Back in 1981, when Philip J. Purcell helped engineer the odd-sounding merger of Sears Roebuck and Dean Witter, he had a vision. He knew the 401(k) legislation encouraging people to invest for retirement would create a voracious appetite for mutual funds among individual investors. He also knew that selling proprietary funds was a lot more profitable than paying for outside money management expertise and teaching a sales force about a slew of external products. So when customers visited a Sears store to shop for a house-brand chainsaw, they also found a Dean Witter kiosk, manned by a friendly broker eager to help them pick a house-brand mutual fund.

Purcell kept the house-brand model intact 15 years later, when he masterminded Dean Witter Discover's $10.2 billion merger with Morgan Stanley. His synergistic vision had expanded. Combining Morgan Stanley's clout in corporate finance and investment banking with Dean Witter's vast retail network, Purcell believed, would produce a behemoth that could not only distribute Morgan Stanley IPOs, but serve up a smorgasbord of products and services to a huge swath of clients at low cost. Open architecture didn't interest him. On the contrary, Morgan Stanley's brokers and their branch managers got marching orders: 75 percent of their sales had to be proprietary product, say former employees, who requested their names not be printed. Those who met the target got fat bonuses; those who didn't often got fired.

By early 2000, the firm's market capitalization had more than tripled in value since the time of the merger. Assets under management ballooned from $338 billion in 1997 to $462 billion in 1999. Morgan Stanley posted an overall return on equity of 33 percent that year; its stock soared 85 percent. Purcell was hailed as one of Wall Street's most brilliant conceptual thinkers. “He had the concept of a packaged product,” says a former employee, “and it was a benefit to everybody. With proprietary sales, you understand the products you're selling, and you can lower your risk profile. It creates a huge amount of value.”

You Say Potato…

But one man's synergy may be another's conflict of interest. After suffering through a cruel bear market, Morgan Stanley has come under regulatory scrutiny and legal fire for practices in several key businesses in the past two years, including mutual fund sales. Its in-house fund strategy is starting to look like a liability. Net revenues for the Individual Investor Group slipped 2 percent in fiscal 2003 and have essentially been flat for three years, hovering around $4 billion. Purcell trimmed the ranks of investment advisors from 12,500 to 11,000. The Investment Management group fared still worse: Revenues were down 8 percent in 2003, and profits fell 22 percent. Total assets under management grew to $565 billion, but Morgan Stanley's overall market share in asset management slid to 2.7 percent, versus 3 percent in 2002 and 3.3 percent in 2001.

First-quarter results for 2004, released in mid-March, showed some improvement. Net revenues for the Individual Investor Group, as its retail unit is called, were up 5 percent over the prior quarter, and pretax profits rose 8 percent, to $166 million. According to Bear Stearns estimates, broker productivity at Morgan Stanley is better, too. Average annualized production per broker in the first quarter was $477,000, compared with $417,000 in the last quarter of 2003 and up 37 percent from the first quarter last year.

Trouble is, the higher numbers for retail brokerage are mainly the result of better market conditions. According to Bear Stearns, Morgan Stanley's pretax profit margins in this business trail its competitors. Bear research analyst Daniel Goldberg is concerned “about whether or not [the] Individual Investor Group's pretax margins can reach peer levels,” he wrote in a March 19 report. But the firm is not cutting brokerage costs as much as it should, according to some analysts. In fact, Morgan is planning on increasing its sales force.

The poor retail showing may be hurting the firm's overall profitability versus its rivals, but not by much; the retail group accounts for only about 20 percent of revenue and a mere 7 percent in net income, at least in fiscal 2003. Despite the pickup in the stock market and in mergers and acquisitions last year, Morgan Stanley posted return on equity of 16.5 percent, compared with Citigroup's 19.8 percent. Meanwhile, at Merrill Lynch, where in-house products account for less than a third of mutual fund sales, ROE zoomed from 11.7 percent in 2002 to 16.1 percent in 2003. After years of trailing Morgan Stanley in that key ratio, Merrill is catching up.

Betamax City

Now, some industry experts say Purcell's paradigm is becoming obsolete. As the 60-year-old chairman and chief executive approaches retirement, Morgan Stanley watchers wonder whether his hand is as firmly on the tiller these days as it was when he first grabbed it after a power struggle with former president John Mack in 2001. “I think Morgan Stanley's ship is going up and down with the tide, as opposed to Purcell's taking control or command of business,” says Richard Bové, managing director and Wall Street analyst at San Francisco-based brokerage Hoefer & Arnett.

