Over a two year period, Morgan Stanley allegedly did not have a firm-wide structured product-specific suitability policy.  Instead, according to FINRA examiners, the firm had an overall suitability guideline that directed supervisors to consider concentration when reviewing all securities purchases.  This observation apparently was supported by a review of sampled transactions, in which examiners found 14 unsuitable recommendations for 8 customers.  The transactions took place at various times, from September 2006 through August 2008.

Structured products are securities ... derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency.  Structured products typically have 2 components - a note and a derivative (often an option).  There are many types of structured products. Some structured products offer a guarantee of return of principal at maturity, subject to issuer credit risk. Many structured products pay an interest or coupon rate substantially above the prevailing market rate; others do not pay a coupon and have no guarantee of a supplemental payment at maturity.

Structured products also frequently cap or limit the upside participation in the reference asset, particularly if some principal protection is offered or if the security pays an above-market rate of interest. In order to receive the benefit of a return of principal, the security must be  held to maturity, which can be 5 or more years after issuance.  These lengthy holding periods increase the risk that an issuer may default on the repayment of principal.  In addition, notes that guarantee a return of principal - i.e., principal protected products - may yield no positive return depending on the performance of the underlying asset.  As stated above, principal protection is provided by the issuer and is subject to the issuer's solvency.

Such inherent "issuer risk," in addition to other characteristics of structured products, underscores the importance of ensuring that customers invest an appropriate amount of their assets in such products.

FINRA Findings and Allegations. During the 2-year review period, customers of Morgan Stanley Global Wealth Management Group ("GWMG") entered into some 224,000 structured product purchases, of which 90% involved proprietary structured products.  Morgan Stanley offered its customers a range of structured products, which the Firm characterized as principal protected, leveraged exposure, yield enhancement, or access investments.  Principal protected products represented about 51% of the Firm's structured product commission revenue.  Leveraged and yield enhancement products represented 19% and 18%, respectively.  The Firm created and offered proprietary products in each of these categories. Selling memoranda specific to each of its proprietary structured product offerings was provided to customers; some of the selling memoranda included a 10% concentration guideline with respect to the specific issue and a $100,000 minimum net worth recommendation.  The firm developed standard concentration and net worth guidelines, which were posted on its structured products website. Despite the concentration and net worth guidelines, the firm nonetheless sold structured products at concentrated levels and to customers who did not meet the firm’s minimum net worth recommendation. So, while the firm expected its branch supervisors to monitor these transactions for suitability, the firm's systems failed to notify the supervisors whether structured product purchases complied with the Firm's internal guidelines related to concentration.

[C-I Note: It would be interesting to find out if any branch supervisors ever became aware that they were not being provided with exception reports for their suitability reviews.  The answer is probably not, because if someone had discovered the deficiency, it's likely the firm would have revised its system to accommodate this need.

A second interesting consider would be the ratio of errors to the population of transactions.  With 224,000 transactions during the review period, the 14 detected error represented less than 1/100 of a percent - although the ratio would be much larger given the fact that this number of errors was detected from a limited sample.  Accordingly, it would make sense that FINRA levied  a $600,000 fine - particularly since the deficient supervisory procedures took place over a 2-year period.]

Settlement with FINRA. To settle the FINRA charges, Morgan Stanley agreed to pay a $600K fine, without admitting or denying the findings. Prior to agreeing to the FINRA settlement, the firm entered into settlements with those 8 customers who had made inappropriate purchases - paying the customers about $329K in total. For further details, go to:   [FINRA AWC #2008015963801]  [FINRA Disciplinary Actions for March 2012]