Morgan Stanley Settles SEC Customer Protection Rule Charges for $7.5 Million

In December 2016, the SEC announced a $7.5 million settlement with Morgan Stanley & Co. LLC. The SEC found that Morgan Stanley used transactions with an affiliate entity to reduce the amount of money it was required to set aside to safeguard its customers’ cash in violation of the Customer Protection Rule.

The Customer Protection Rule (or Rule 15c3-3), encompassed in the Securities Exchange Act of 1934, is intended to protect consumers from the risky use of their funds by broker-dealers – financial firms that trade securities both for themselves and on behalf of customers, like Morgan Stanley. The rule is designed to prevent broker-dealers from using customer cash to finance their own transactions or any non-customer activities.

To that end, the SEC requires a broker-dealer to segregate the customers’ cash so it can promptly return what it owes to the customers in the event of the broker-dealer’s failure. Broker-dealers must maintain a separate “customer reserve account” with a minimum balance equal to the net amount the firm owes its customers. On a weekly basis, a firm must determine the required minimum by calculating the excess of customer credit over its debits. Therefore, the more debits a firm can include in this calculation, the lower the minimum balance it will be required to maintain in customer reserve account. As such, the SEC rule also prohibits broker-dealers from including in their calculations the debits of their affiliates that are not directly related to customer activity.

About Morgan Stanley’s Actions

Morgan Stanley ran afoul of the rule by trading with its own affiliate in a way that improperly lowered the required minimum balance in the customer reserve account. Morgan Stanley offered certain structured products that allowed customers to benefit from the price changes of an equity security without owning the security itself. To provide this “synthetic exposure,” Morgan Stanley would enter into an equity swap with the customer. This left the firm with the need to hedge its exposure.

In an attempt to lower these hedge costs, the firm created an affiliate, Morgan Stanley Equity Financing Ltd., to act as a “customer,” the SEC found. Morgan Stanley provided the affiliate with margin loans, and the affiliate then used the resultant profits to finance the firm’s hedge costs. This trading scheme allowed the firm to obtain lower financing rates for purchasing the equities it needed to hedge its risks. Further, Morgan Stanley included the affiliate’s debits in calculating the customer reserve account amount. By including the affiliate’s debits, the amount fell by an average of $78 million per day, and as much as $417 million in a single day.

How Morgan Stanley Violated the Customer Protection Rule

The SEC found that these activities violated the Customer Protection Rule in two ways. First, the use of the affiliate’s margin loan profits to hedge the firm’s risk from transactions with customers was inconsistent with the rule’s objective to prevent broker-dealers from using customer funds to finance non-customer operations. Second, the inclusion of the affiliate’s debit that impermissibly lowered the amount Morgan Stanley was required to deposit in the customer reserve account.

Morgan Stanley did not admit or deny the SEC’s findings, but agreed to pay the $7.5 million civil penalty, to cease and desist from similar future SEC violations, and to censure by the SEC. 

For more information on this announcement from the SEC, click here.