Critics say Purcell's strategy has produced a sluggish sales force. “In my view, the [Morgan Stanley] broker is actually less well-developed than a guy at Merrill or Smith Barney or UBS,” says another former Morgan Stanley employee. “Wholesalers aren't competing to show you their programs, their marketing approaches, their value-added. Dean Witter historically always had lower sales per broker than other firms, by a large amount.” That didn't matter so much in the 1990s, when Morgan Stanley was rolling out a new, high-margin proprietary product every month and brokers were selling in-house funds fast. But those sales have slowed down enough that they no longer disguise low overall productivity.

As a result, according to one Morgan Stanley rep, things are changing for the sales force. He says that brokers still earn a 5 percent commission on proprietary products, versus 4 percent for third-party funds — something disclosed in the very, very fine print of in-house prospectuses. (The firm's new “Bill of Rights” for mutual fund investors, created at the end of last year, says broker compensation formulas are the same “regardless of which mutual fund you purchase.”) But the broker adds that management is no longer pushing people to sell the fund of the month. “We've really backed way off from that in the last couple of years.”

Part of the change is a function of market demand. Mutual fund investors, increasingly sophisticated, demand best-of-breed products, and Morgan Stanley's don't stack up particularly well against competitors' in terms of returns versus the expense of ownership (see chart on page 34). According to Bear Stearns, only 54 percent of the firm's fund assets are performing in the top half of the Lipper rankings, and that's down from 60 percent a year ago. “If you're paying 5 percent,” says the broker, “you want to get your money's worth.”

Unwanted Attention

Then there's the regulatory spotlight on fund sales practices. Last July, the State of Massachusetts filed a complaint against Morgan Stanley for the way it compensates its brokers for mutual fund sales. Massachusetts Secretary of State William Galvin charged that brokers and managers received monetary incentives for peddling proprietary products that in some cases underperformed third-party funds. Galvin estimates that the aggressive practices, including “sales contests” between broker teams and extra compensation for regional managers who met quotas for selling in-house fund shares, yielded $5 million to $8 million in extra commissions and fees since January 2003. Morgan Stanley was fined $50 million. It also paid a $2 million settlement to the NASD over allegations of overcharging third-party fund vendors for shelf space. The firm recently admitted that the SEC is investigating its fund sales practices as well.

Some observers think the legal and regulatory pressures will force Purcell to rethink his synergistic selling strategy. “Purcell recognizes that if he doesn't do something, it'll cost him a lot of money,” says the former employee. Sure enough, in November, at the Securities Industry Association's annual conference in Boca Raton, Purcell announced he was launching an in-house investigation into conflicts of interest. Leading the effort is Eric Dinallo, who helped New York Attorney General Eliot Spitzer probe Morgan Stanley's research practices in 2002 and then joined the firm last September. “Dinallo will know whom to talk to and how to settle,” says Tim Woolston, senior vice president at Boston Advisors, which holds Morgan Stanley stock.

But that won't ease the earnings squeeze on Morgan Stanley's brokerage force. Commissions in fiscal 2003 dropped to $2.9 million, from $3.6 million in 2000. Now, outside fund wholesalers are clamoring for the firm to break down distribution fees and cut commissions. And fees from asset management, distribution and administration have been declining, from a high of $4.3 million in 2000 to $3.7 million last year. Proprietary Addiction

The answer, of course, would be to boost broker productivity in external product sales and spend more money on attracting top talent to run in-house funds. But changing Morgan Stanley's culture won't be easy. “Once you've hooked yourself into a proprietary model, it's like heroin,” says another former employee. “It's so profitable relative to selling third-party products that you can't stop.” He expects Morgan to continue losing assets under management until it cleans up its reputation for both performance and disclosure.

That's not to say the firm as a whole is struggling. Quite the contrary. Thanks to the improvement in the stock market and M&A, “Morgan Stanley is minting money right now,” says Boston Advisors' Woolston. The firm reported net income of $3.8 billion for the fiscal year ended in November 2003, compared with $3 billion in 2002. Pretax profits rose 22 percent. In the league tables, it ranked No. 2 in global M&A, with a 20.2 percent market share, and No. 3 in global equity underwriting, with a 10 percent share. The first quarter results also beat consensus estimates with earnings surging by 35 percent.

As for regulatory censure, Morgan Stanley is by no means the only financial house to be told it needs cleaning. And few people think the firm's regulatory problems will have any significant impact on either its bottom line or its shares. “I don't think the regulatory stuff is material for the stock,” says Standard & Poor's equity analyst Robert Hansen. “Most of the scrutiny is industry-wide rather than company-specific. Plus, the SEC and other regulators have so far shown a willingness to settle.”

Even the outspoken Bové agrees. “Conflict of interest isn't an issue,” he says flatly. He notes that market dynamics will always trump scandals. For example, money has been pouring into mutual funds over the last six months, even though the industry's overall integrity has taken a huge hit.

