Morgan Stanley got off lightly

Leo Rosten’s The Joys of Yiddish defines “chutzpah” as “that quality enshrined in a man, who having killed his mother and father, throws himself upon the mercy of the court because he is an orphan”.

On Friday the US Securities and Exchange Commission charged Morgan Stanley and its former equity syndicate desk head Pawan Passi with fraud in the conduct of block trading business. The SEC’s report describes several damningly flagrant breaches of confidentiality, but one example stands out as the epitome of chutzpah.

According to the SEC, in June 2018 Morgan Stanley was invited along with other banks to bid for a block of Medpace shares to be sold by private equity firm Cinven (“Selling Shareholder A” in its report, but it’s clear who it was). Passi leaked the news to a portfolio manager who in turn shorted Medpace, forcing the share price lower. Morgan Stanley won the auction and allocated over 11 per cent of the offering to that investor.

Here’s the SEC’s recounting of the events:

45. At 12:46 pm ET on June 11, 2018, Passi conveyed in an email to another employee of the Syndicate Desk that Morgan Stanley would be bidding on a 3 million share block of MEDP. At 12:57 pm ET, an SEC-registered broker-dealer (“Broker A”), which was acting as an advisor to 10 Selling Shareholder A, sent Passi a BWIC email for 3 million shares of MEDP, which included the following confidentiality provision:

Following up on our earlier discussion, attached please find a number of draft documents which have been prepared in anticipation of today’s bid. By opening these documents you are agreeing to treat them as confidential.

46. The BWIC email also indicated that that the block trade would be registered.

47. At 1:12 pm ET on June 11, 2018, Portfolio Manager A called Passi for approximately nine minutes. During that call, they discussed the impending MEDP block trade.

48. At 1:17 pm ET, while Portfolio Manager A’s phone call with Passi was ongoing, Hedge Fund A resumed shorting MEDP shares. Between 1:17 pm ET and 3:59 pm ET, Hedge Fund A synthetically sold short 87,000 shares or approximately $3.8 million of MEDP using equity swaps. During that same time period, the price of MEDP declined from $43.79 to close at $43.39. Hedge Fund A’s trading during that time period represented 88.9% of the trading in MEDP.

Two months later, at Passi’s urging, his investment banking colleagues implored Cinven to mandate Morgan Stanley exclusively for the next Medpace share sale and not invite bids from other banks in an auction. Why? Because the share price had fallen while the previous auction in June was happening!

“A negotiated trade,” the Morgan Stanley slide deck said, “can prevent . . . ‘leakage’ and ensure an unaffected share into a block execution [and] . . . save important basis points in a stock price vs. an auction.”

(In its separate report, the DoJ said that other Morgan Stanley employees sometimes referenced slides like this as “bad boy” slides.)

In the end, Cinven auctioned the block again. According to the SEC, Passi tipped off the same portfolio manager, who in turn shorted shares again and, when Morgan Stanley won the auction again, was allocated 12 per cent of the deal. Wash, rinse, repeat.

57. At 1:19 pm ET on August 7, 2018, Passi called Portfolio Manager A at Hedge Fund A. That call lasted approximately three minutes. During that call, they discussed the impending MEDP block trade.

58. At 1:23 pm ET on August 7, 2018, Hedge Fund A resumed short selling MEDP shares synthetically using equity swaps. Specifically, between 1:23 pm ET and 4:00 pm ET, Hedge Fund A synthetically sold short 93,096 MEDP shares for approximately $5.2 million. Hedge Fund A’s trading during that time period represented 26.2% of the trading in MEDP.

59. At 1:26 pm ET, Passi sent an email to other Morgan Stanley employees stating that MEDP was “down $1 already.”

60. At 4:16 pm ET, Passi responded to the BWIC with Morgan Stanley’s bid of $54.35 per share for 4.5 million MEDP shares, and at 4:18 pm ET Morgan Stanley’s bid was accepted. At 4:33 pm ET, Medpace announced its registered secondary offering of 4.5 million shares of MEDP “made only by means of a prospectus supplement and an accompanying prospectus.”

61. At 6:31 pm ET on August 7, 2018, Passi sent an email to several employees of Selling Shareholder A stating “pleased we were able to execute this block for you. Hopefully you felt that Morgan Stanley was good to our word.” Passi then expressed a desire to help Selling Shareholder A sell the remainder of its MEDP position through a negotiated transaction with Morgan Stanley.

62. Hedge Fund A was allocated 550,000 MEDP shares from Morgan Stanley, approximately 12% of the block trade, at a price of $55 per share. Morgan Stanley generated approximately $3.1 million in profits from this block trade.

This conduct is as shameless and it is shameful, so let’s not mince words: Morgan Stanley has gotten off very, very lightly – a $249mn fine, along with a three-year non-prosecution agreement with the US Attorney’s Office.

