Morgan Stanley settles customer protection rule case

Dec 29, 2016
<p>Finra says the firm had a system that allowed it to erroneously release certain securities from segregation</p>

Morgan Stanley has agreed to pay a $2.75 million penalty to settle allegations that it had compliance lapses that led to it violating the customer protection rule.

The Financial Industry Regulatory Authority (Finra) has accepted a letter of acceptance, waiver and consent from the firm, which did not admit or deny wrongdoing. A request for comment from Morgan Stanley’s press office was not returned immediately.

According to the self-regulatory organization (SRO), Morgan Stanley from at least 2012 through 2013 failed to establish and maintain systems and procedures reasonably designed to ensure that it kept possession and control of all customer fully paid and excess margin securities.

At times, Finra says in a related filing, the firm mistakenly released certain customer shares that should have been held in a segregated account. This led to the shares being made available for Morgan Stanley’s use, and at times they were used by the firm, according to Finra. As a result, the SRO said, the firm violated Rule 15c3-3(b).

Rule 15c3-3 - known as the customer protection rule – is designed to avoid, in the event of a broker-dealer failure, a delay in returning customer securities or a shortfall in which customers are not made whole, by requiring firms to safeguard the cash and securities of their customers. 

Among other things, the rule requires broker-dealers to promptly obtain and then maintain physical possession or control of all fully-paid and excess margin securities they carry for the accounts of customers.

This means that a broker-dealer must protect securities that customers leave in the firm’s custody. To comply with the rule, broker-dealers segregate these customer securities and hold them in a separate account from the broker-dealer’s own assets.

To comply with the customer protection rule, Morgan Stanley had a control system that calculated what customer securities it was required to segregate, Finra says. To the extent the firm also had excess securities, over and above the amount it was required to segregate, it could ‘release’ those securities from segregation, the SRO adds.

But the system contained a design flaw that allowed Morgan Stanley to release certain securities from segregation that the system deemed to be excess, when in reality no such excess existed, and releasing these securities resulted in deficits in the customer securities the firm was supposed to segregate, Finra alleges.

These situations occurred when the firm erroneously understood that customer securities had been segregated, but the segregation instructions had in fact not yet been processed, according to the SRO. Based on that belief, it adds, Morgan Stanley mistakenly released the shares from segregation.

This resulted in the shares being made available for the firm’s use - and at times they were used by the firm – before Morgan Stanley corrected the deficit by the end of the day, Finra says.

Although the firm typically segregated the customer shares at the end of the day, thereby correcting intraday deficits, it did not have adequate systems and procedures to investigate the cause of these deficits or to prevent them occurring again, according to the SRO.

After each trading day, the firm’s segregation system calculates what shares are available for its use for the next trading day - a process it completes around 3 a.m. on the next business morning, Finra says. This process occurs in New York and the information gathered is distributed to the Morgan Stanley’s settlement departments overseas, the SRO says.

The firm relies on this information generated by the segregation system to move excess shares to and from the customer segregation location, but it failed to have adequate systems and procedures that accounted for trading in disparate time zones and on US holidays to prevent the creation of deficits in customer securities, Finra alleges.

When it effected certain transactions at times outside the US trading day, the firm’s overseas-based settlement department relied on stale information – an issue predominantly affecting countries in Asia with time zones that are 13 hours or more ahead of New York, where the firm ran its segregation process, the SRO says. It adds that the firm created or increased deficits when it engaged in these transactions.

Although Morgan Stanley implemented a temporary manual process to minimize the impact of this time zone problem, the process was only 80% effective in the Asian markets, Finra said.

The firm's segregation system did not run on US holidays, meaning that Morgan Stanley did not give its overseas-based settlement departments accurate share availability information on US holidays, according to the SRO. The firm created deficits in customer securities when its overseas-based settlement departments relied on this inaccurate information and used shares that were not in fact available, Finra alleges.

Following the Finra 2012 cycle exam, Morgan Stanly self-reported that it had identified additional compliance issues, Finra says. First, the SRO says, from August 2 to August 8 2012, the firm created deficits in three securities averaging $932,000 per day when it erroneously moved all non-US dollar-denominated customer securities segregated at the Depository Trust Company from segregation.

Second, the firm created seven intraday deficits totaling $1.5 million on September 4, 2012 due to a failure to deliver recently purchased deposit/withdrawal at custodian customer shares to transfer agents, according to Finra.

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