The National Association of Securities Dealers today fined Morgan Stanley DW Inc. US$1.5 million and ordered the firm to pay more than US$4.6 million in restitution for failing to adequately supervise its fee-based brokerage business.

Morgan Stanley began offering its customers a fee-based brokerage account program, called “Choice” in 1996, following a U.S. Securities and Exchange Commission report that was issued in 1995 (commonly known as the “Tully Report”), which found that fee-based accounts are appropriate for investors who are building assets, and may be appropriate for investors with moderate trading activity. Although the SEC report also noted that because of the imposed annual fee, small and low-trading-activity accounts would pay higher costs as a fee-based account than as a commission-based account.

The NASD found that Morgan Stanley instructed its brokers, consistent with the Tully Report, that Choice accounts were not appropriate for certain categories of investors, including buy-and-hold customers and certain accounts that fall below $50,000. However, the NASD’s investigation showed that from January 2001 through December 2003, Morgan Stanley failed to establish and maintain a supervisory system reasonably designed to review and monitor its fee-based brokerage business to determine whether Choice accounts remained appropriate for its customers.

As a result, it allowed 3,549 of its customers to continue using Choice accounts without adequately reassessing whether the accounts remained appropriate for them. These customers, who either conducted no trades in their Choice accounts for at least two consecutive years or had accounts whose assets averaged below $25,000 for at least one full year, or both, will be receiving restitution under the settlement announced today.

The NASD found that between January 2001 and December 2003, there were 1,818 Choice customers whose billable asset level averaged below $25,000 for at least one full year. All of these customers paid at least the minimum annual fee of $1,000, which represented at least 4% of the assets in their accounts – well in excess of Morgan Stanley’s stated maximum rate of 2.25%. Those customers paid a total of $2.7 million in Choice fees.

In addition, it found that 2,062 customers conducted no trades in at least two consecutive years. As a result, they incurred an additional $2.8 million in fees without conducting any trades.

“Fee-based accounts can be appropriate for a wide range of customers,” said NASD vice chairman Mary Schapiro. “But firms have an obligation to their customers to periodically reassess whether a fee-based account, like that offered by Morgan Stanley, remains appropriate. Firms must have systems and procedures in place that adequately evaluate the continued appropriateness of these accounts for their customers.”

In sanctioning Morgan Stanley, NASD took into account the firm’s demonstrable steps, undertaken shortly after NASD’s inquiry began, to enhance its system and procedures and which led to the firm’s identification and removal of large numbers of accounts for which the Choice program was not appropriate. In settling these matters, the firm neither admitted nor denied the charges, but consented to the entry of NASD’s findings.

This case is part of NASD’s continuing focus on fee-based brokerage accounts. In April, NASD fined Raymond James & Associates, Inc. $750,000 and ordered the firm to pay $138,000 in restitution for fee-based account violations. In November 2003, it issued a notice to members, reminding firms that before opening a fee-based account they must have “reasonable grounds for believing that a fee-based program is appropriate for that particular customer” – taking into account the services provided, the projected cost to the customer, alternative fee structures available and the customer’s fee structure preferences. In that notice, firms were also reminded that after a fee-based account has been opened, firms should implement procedures requiring a periodic review to determine whether the fee-based account remains appropriate for each of their customers.