Structured investments have rendered a countless number of investors financially ruined – many of whom would never have been invested in the exotic products if not for the recommendations of their financial advisor.  The 2008 financial crisis cast a new light on the potential problems of structured products, from so-called principal-protected investments issued by Lehman Brothers to reverse convertible notes from Morgan Stanley. The result was the same: Investors lost big.

Jargon-laden literature, illiquidity, counter-party risk and lack of transparency all make structured products a complex and often unsuitable investment for the average investor. Despite these characterizations, many financial advisors continue to sell structured products because of the large mark-ups and commissions they bring – not because they are in the best interests of a client.

In the case of Morgan Stanley, a review by the Financial Industry Regulatory Authority (FINRA) into sales of the firm’s structured products – which included principal-protected investments, leveraged exposure, yield enhancement, and access investments – revealed that in many instances the true risks of the structured products were never disclosed to clients.

FINRA’s findings were officially documented in a Letter of Acceptance, Waiver and Consent (AWC) in which Morgan Stanley signed on Dec. 7, 2011, and agreed to pay a $600,000 fine to settle the violations outlined. Among the violations cited: Supervisory deficiencies, as well as unsuitable recommendations of structured products to retail customers.

In the AWC letter, FINRA states that Morgan Stanley failed to create “reasonable systems or procedures to notify supervisors whether structured product purchases complied with the firm’s internal guidelines.” Instead, Morgan Stanley placed the responsibility with branch supervisors.

“During the Review Period, Morgan Stanley had no reports or tools for sales supervisors or compliance personnel that were specific to structured products, or which highlighted and detected single concentrated structured product purchases. As a result, of the 224,000 structured product purchases between September 2006 and August 2008, more than 28,000 were in net amounts that exceeded 25% of the customer’s disclosed liquid net worth and more than 2,600 were effected by customers with slated net worth less than $100,000,” the AWC letter said.

A federal judge has decided that Morgan Stanley must face the music and defend itself in a lawsuit brought by 18 Singapore investors over failed structured products. Among the allegations, investors accuse Morgan Stanley of committing fraud in 2006 and 2007 when it sold them nearly $155 million of Pinnacle Notes structured products. The notes, which were linked to synthetic collateralized debt obligations (CDOs), lost almost 100% of their value amid the financial crisis.

Morgan Stanley tried to get the lawsuit dismissed, but District Judge Leonard Sand rejected its request.

“Defendants point to generalized warnings cautioning investors not to rely solely on the offering materials,” Judge Sand stated in this ruling. “But even a sophisticated investor armed with a bevy of accountants, financial advisors and lawyers could not have known that Morgan Stanley would select inherently risky underlying assets and short them.”

As reported Nov. 4 by Reuters, the October 2010 lawsuit is seeking class-action status. It is one of several lawsuits accusing banks of misleading investors into buying supposedly safe securities backed by risky debt, even as other investors or the banks themselves were actually shorting them.

In the Morgan Stanley case – Dandong et al. vs. Pinnacle Performance Ltd et al., U.S. District Court, Southern District of New York, No. 10-08086 – plaintiffs allege that the bank represented the Pinnacle Notes as “conservative” and that they would keep their principal safe.

Instead, Morgan Stanley allegedly invested their money into synthetic CDOs that were tied to risky companies. In addition, investors say they were kept in the dark to the fact that Morgan Stanley acted as a counterparty in the CDO deal whereby it collected one dollar for every dollar investors lost.

“Morgan Stanley designed the synthetic CDOs to fail,” the complaint said. “It placed itself on the side guaranteed to win (the “short” side) and placed plaintiffs and the class on the side guaranteed to lose (the “long” side).”

When it comes to financial adviser satisfaction, Morgan Stanley Smith Barney rates at the very bottom of six national broker/dealers, according to a J.D. Power and Associates Survey.

Among independent broker/dealers, the survey says Commonwealth Financial Network came out on top, while MetLife Broker Dealer Group ranked the lowest.

As reported Oct. 24 by Investment News, the 2010 U.S. Financial Advisor Satisfaction Study was based on responses from 2,863 advisers who hold a Series 7 license. The study was conducted in February and March, and again between July and September.

Key areas covered in the survey included adviser satisfaction, firm performance, technology and work environment.

This is the first time that the survey has ranked independent broker/dealers.

Last week, Morgan Stanley was sued by a group of Singapore investors who accused the company of rigging a bond sale related to collateralized debt obligations in order to wipe out their $155 million investment. The notes were issued by Pinnacle Performance Ltd, a Cayman Islands-registered outfit that Morgan Stanley had allegedly marketed as “conservative,” with the goal to protect investors’ principal.

