Share All Risks and Costs with Investors When Selling Securities

Sometimes even the big players need to learn a lesson about disclosure. Morgan Stanley Smith Barney and Citigroup Global Markets found this out the hard way when they each settled charges from the SEC that they made false and misleading statements about a foreign exchange trading program they sold to investors.

The two firms, each a dually registered investment adviser and broker-dealer, paid $2.96 million apiece to put to rest agency allegations that written and verbal presentations regarding the program, CitiFX Alpha, were based on the program’s past performance and risk metrics, and were not forthcoming about other key factors. "They failed to adequately disclose that investors could be placed into the program using substantially more leverage than advertised and markups would be charged on each trade," the SEC said. "The undisclosed leverage and markups caused investors to suffer significant losses."

"Investors simply cannot be sold investments based on disclosures that are inaccurate or incomplete," said agency Miami Regional Office director Eric Bustillo.

"Advisers should always be aware that anytime they go to market or advertise an investment strategy or a program to prospective investors, disclosures should be made about any limitations related to risks or fees going forward," said Stradley Ronon partner Lawrence Stadulis.

"While investment advisers must always be mindful of their oral and written disclosures to clients, they should be particularly vigilant about disclosures regarding new or exotic products," said Paul Hastings of counsel Sam Puathasnanon.

"The lack of familiarity regarding such products on the part of both financial advisers and investors can lead, even unintentionally, to misleading disclosures and misunderstandings," he said. "Here, more careful scrutiny by the advisers of the written disclosures, perhaps working in conjunction with the firm’s compliance personnel, would have increased the likelihood that the misleading disclosures would have been identified and corrected."

Morgan Stanley, in its settlement, and Citigroup, in its settlement, were each charged with violating Section 17(a)(2) of the Securities Act of 1933, which prohibits obtaining money or property by means of any material misstatement or omission in the offer or sale of securities. Morgan Stanley and Citigroup separately agreed to pay disgorgement of $624,458, plus interest of $89,277, and a civil money penalty of $2.25 million. That makes for a combined settlement of $5.9 million – perhaps not that much for two firms of this size, but enough so that the SEC’s point is made.

"We are pleased to settle this matter, which relates to disclosures prepared by Citi for an investment created and marketed to a limited number of clients in 2010-2011," said a spokesperson for Morgan Stanley. "Citi marketed this investment to a small group of former Smith Barney Financial Advisors who had not yet converted to the Morgan Stanley platform. Today’s settlement relates to three such Financial Advisors. There is no finding that Morgan Stanley or its financial advisors acted willfully or fraudulently."

A spokesperson for Citigroup said that it was pleased to have the matter settled.

What happened

CitiFX Alpha, the foreign exchange trading program, was developed by Citigroup, which held a 49 percent ownership interest in Morgan Stanley. The program was then sold to investors through Morgan Stanley financial advisers between August 2010 and July 2011, according to the agency’s administrative order instituting the settlement with Morgan Stanley.

"Fifteen investors – each of whom also had a pre-existing relationship with one of three [Morgan Stanley] financial advisers as a brokerage customer, advisory client, or both – invested in CitiFX Alpha following pitches that were based on CitiFX Alpha’s past performance and risk metrics," the SEC said. "As it operated with respect to the relevant investors, the CitiFX Alpha program constituted an investment contract."

But when investors enrolled in the CitiFX Alpha program, their dollars were not the notional amounts that were actually traded, the agency said. Instead, the investors’ cash was used as collateral.

This created a situation where the investments became highly leveraged. "The amount of collateral that each of the relevant investors posted was less than the notional amount of the foreign exchange portfolio they traded," the SEC said. "Some of the relevant investors posted collateral equal to as little as 10 percent of the notional amount."

Further, according to the Morgan Stanley administrative order, the investors’ Morgan Stanley financial advisers "selected the size of the mark-ups [Citigroup] charged on each CitiFX Alpha trade, using a range of mark-ups provided by [Citigroup] personnel." Citigroup and Morgan Stanley each received half of the mark-ups, "and each thereby obtained money or property from the relevant investors," the agency said.

How the sales were conducted

In addition to the CitiFX Alpha program being sold by Morgan Stanley financial advisers, it was also sold, both directly and indirectly, through Citigroup personnel, the SEC said. This sometimes involved Citigroup personnel leading presentations in which Morgan Stanley financial advisers participated.

"At sales pitches, [Citigroup] personnel and [Morgan Stanley] financial advisers gave the relevant investors a copy of a PowerPoint presentation that [Citigroup] had created about the CitiFX Alpha program," the agency said. "[Citigroup] personnel gave some of the relevant investors an oral presentation that tracked the contents of the PowerPoint presentation."

Both of these programs focused on the CitiFX Alpha program’s past performance and metrics. "These past performance and risk metrics assumed fully collateralized accounts – that is, the accounts in which the amount of collateral was equal to the notional amount being traded – and that no mark-ups would be charged on trades," according to the administrative order. "Neither of these assumptions was adequately disclosed to investors."

The investors were hardly sophisticated, if the SEC’s allegations are to be believed. They included "individuals who had no experience in foreign exchange trading and who did not understand what a notional amount is; that the cash they posted to their foreign exchange accounts merely served as collateral; or that there was a difference between the notional amounts they traded and the amount of collateral they posted to their accounts."

The SEC’s allegations appear to boil down to these two points of disclosure involving the Morgan Stanley financial advisers:

• Leverage. The financial advisers allegedly "did not adequately disclose that these past performance and risk metrics did not reflect the degree of leverage that the relevant investors actually would employ, which would have materially altered the disclosed performance and risk metrics, and thus omitted material information necessary in order to make statements about the CitiFX Alpha program not misleading," the agency said.
• Mark-ups. The Morgan Stanley financial advisers "did not adequately disclose that the stated performance figures were gross of mark-ups or adequately disclose the amount of the mark-ups, which would have materially altered the disclosure performance figures" the agency said, "and thus omitted material information necessary in order to make statements about the CitiFX Alpha program not misleading."

Morgan Stanley’s compliance department performed a review of the program, and in the spring of 2011, placed "certain restrictions" on it, the agency said. "No new investors enrolled in the program after July 2011."