bill.

Senator Chris Dodd has issued a much needed proposal that removes the distinction between brokers, insurance agents and an investment advisers.  This, combined with a comprehensive fiduciary standard would go a long way to protecting investors.

However, it’s increasingly unlikely that the fiduciary standard, under pressure from the insurance lobby and Wall Street, will ever see the light of day. Once again the interests of individual investors will be ignored.

SEC Enforcement: The More Things Change…

In my last post I was downright jubilant that Wall Street endorsed the fiduciary standard for brokers. And don’t get me wrong, this is a major development. But, as they say, one step forward…two steps back.  To wit, I read with great dismay two recent cases where the SEC enforcement division levied fines equivalent to a love tap for what appears to be serious wrongdoing.

In what I’m sure was a delight to Morgan Stanley’s PR office, the first case was buried in the Wall Street Journal in a five paragraph blurb on page C4. So allow me to give you some background.

Morgan Stanley was recently censured a paltry $500,000 by the SEC for allegations that one of its former financial advisors misled his clients and failed to disclose conflicts of interests. According to the SEC, William Keith Phillips, who was based in a Nashville, Tennessee branch of Morgan Stanley, breached his fiduciary duty when he allegedly recommended “unapproved” money managers to clients.  Under the terms of a proprietary program, Morgan Stanley would provide custody, execution, performance reporting, and, importantly, due diligence on money managers for their clients.

The SEC alleged that Mr. Phillips had a financial incentive to recommend these three money managers, after developing a relationship with them and negotiating $3.3 million in commissions.  Moreover, two of the unapproved money managers convinced some clients to open advisory accounts with the Morgan Stanley Nashville branch, generating an additional $200,000 in fees and commissions, a portion of which was paid to Morgan Stanley.

Investors harmed by this will no doubt file arbitration cases.  And while I’m sure Morgan Stanley wasn’t happy to sign a check to the United States Treasury for $500,000, I’m pretty sure they did the math a realized they were still ahead.

The second case involved Perry Corp., a $6.6 billion hedge fund managed by Richard Perry.  According to the SEC, Perry Corp. withheld a critical regulatory filing which serves to give the market notice when an investor has amassed more than a 5 percent stake in a public company.  The goal of the rule is to ensure investors understand if there is another investor that could influence company decision making.  In this instance, it is alleged Mr. Perry bought a 10 percent stake in Mylan Inc. in order to throw his weight behind a potential merger in which he stood to profit.

Representing Mr. Perry was William McLucas, who ran the SEC’s enforcement division for eight years before leaving the agency in 1998. When I say the there is a “revolving door” phenomenon between the SEC and Wall Street, this is precisely what I mean.  Mr. McLucas negotiated a measly $150,000 fine with his old employer.

Not surprisingly, Mr. Perry called the settlement a “satisfactory conclusion.” What is “satisfactory” to Mr. Perry most assuredly isn’t for other shareholders in Mylan Inc.  Nor will it likely deter anyone else from playing the same game.

On the other side, David Rosenfeld, associate director of the SEC’s New York regional office, who oversaw the case, said he “[hopes this] will deter others from engaging in this type of conduct.” I wish I could be so hopeful but I’m afraid the fines are a far cry from a deterrent.

What happened to “getting tough” on Wall Street?

Shedding Light on DOJ’s Investigation into the Credit Swaps “Markit”

For those who are intimidated by the complexity of the esoteric $59 trillion credit default swaps market (CDS), let me explain in raw layman’s terms the likely nature and significance of the Department of Justice’s antitrust inquiry into Markit, a company owned by more than a dozen Wall powerhouses including Goldman Sachs and JP Morgan:  The DOJ wants to know whether Markit’s owners manipulated the company’s pricing data and index formulation to enrich themselves and screw their customers.  If the Obama Administration has the conviction and political temerity to investigate and prosecute the wrongdoing the DOJ suspects, it could forever change the “heads I win, tales you lose,” way the big Wall Street firms do business and could result in billions of dollars in fines and restitution, not to mention possible jail sentences.