Instead, the investors say Morgan Stanley invested their funds into synthetic CDOs, with the bank itself serving as the counterparty on the underlying swap agreements. The investors allege that the arrangement was structured so that Morgan Stanley would collect one dollar for each dollar they lost.

Citigroup and Morgan Stanley appear to be taking a lead from Goldman Sachs when it comes to collateralized debt obligations (CDOs). As reported in a May 21 article by Bloomberg, Citigroup is the focus of several inquiries for allegedly selling a series of mortgage-linked securities – known as the Jackson Segregated Portfolio – to investors without disclosing the fact that Morgan Stanley helped shape the investments while also betting they would fail.

According to the Bloomberg article, marketing documents for the products – which were underwritten by Citigroup in 2006 – failed to provide information on the entity responsible for selecting the underlying mortgage bonds. Sources close to the deal contend that the entity was a Morgan Stanley unit. Six of the seven series of Jackson bonds later defaulted, costing investors more than $150 million of losses, according to Bloomberg data.

So far, Citigroup hasn’t been publicly accused of any violations tied to the Jackson deals.

In a similar situation last month, the Securities and Exchange Commission (SEC) accused Goldman Sachs of misleading investors by failing to disclose that the hedge fund, Paulson & Company, had a role in picking securities it then bet against.

As in the Goldman Sachs case, the Jackson Segregated investments involved a synthetic CDO. Derivatives linked to mortgage bonds were pooled together, packaged into new bonds and then sold investors. On the other end of the Jackson derivatives was a “short” investor. Profits were made when the underlying bonds failed.

“To get the deals done, most underwriters of synthetic CDOs initially took the short positions, sometimes with a plan to sell them off later. When Citigroup set up Jackson, it arranged with Morgan Stanley to take over the short positions once the deal closed . . . Citigroup allowed the firm to help select the bonds linked to the derivatives because Morgan Stanley would have a stake in the performance of the securities,” the Bloomberg article reports

Investments deals involving CDOs have come back to haunt Morgan Stanley. Federal prosecutors apparently are investigating whether the investment bank intentionally misled investors about various synthetic collateralized debt obligations that it helped design and sometimes bet against. The story was first reported by the Wall Street Journal on May 11.

According to the story, Morgan Stanley marketed and sold the CDOs in question to investors and then subsequently placed bets that their value would fall. Among other things, investigators want to know whether the bank disclosed certain facts to investors, as well as its role in the deals themselves.

In April, the Securities and Exchange Commission (SEC) charged another investment firm – Goldman Sachs – with fraud in connection to sales of synthetic CDOs.

According to the SEC’s complaint, Goldman Sachs failed to tell investors certain details regarding the financial products, including the fact that a major hedge fund not only selected the securities held by the CDO but also bet against them to fail.

Meanwhile, the probe into Morgan Stanley’s CDO is at a preliminary stage.

Francisco P. Esparza, a broker whose employment history include stints with J.P. Turner & Company, LPL Financial, UBS, Citicorp Investment Services and Morgan Stanley, has been fined $10,000 and suspended from association with any member of the Financial Industry Regulatory Authority (FINRA) for 15 business days.

FINRA’s actions were related to findings that allege Esparza made unsuitable recommendations to customers to buy closed-end funds without fully understanding the pricing of the products or the risks associated with the investments.

FINRA noted its actions against Esparza in its March 2010 Disciplinary Report.

Esparza, who didn’t deny or admit to the findings, nonetheless consented to the regulator’s sanctions. According to FINRA, Esparza’s recommendations accounted for customer losses totaling approximately $73,290.

Investment firm Morgan Stanley is facing an arbitration claim by the city of Burlington, Vermont, which alleges breaches of fiduciary duty and fraud involving something known as a wrap account. According to the claim, Morgan Stanley’s actions resulted in damages of more than $21 million for the Burlington Employees’ Retirement System – losses that were mainly due to hidden fees and commissions associated with the wrap account Morgan Stanley recommended.

As reported Feb. 11 by Investment News, the city alleges that the fraud occurred from 1981 through 2006 and that the Morgan Stanley employees in charge of its account engaged in a “pay-to-play” scheme. According to the claim, Morgan Stanley selected only managers who funneled a portion of their management fees to the brokerage firm.

In addition, the claim alleges that Morgan Stanley was charging per-trade commissions despite an initial contract that promised free trading. The allegedly excessive fees and mark-ups dramatically reduced the city pension fund’s returns, contributing to the $21 million in losses.

A Feb. 9 article in Forbes (Wrap Account Rip-Off?) highlights the potential drawbacks of wrap accounts. A wrap account is essentially an investment account in which clients are charged a flat percentage of their assets (usually between 1% and 3%) in return for unlimited trading.

