Morgan Stanley case may be ugliest thus far

Your Funds

Dollars & Sense

November 30, 2003|By CHARLES JAFFE

THE PROBLEM with a scandal that has a new development every day is that it's easy to get ho-hum about the most current events.

The reaction to Morgan Stanley's recent $50 million settlement with the Securities and Exchange Commission tended to be a yawn, as if investors and commentators have seen it all before.

But the Morgan Stanley settlement covered new ground, and for investors who use a broker or financial planner, the deal was new territory for concern.

In fact, the charges Morgan faced have a much more tangible impact on shareholders than the deals that have been in the news for two months now.

The vast majority of those problems, involving firms such as Putnam, Janus, Strong, Alliance and others, have revolved around trading situations in which managers or privileged customers were allowed to make rapid-fire trades that were supposed to be prohibited for all shareholders.

Regulators and industry watchers have had a difficult time quantifying just how much damage was done to shareholders in total, so while investors know for sure that the firms have done them wrong, they can't quite picture the impact on their own pocketbooks.

The Morgan Stanley case is different, and regulators are hinting that there will be other firms nailed for similar offenses.

It's important to recognize that Morgan's settlement with the invertebrates at the SEC was not an admission of wrongdoing. That's the likely outcome in almost all of these types of settlements, so investors should only imagine how much these companies might have to pay if they actually did anything wrong.

Morgan was alleged to have failed to state that financial advisers and branch managers were paid to steer customers to certain mutual fund products. The fund firms paid Morgan Stanley for the promotion.

Regulators also said that Morgan Stanley brokers pushed B shares to investors, without explaining that those shares carried higher sales charges or fees. Typically, a B share carries no upfront sales costs, but higher expenses and a back-end sales charge. That pay-as-you-leave payment typically shrinks until it disappears after five or six years in the fund; in most fund families, B shares are converted into A shares, where the accompanying expenses are lower, when the load is gone.

By comparison, A shares carry the traditional front-end sales charge, meaning that the investor pays several points off the top to compensate the broker.

The key issue here is that A shares have "breakpoints," where an investor who plugs in a lot of money - at least $50,000 - can get a discount on the sales charge.

The more breakpoints for which an investor qualifies, the less he pays in sales charges, the better the deal he gets on the fund by purchasing A shares.

There are no breakpoints in B shares.

So by not telling the investors that they might save money in A shares, Morgan's staffers were pulling money directly from the pockets of the shareholders.

And by not telling them about the additional compensation brokers could earn for selling the funds they were recommending, the brokers and planners were enriching themselves without being completely honest with the people trusting them.

That's why among the current problems, this scandal is the one from which investors will feel the most pain.

While an investor might be disturbed that a Putnam or Janus would give a big customer special trading privileges, it is a much bigger betrayal for an investor to feel that the adviser they trust has ripped them off.

What's more, investors with big wads of money in B shares will be able to look at their accounts and figure out the cost.

The fund industry has known about B share fraud for years, and regulators have been harping on it for a while. Likewise, the practice of "paying for shelf space," where a fund firm compensates a brokerage firm to get more exposure to clients, is nothing new.

But investors haven't been looking for them.

They might start now.

If you invest through a financial adviser, the current case - and the ones to come - is a reminder that you must include the following questions in your evaluation of any investment you're being pitched:

How much do you get for selling me this? You want to know exactly how much of your money is going to pay the adviser. If there is no obvious sales charge, as in a B share, make sure you understand how the compensation works.

Do you or your firm get anything extra for selling me this? The motivation for good advisers is finding the right investment for your portfolio, not the right bonus for themselves.

What are the alternatives, in terms of investments and payment structures? In an era where investors need to be distrustful, an adviser should be showing you options and helping you sift through them, rather than pushing hard toward one end.

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