Morgan Stanley Fined $6.1 Million for Fee-Based Brokerage Slip-Ups

Fee-based brokerage may be here to stay, but regulators are putting it through the wringer. On Tuesday, Morgan Stanley became the second firm to be penalized this year for failure to supervise its fee-based brokerage business. The NASD says the firm would pay $1.5 million in fines and $4.6 million in restitution to investors for the violations.

With $33 billion in assets in its fee-based brokerage accounts at the end of last year, Morgan Stanley is the second-largest player in the industry, according to Boston-based Cerulli Associates. Like Raymond James, which faced similar charges earlier this year, a number of clients in Morgan Stanley’s fee-based brokerage, or Choice, accounts did not trade frequently enough to justify the annual fees on the accounts during the period under investigation. Unlike Raymond James, Morgan didn’t place customers in these accounts inappropriately at the outset, but it did fail to monitor whether the accounts continued to suit the client over time, such as when trading activity was minimal or the account balance dropped below the minimum required for eligibility—in Morgan’s case $50,000.

Morgan Stanley says it will continue to offer fee-based brokerage accounts under an improved supervisory system. “We continue to enhance our surveillance and to remove Choice pricing for accounts with low activity,” says a Morgan spokeswoman. “We also continue to communicate with clients through discussions and through several types of letters.” Raymond James dropped its fee-based brokerage business all together after it settled with the NASD, moving clients from this program into fee-based advisory or commission-based brokerage accounts. (See our story Raymond James Fined, Drops Fee-Based Brokerage—Will Others Follow?)

NASD spokesman Herb Perone says a number of other firms are under investigation for supervision of their fee-based brokerage accounts, but he declined to say how many. Merrill Lynch is No. 1 in the business, with $89.1 billion in assets in its “Unlimited Advantage” accounts and a third of the market at the end of last year, says Cerulli. UBS, Wachovia, Smith Barney and Charles Schwab are also big players. Many of these firms have set up periodic reviews of their fee-based accounts in light of increased regulatory scrutiny.

Matt Schott, an analyst with Needham, Mass.-based Tower Group, says it’s possible that some firms will reconsider continuing to operate fee-based brokerage accounts. “All firms are going to have sit up and take notice and see whether these accounts do make sense,” he says. “There is a specter that more firms will get looked at, challenged and fined, so there’s the added cost of that. There’s also the potential for a change in revenue mix, because there will be some accounts that were in a fee brokerage arrangement and won’t be in the future. And then there’s this whole evolution towards managed money,” he says.

The top firms launched fee-based brokerage accounts back in 1995, when the SEC said charging a fee based on assets under management would better align a broker’s interests with those of his clients. “Commission rates were getting crunched anyway, and firms looked at this as a more lucrative way to sell these services,” says Schott.

But for buy-and-hold investors, commission-based accounts often make more sense than fee-based brokerage accounts. In a fee-based brokerage account, the 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. In the fall of 2003, the NASD warned broker/dealers to determine whether fee-based brokerage accounts are appropriate before recommending them to clients and to engage in continued oversight.

NASD’s investigation showed that from January 2001 through December 2003, Morgan Stanley failed to establish and maintain a supervisory system to review and monitor its fee-based brokerage business. As a result, there were 1,818 Choice customers whose billable asset level averaged below $25,000 for at least one full year. All of these customers paid at least the minimum annual fee of $1,000 applicable at the time, which represented at least 4 percent of the assets in their Choice accounts—well in excess of Morgan Stanley's stated maximum rate of 2.25 percent.

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 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.