WASHINGTON -- A West Virginia county court ruling against Morgan Stanley & Co. could have "serious adverse consequences" for broker-dealers and their institutional investor clients, the Public Securities Association has told an appeals court.
The ruling by the Circuit Court of Kanawha County that Morgan Stanley is liable for losses from state investments improperly shifts responsibility for investment losses to securities dealers and wrongly makes the dealers insurers of profit for clients, the PSA said in a friend-of-the-court brief filed last week with the Supreme Court of Appeals of West Virginia.
The PSA was particularly troubled by, and asked the appeals court to vacate, the lower court's use of the term "speculation" and its application of ultra vires principles in ruling that the investments were beyond the legal authority of the state and could not have been entered into by state officials.
The term ultna vires is increasingly used in court cases involving derivatives in which"state or local governments contend their finance officials were not permitted to engage in derivatives transactions under their investment laws.
The appeals court case, State of West Virginia v. Morgan Stanley & Co., stems from $279 million in losses that West Virginia's multimillion dollar consolidated investment pool suffered in 1987 from investments in government securities, several lawyers said.
The state filed lawsuits against six broker-dealers, including Morgan Stanley, to recover its losses. Five firms were named in one suit -- NatWest Government Securities Enc.; Greenwich Capital Markets; Goldman, Sachs & Co.; Salomon Brothers Inc.; and Morgan Stanley. The state subsequently filed a separate suit against Chase Securities Enc.
The state charged that securities firms enticed state finance officials into violating state statutes and investment guidelines by engaging in risky and speculative trades involving options, "when-issued wading," and reverse repurchase agreements.
The firms denied the charges and claimed that the state treasurer's office had authority to enter into the transactions and did so as part of its own trading strategy. The losses were incurred when the government bond market experienced a sudden, steep decline that caused many investors to lose money, they said.
The controversy led to the resignation of state Treasurer A. James Manchin, one day before the State Senate was to begin impeachment proceedings against him, state officials said.
The state ultimately collected $28.15 million from settlements with seven securities firms, including Merrill Lynch Pierce Fenner & Smith Inc., Citibank, and Shearson Lehman Hutton Inc. which were not named in either of the two lawsuits, the lawyers said.
Morgan Stanley and Chase Securities have continued fighting the state in separate court cases, they said.
The Circuit County of Kanawha County ruled in May 1992 that Morgan Stanley was liable for $34.4 million of losses, plus interest, because the firm entered into speculative transactions with the state that were ultra vires, or beyond the authority of the state.
The losses assessed by the court against Morgan Stanley now total more than $56 million because of interest earnings that have accumulated. The judge failed to enter a judgment against the finn for 14 months after the court's ruling and the firm spent several months going through the steps needed to appeal the decision, the lawyers said.
Morgan Stanley asked the appeals court to reverse the county court decision last month. The firm said the ruling "effectively made Morgan Stanley -- a counter-principal in the various transactions who was never the board's broker or agent or investment advisor -- an absolute insurer of the state's performance in the $120 billion-a-day government securities market."
In its friend-of-the-court brief, the PSA contended that the lower court incorrectly interpreted state investment laws as prohibiting the use of state funds in "speculative investments" which the court defined as any "financial transaction in which there is a real and identifiable element of risk depending on market fluctuations."
The association told the appeals court that West Virginia's investment management law was developed under a "prudent man" standard that recognizes "diversification and liquidity in light of the investor's particular time horizon, cash flow needs and risk aversion."
The court's definition of speculative investments is "inconsistent" with the state's investment laws and, if upheld, could force the state to "adhere exclusively to a buy-and-hold investment" strategy, the PSA said. The ruling suggests that the state's investment law permits no investments that would expose the state to any measurable risk based on market events, it said.
The association said the court was wrong in using this definition of "speculation" to find the transactions were ultra vires, or beyond the authority of the state. "The lower court unjustifiably shifted investment responsibility to the dealer although the dealer had no fiduciary duty to the state, and had neither been expected nor able to oversee the state's compliance with its investment guidelines," it said.
West Virginia plans to file its response to the Morgan Stanley appeal and the PSA brief next week, attorneys for the state said.