That’s not to say that the block trading probe hasn’t inflicted damage. Passi and another equity syndicate professional lost their jobs, careers, and millions of dollars of unvested stock. The investigation also demoralised and distracted Morgan Stanley’s bankers, deflating its market share in equity underwriting. Legal and compliance teams stepped up oversight, putting a crimp on day-to-day execution.

But this could have turned out a lot worse.

The Department of Justice and SEC were investigating the block trade practices as both a criminal and civil matter. Investigators were examining Morgan Stanley’s relationships with hedge funds, and the DOJ was reviewing communications by other senior bankers. Funds filed suit, alleging monetary damages from leaks from Morgan Stanley in the run-up to share sales. Competitors, including Goldman Sachs and Credit Suisse, had taken the extraordinary step of complaining to prosecutors and regulators about Morgan Stanley’s block trade practices.

Morgan Stanley had been the “dominant” bank in block trades, and the business was making bucketloads of money — $1.4bn from January 2018 to August 2021. This is easily several times more revenue than what its competitors were generating.

As the investigation rumbled on, rumours swirled around Wall Street on the potential size of the settlement. Six months ago, the consensus opinion was that the fine would exceed $1bn and could reach $2bn or more. Even as recently as late October, the media were reporting that Morgan Stanley would have to pay “up to $1 billion.”

Instead, the fine isn’t much bigger than the $200mn penalty imposed last year on each bulge-bracket bank for their employees’ use of unapproved channels of communications. There was never any suggestion that bankers using apps like WhatsApp or iMessage had sought to conceal wrongdoing or make illicit gains. It was a kind of “books-and-records” violation – wrong in itself, but an order of magnitude less serious than the breaches identified in Friday’s SEC order.

One reason may be that messaging apps violations are relatively easy to prove – for example, if you forget to turn on WhatsApp’s “disappearing messages” function – but it’s much harder to prove block trade shenanigans. A market abuse case like this relies on circumstantial evidence. The feds identified a few cases of serious misconduct but presumably couldn’t substantiate competitors’ claims of a “Morgan Stanley fade” on the longer list of trades raised in media reports.

Many hedge funds have personnel dedicated to monitoring blocks. They map out holdings by private equity firms or other inside shareholders, track lock-up expiration dates, and look for any clues that a deal is imminent. In some cases, it’s possible to intuit roughly when a block is coming. So if a hedge fund shorts a stock before a placement, that alone may not suffice as proof of insider dealing.

Morgan Stanley will also be relieved that the probe doesn’t implicate anyone beyond the two syndicate guys. In a statement Morgan Stanley said:

We are pleased to resolve these investigations and are confident in the enhancements we have made to our controls around block trading, including strengthening our policies, procedures, training and surveillance.

The core of this matter is the misconduct of two employees who violated the Firm’s policies, procedures and our core values, as outlined in the settlement documents.

This is a striking feature of the settlement. After all, Morgan Stanley was earning several multiples more from block trades than its peers. Yet the pattern of misconduct has been pinned entirely on two rogue employees and not on anyone higher up the organisational chain. Competitors and some investors might scoff at this finding, but it also means the damage can be contained.

Here’s what the Southern District of New York said helped mitigate its penalty:

(i) MORGAN STANLEY has provided extraordinary cooperation with this Office’s investigation;

(ii) the investigation has not uncovered evidence of corporate management’s complicity in or knowledge of the wrongdoing;

(iii) MORGAN STANLEY’s controls, while ultimately unsuccessful in uncovering the misconduct, were designed in part to detect misconduct in the block trades business and were applied in good faith;

(iv) in 2022, MORGAN STANLEY implemented a series of remedial measures to create clearer policies governing its ability to communicate with the buy-side in advance of block trades and trained its employees on those policies;

(v) MORGAN STANLEY has no prior criminal history of any kind, including no prior NPA or DPA; and (vi) MORGAN STANLEY has accepted full responsibility for its conduct and agreed to resolve with the U.S. Securities and Exchange Commission (“SEC”).

As for Pawan Passi, his life has been upended by “two difficult years of intense government scrutiny,” as his lawyer says. But the spectre of criminal prosecution no longer hangs over him.

Moreover, a civil penalty of $250,000 pales in comparison with the £350,000 fine imposed in 2012 by UK watchdogs on a banker for telling Greenlight Capital about an upcoming share sale by Punch Taverns. Or the £450,000 fine slapped on a JPMorgan banker in 2014 for sending two emails with potentially inside information, even though no one ever traded on the information.

It appears that the SEC took into account Passi’s forfeiture of $7.4mn of unvested Morgan Stanley stock, but the UK bankers had also suffered a clawback of millions’ worth of restricted shares. Either the UK Financial Conduct Authority is too harsh or the SEC is too lenient. Or both.

Overall, the block trading probe has turned out as well as it could have for Morgan Stanley. The fallout is limited, criminal charges have been averted, and the financial penalty borders on the derisory. Ted Pick’s new reign can start with a cleaner slate.

Morgan Stanley reportedly is cutting compensation for dealmakers this year, but the lawyers who negotiated this settlement deserve a big bonus.