It smacked of the worst kind of grandstanding. On Aug. 10, in a lawsuit, press release, and press conference, Massachusetts fired the first shots in a legal war against Morgan Stanley. The allegation was that the firm put its revenues far ahead of the interests of its customers. Secretary of the Commonwealth William F. Galvin accused the firm of "fraudulent" practices that gave brokers special incentives, including sales contests, to sell its in-house funds. Morgan Stanley declined comment pending its formal response to the suit.
The timing of this action was either propitious or suspicious, depending upon your point of view. It coincided with an effort in Congress by House capital markets subcommittee Chairman Richard H. Baker (R-La.) to curb state securities regulators' powers (BW -- July 28). The practices complained of in the suit are not explicitly prohibited and are widespread. The Massachusetts action thus would appear to be more hype than substance, if not for one thing: This is just the kind of intense policing that Wall Street desperately needs.
Motives notwithstanding, Massachusetts' assault on Morgan Stanley points up the need for vigorous state regulators to pursue their own investigations and enforcement actions against securities firms. The practices described in the Morgan Stanley suit have been allowed to flourish on the Street by the Securities & Exchange Commission and NASD -- which only just proposed a rule dealing with the issue -- in the same way as analyst conflicts went unchecked until New York State Attorney General Eliot Spitzer stepped up to the plate. Says Henry T.C. Hu, a corporate and securities law professor at the University of Texas: "In a perfect world, there would be no role for state regulators for this kind of stuff. But in the real world, regulatory competition is very useful -- it gets the blood going."
The SEC certainly could use a nudge. Chairman William H. Donaldson has commendably moved to beef up mutual-fund fee disclosures but has yet to show much stomach for going after sales practices at the big firms. It's high time he did. Way back in '95, an SEC blue-ribbon committee found persistent conflicts of interest in the way investment firms paid brokers -- including some of the same practices that Galvin alleges Morgan Stanley followed. Such things "have been going on in the brokerage business forever," says Bryan Farrell, a former federal prosecutor who is now managing director of Smith & Carson, a private investigative outfit.
Such "going on forever" stuff bores the feds, but not the states. Historically they have been swifter to act against deeply ingrained, questionable industry practices than the SEC and NASD. Long before Spitzer moved against analysts -- thereby prodding a somnolent SEC into action -- state regulators were among the first to hone in on microcap fraud, beginning with a multistate initiative in mid-1996. That sparked competition among the states, the SEC, and the NASD to prosecute microcap crooks -- a flurry of activity that led to dozens of civil actions and criminal prosecutions. Ultimately, the outcome was beneficial to investors, because cases not pursued by the feds were often picked up by local prosecutors such as Manhattan District Attorney Robert Morgenthau.
Investors will probably benefit, too, from a similar competition to act against large-firm mutual-fund sales practices. The exhibits in the Massachusetts case against Morgan Stanley, posted on Galvin's Web site, paint a sorry picture of a firm that apparently gave brokers huge incentives to push Morgan funds. Critics of state regulators maintain that the U.S. securities market should have only one watchdog: the SEC. Baker's legislation would prevent the states from imposing tougher rules on brokerages than the SEC's. This idea, endorsed by Donaldson and Federal Reserve Chairman Alan Greenspan, has an appealing orderliness. But before endorsing it, Congress needs to consider whether it wants a neat-as-a-pin securities-oversight scheme that protects SEC and NASD turf -- or a feisty, competitive one that protects investor interests.
By Gary Weiss