WASHINGTON - Two divisions of Morgan Stanley have been censured and ordered to pay $675,000 to settle Financial Industry Regulatory Authority charges that they misrepresented municipal bond interest paid to customers as tax-exempt, when it should have been taxable.
Morgan Stanley Smith Barney and Morgan Stanley & Co. agreed to the penalties April 1 without admitting or denying FINRA's charges that they violated a slew of Municipal Securities Rulemaking Rules from July 2009 through December 2013.
"The settlement involves a very small fraction of the firm's interest payments on municipal bonds during the relevant period," said Morgan Stanley spokeswoman Christine Jockle. "The firm addressed the tax issues with the [Internal Revenue Service] without impact to its customers. The firm cooperated fully with FINRA and revised its procedures to prevent recurrence of such issues. FINRA did not allege any willful or fraudulent behavior."
During the examination period, FINRA said, the firm paid out to customers at least $880,000 dollars of interest that the customers believed was tax-exempt from muni bonds held by the companies in customer accounts. In fact, FINRA found, the firm was "short" on its positions and the interest they were paying was actually taxable.
Short positions occur when a firm sells bonds that it does not own at the time. A dealer who executes a short sale must then go to the market and subsequently purchase the securities from a third party in order to make delivery on the transaction. When a short position corresponds to a customer's "long" position, the dealer makes a substitute interest payment to the customer. But because only interest from municipal issuers is tax-exempt, interest generated from a short position is taxable.
"During the relevant period, Morgan Stanley generated or held more than 1,500 short positions in tax-exempt municipal securities that corresponded to long positions in customer accounts," FINRA found. "The short positions resulted primarily from trading and operational errors. ln these instances, Morgan Stanley paid the interest to the customer and the interest was taxable."
Most of the short positions resulted from trading errors that occurred at the firm's retail branches, FINRA said. When an error occurred in connection with a customer's municipal bond order, the resulting short position was first moved to a branch error account and then, if not covered by the branch, eventually moved to a centralized error account maintained by the firm's muni desk.
FINRA examiners found that the firm knew as early as 2006 that its short positions were not being covered quickly enough, with some positions remaining short for months or even years. Morgan Stanley's capital markets division, which was responsible for covering short positions, was not made aware of how the firm was characterizing interest payments, FINRA found.
The firm's tax reporting department, which was responsible for issuing 1099 forms on interest income, and its income processing department responsible for how interest was coded on the 1099s, were not aware that the short positions existed.
FINRA alleged that because of these issues, Morgan Stanley's automated system calculating interest owed to customers was not taking into account whether interest paid to customers who held munis should be designated as taxable when the interest was being paid by Morgan Stanley rather than by a municipal issuer.
When FINRA examiners discovered the problems in 2013, Morgan Stanley agreed to pay a settlement to the IRS to prevent customers from having to file amended tax returns.
The alleged conduct resulted in violations of MSRB rules G-27 on supervision, G-17 on fair dealing, and G-8 on books and records, FINRA said. The firm failed to maintain a supervisory system reasonably designed to prevent rule violations, misstated the nature of interest payments to at least 1,500 customers, and created and distributed inaccurate account statements.
Morgan Stanley Smith Barney agreed to a censure and fine of $675,000, of which $124,406.93 was paid jointly with Morgan Stanley & Co. The latter division was censured along with its share of the fine.