Looking Inward

Moody's Investors Service analyst Peter Nerby believes Morgan Stanley's internal probe is “an honest effort by the company to assess how to do business and improve practices.” Other Morgan Stanley watchers, however, think that hiring a former Spitzer aide amounted to little more than window-dressing. And despite the management shuffle, Bové still doesn't think Purcell is paying enough attention to long-term strategy.

“What they're doing isn't great enough to suggest major change within the company,” he says.

A couple of top-level staff changes suggest that the firm may be sharpening its focus on strategy. Purcell has replaced chief financial officer Stephen Crawford with David Sidwell, brought over from J.P. Morgan Chase, and promoted Crawford to chief administrative officer. That, writes Merrill Lynch analyst Guy Moszkowski, frees Crawford to concentrate on strategic issues. Company spokesman Ray O'Rourke denies that the executive changes signal a reevaluation of long-term strategy. He also declines to comment on the internal conflict-of-interest probe, except to say it is a work in progress with no set time limit. The company is going “product by product and business by business,” O'Rourke says, systematically examining each for problems.

But some observers say that unless Dinallo makes prompt and verifiable changes in things like broker compensation and disclosure, his presence won't keep the regulators off Morgan Stanley's back. One reason is that Purcell himself has annoyed them. Last April, along with 10 other large firms, Morgan Stanley agreed to a $1.4 billion settlement after state and federal regulators alleged that research analysts had issued biased stock ratings to attract or keep investment banking clients. Morgan Stanley's share of the settlement came to $125 million, a sum many considered a mere wrist-slap. The day after the agreement was announced, Purcell told a New York financial conference that the settlement should not “concern the retail investor.” His remark raised hackles at the SEC, whose chairman, William Donaldson, fired off a sharp letter reminding Purcell that the terms of the settlement forbade him from denying the SEC's allegations: Donaldson added that Purcell had a “disturbing and misguided perspective” on the matter.

Purcell retracted his comments, but he may not have gone far enough. “When the research settlement came out in April, he boasted,” says a Wall Street consultant. “He didn't say he apologized and would get to the bottom of it. It was hubris.”

In addition, according to this source, Purcell isn't doing enough on the mutual-fund front. One Massachusetts regional manager implicated in the sales contest fracas was fined $250,000 — and then promoted. A Morgan Stanley lawyer charged with responding to State Secretary Galvin's inquiries dragged his heels and ultimately supplied incomplete information. “When you piss off Galvin that badly, you poison the atmosphere,” says the consultant. “Instead of being the last person [regulators] look at, you become the first.”

If changes lie ahead for Morgan Stanley's reps, they haven't suffered much so far. “I think they like Purcell a lot better than the Merrill brokers like [Private Client head James] Gorman,” says one analyst who covers both companies. “He has a broker [John Schaefer] running the brokerage. It makes his brokers happy.”

For now, Morgan Stanley investors are laughing all the way to the bank; Morgan Stanley common stock is trading near its 52-week high. And analysts still see more positives than negatives. Sanford Bernstein's Brad Hintz upgraded the stock to a buy last summer. “Morgan Stanley will perform well because it has won wonderful M&A business, plus it's part of the investment banking oligopoly, plus it has a seasoned private banking portfolio,” he says. “I think earnings will lift on the institutional side. And while I think we have a ways to go on the retail recovery, that business will hit maximum speed later this year, through 2005, and into 2006.” (Hintz was formerly Morgan Stanley treasurer, but he won't be allowed to exercise his options for many years to come.)

At Standard & Poor's, Hansen gives the stock a buy rating based on its valuation. “We think the stock is cheap,” he says. Like his colleagues, Hansen notes that Morgan Stanley's retail brokerage and Discover units lack momentum. But he believes the economic recovery will offset those weaknesses, at least in the short term.

The next big round of rumor and innuendo surrounding Purcell is likely to involve his successor. Wall Streeters are looking forward to the scrum as the firm's three group president/COO — Mitchell Merin at Morgan Stanley Investment Management, Vikram Pandit at Institutional Securities & Investment Banking and Schaefer at Individual Investor Group — vie for power. No one seems very worried that Purcell will leave the firm with a gaping hole. “This bank is so deep in talent at that level that there are any number of capable people,” says Boston Advisors' Woolston. “There's no big transition issue, like at AIG or Disney.”

Some industry watchers think Purcell would like to pull off one more big merger before his tenure ends. Of course, only another giant would make sense as a partner, an American Express, a Bank of America, or, more incestuously, a J.P. Morgan Chase. Germany's Deutsche Bank has also been in the rumor mill as a possible cohort. If Purcell is really thinking along these lines, his vision of size and scale will survive him. But his successor may still have his work cut out for him getting the sales force back up to speed.