Although no one has yet been accused of any wrongdoing, having cut my teeth at the Federal Trade Commission litigating antitrust cases (including the one that attacked “Big Oil’s” price-fixing scheme), I can say with considerable authority that the DOJ hasn’t opened this investigation merely on a hunch.   The potential for wrongdoing is enormous because Markit determines the critical month-end pricing that major financial institutions use to “mark” their CDS securities; Markit also compiles critical indexes and the company’s Wall Street owners could benefit greatly if they have input on how these indexes are compiled and weighed.

Even for those with unlimited charity in their hearts should find it difficult to give the big Wall Street firms the benefit of the doubt.  There are countless examples of these firms putting their interests ahead of their customers.  In 1996, NASDAQ market makers settled an antitrust case for more than $1 billion because they were artificially widening the spread on stock trades so they could pocket additional commissions.  Wall Street’s manipulation of the IPO market during the dot.com boom provides yet another example.  And let’s not forget Wall Street’s rigging of the auction rate securities market.

It’s one thing to launch an investigation, having the political will to see it through is another.  Wall Street’s influence in Washington is immeasurable and there is some disturbing evidence that Congress and the Fed serve at the pleasure of Goldman Sachs and not the other way around.  The financial consequences Markit’s owners could suffer is immense if wrongdoing can be found and proven.

Wall Street firms have long regarded regulators as mere gnats that can easily be swatted away.  If the DOJ aggressively investigates and pursues this investigation and holds the big Wall Street firms criminally and financially accountable for any wrongdoing, President Obama will have indeed made good on his pledge to achieve “Change We Can Believe In.”

SIPC and the Madoff Victims

Joe Nocera’s column in last Saturday’s New York Times about the victims of the Madoff fraud has been weighing on my mind.  Nocera passionately defends Irving Picard, the trustee of the Madoff bankruptcy, for refusing to accept the Madoff statements at face value and seeking to claw back any monies that were in excess of what investors put in.  The Securities Investor Protection Corp. will only reimburse Madoff investors for up to $500,000, regardless if the money they invested is well in excess of what they took out.

Nocera posits that Picard “almost certainly is not” misreading the law, but in focusing on the legal issue, he can’t see the forest from the trees.  Nocera would serve his readers considerably better by asking this question: “Why is SIPC coverage a mere $500,000?”

As I’ve noted before, the SIPC $100,000 maximum limit for stolen cash and $500,000 for stolen securities was set in the 1970s, when investor balances were considerably lower than today.  The agency is funded by Wall Street, so it’s hardly a surprise that the powerful brokerage house lobby has been successful in keeping the archaic limits in place.  Despite the slew of Ponzi schemes that have surfaced in the past year, there has been nary a peep on Capital Hill to raise SIPC’s insurance maximums to realistic levels.

An investor who has a good reason to believe that his investment returns are bona fide should be made whole if it turns out he or she was a victim of a scam. Ponzi schemes cannot be facilitated without the support or complicity of established banks and brokerage firms.  These firms must be held accountable for their duplicitous activities and there is no better way to do that than requiring them to make investors who have been scammed completely whole.   If SIPC had to cover all real and fictitious investment losses, Wall Street would be more aggressive policing itself and ferreting out fraudsters like Bernie Madoff.

Indeed, the time has come to require that any manager or firm who accepts investments, including hedge funds, contribute to an insurance fund that would make investors whole in the event of wrongdoing.  If such a rule were in place, people who invested with Bernie Madoff through so-called feeder funds would also be eligible for SIPC reimbursement.  Sadly, the only potential source of recourse for these investors is to sue the feeder funds, a long and costly process.

Wall Street firms had no shame taking taxpayer money to avert their near financial implosion, which was induced by their own recklessness and wrongdoing.  Innocent investors without question are entitled to an industry-funded bailout.