Wraps have become an increasingly popular sales product on Wall Street – so popular, in fact, that brokerage firms now have roughly $1.5 trillion in assets under management in them, according to the Forbes article.

Critics, however, say wrap accounts have plenty of pitfalls and may be just as bad – if not worse – as commission-based accounts.

Burlington is asking a Financial Industry Regulatory Authority (FINRA) arbitration panel to order Morgan Stanley to pay the city, its board and the plan actual damages incurred as a result of Morgan Stanley’s alleged misconduct. The claim also is requesting punitive damages.

Morgan Stanley denies all the allegations.

Synthetic collateralized debt obligations, or CDOs, are complex mortgage-linked debt products that have been blamed for bringing Wall Street to its knees and pummeling millions of investors in the process. It was in the fall of 2007, when the financial markets first started to become unhinged, that these high-risk instruments found their way into the public’s eye.

Today, CDOs are a hot topic on Capitol Hill, where members of Congress and regulators like the Securities and Exchange Commission (SEC) are trying to determine exactly how and why synthetic CDOs created the financial tsunami that they did.

As reported Dec. 24 in an article by Gretchen Morgenson and Louise Story for the New York Times, regulators are said to be looking at whether current securities laws or rules of fair dealing were violated by the investment firms and banks that created and sold CDOs and then turned around to bet against clients who purchased them.

“One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded,” the article says.

Pension funds and insurance companies are some of the institutional investors that lost billions of dollars on synthetic CDOs – investments they thought were safe investments.

The New York Times article devotes space mainly to the synthetic collateralized debt obligation business of Goldman Sachs and, specifically, mortgage-related securities called Abacus synthetic CDOs. Abacus CDOs were developed by Goldman trader Jonathan Egol, who had the idea that they would protect Goldman from investment losses if the housing market ever collapsed.

According to the article, when the market did tank, Goldman created even more of these securities, enabling it to pocket huge profits. Meanwhile, clients of Goldman who purchased the CDOs – and who thought they were solid investments – lost big.

One can easily infer from the article and other news reports on the subject that Goldman put the best interests of clients in harm’s way with Abacus because it not only served as the structurer of the deals involving the product, but also held onto the short side of those same deals. In other words, the company would be advising clients to buy assets that, in turn, it was betting to fail.

Goldman certainly is not the only investment firm that employed this strategy. Others banks created similar securities that they sold to clients and then bet against the future performance of those assets.

Goldman and other investment banks will soon have to answer tough questions about accountability and fiduciary duty. In the meetings being held on Capitol Hill, the Financial Crisis Inquiry Commission – a group that has been compared to the 9/11 Commission – plans to call several panels of investment banks to appear as witnesses. Among them: CEOs of Goldman Sachs, Morgan Stanley, JP Morgan Chase, and Bank of America.

Speaking at the Barclays Capital Global Financial Services Conference on Sept. 15, Citigroup CEO Vikram Pandit for the first time announced publicly that he anticipates the bank to divest its entire 49% stake in Morgan Stanley Smith Barney LLC.

New York-based Citigroup has been among the country’s hardest-hit financial institutions from the credit crisis. Over the past 18 months, the struggling bank – which Richard Shelby, R-Ala., referred to in March as a “problem child” – slashed its assets by $500 billion. As a result of ongoing liquidity concerns, Citigroup has borrowed about $45 billion in taxpayer bail-out money through the Troubled Asset Relief Program.

Citi also continues to face mounting legal and financial woes over its alternative investments, including the ASTA/MAT hedge funds. Currently, the funds are at the center of numerous lawsuits and arbitration claims with the Financial Industry Regulatory Authority (FINRA) by investors who allege Citigroup misrepresented the products as safe, conservative and stable fixed-income investments. Any losses were projected to be minimal – no more than 5% a year in the worst-case scenario, according to the company.

Instead, ASTA/MAT plummeted in value last summer because of turmoil in the financial markets and housing markets. During the same time the funds were sinking, however, Citigroup allegedly told investors to “stay the course” and that ASTA/MAT would rebound once the markets stabilized.

That didn’t happen. As it turns out, the ASTA/MAT funds were highly leveraged, borrowing approximately $8 for every $1 raised. Meanwhile, the managers ASTA/MAT continued to invest in some of the most risky and speculative investments possible.

A Portland, Oregon, Financial Industry Regulatory (FINRA) arbitration panel has found Morgan Stanley liable regarding an investor’s claims of making unsuitable investments, misrepresentation and omissions.  

The award, which was rendered on July 24, included nearly $40,000 in compensatory damages plus 9% interest, $39,000 in claimant’s attorney fees and $4,200 in arbitration filing and hearing fees. 

The case is Arbitration No. 08-03307.