WASHINGTON -- Morgan Stanley & Co. engaged in illegal, speculative government securities transactions with the state of West Virginia and should be held liable for the losses that resulted, the state told an appeals court this week.

West Virginia made the charge in a brief filed Monday with the Supreme Court of Appeals of West Virginia.

The state urged the appeals court to uphold the Circuit Court of Kanawha County's May 1992 ruling that found Morgan Stanley liable for more than $30 million from three risky transactions involving when-issued Treasury notes, reverse repurchase agreements, and options that were prohibited under state law.

Morgan Stanley has asked the appeals court to overturn the lower court's ruling. The firm contends that it should not be held liable for losses that the state suffered because state officials engaged in an aggressive trading strategy with government securities and refused to get out of positions when the market changed and losses began mounting.

The case stems from $279 million of losses that West Virginia's consolidated investment pool suffered in 1987 from investments in government securities. The state filed lawsuits against six firms and ultimately collected $28.13 million from settlements with seven firms, three of which were not sued. Morgan Stanley, in State of West Virginia v. Morgan Stanley & Co., and Chase Securities, in a separate suit, are still fighting the state.

The case involving Morgan Stanley is important for all broker-dealers and their institutional investor clients, according to the Public Securities Association.

The association has filed a friend-of-the-court brief with the appeals court challenging the court's use of the term "speculation" and its application of ultra vires principles in ruling that the transactions are beyond the legal authority of the state.

The lower court's ruling against Morgan will be devastating for dealers if upheld, the PSA told the appeals court, because it improperly shifts responsibility for investment losses to securities dealers and makes dealers the "insurers" of profit for clients.

In their briefs to the appeals court, West Virginia and Morgan paint completely different pictures of the events that led them to participate in the government securities transactions that incurred losses.

West Virginia claims that Morgan's traders aggressively solicited the state's business, telling state officials they could be investing more funds from their investment pool in government securities.

West Virginia law requires that funds not currently being used by the state and its agencies be put in the pool so they can be invested on a short-term basis. The law and investment policy guidelines, however, prohibit the funds from being invested on a speculative basis.

In late 1986 and 1987, the pool had about $2.5 billion in assets. The guidelines state that no more than 35% of the pool's assets can be invested in securities with maturities of more than five years.

The state contends that Morgan officials reviewed the state's investment policy guidelines in November 1986 and became concerned about the prohibition on speculation.

The state notes that in one taperecorded conversation, Mike Maher, a Morgan vice president and sales representative, told a state official: "In the investment guidelines, it says the account is not for speculation .... [We're] trading billions and billions .... [We] want to ... find out why can't these ... guidelines be changed because what it is ... is speculating .... If anything happens ... we're going to get caught .... "

Morgan suspended trading with the state in November 1986 because of the concerns about the prohibition on speculation, West Virginia says. But trading was resumed after Morgan officials visited with state officials and determined, according to state officials, that they could "go beyond the guidelines because they were nothing but guidelines."

The state claims that Morgan increased its trading with the state dramatically so that the par value of Treasury notes alone traded between the firm and the state from November to the spring of 1987 totaled about $19.8 billion. This was 94% of Maher's total dollar trading volume and 10 times the par value of all transactions done between other governmental entities and Morgan's entire fixed-income division, the state says.

Morgan stopped trading with the state only after the huge losses were incurred in 1987, the state says.

In a tape-recorded conversation after the losses were incurred, Maher quotes Ken deRegt, a Morgan managing director, as saying, "The amount of trading that's done ... has to fall under the category of speculation .... If you went to ... professionals in the business ... four out of four would guaranteed say speculation."

Morgan, however, claims that it was only one of 25 primary dealers in government securities with which the state did business on a regular basis. State officials did not rely on Morgan as a broker, agent, or investment adviser and made all of their own decisions about when to buy, hold, or sell securities, the firm says.

Morgan claims that in March 1985, the state sent the firm a resolution signed by the state treasurer that certified the state had authority to enter into government securities transactions, including options and reverse repurchase agreements.

The state began an aggressive trading strategy and stepped up trading government securities with all dealers in 1985 and 1986, the firm says. The strategy resulted in above-market returns for several years, Morgan says.

Morgan suspended trading with the state and visited state officials in November 1986 to make sure they were fully aware of the state's trading activities and were willing to liquidate positions rather than incur huge losses, the firm says.

State officials said they were fully aware of the risks associated with the trading strategy. Morgan says A. James Manchin, who was state treasurer then, said "if Morgan Stanley did not want to do business with West Virginia, there were plenty of other dealers that did."

Morgan claims that West Virginia incurred huge losses with its trading after Arnold Margolin, an associated treasurer in change of investments, refused to allow Kathryn Lester, the key trader for the state, to sell all of the $1.5 billion in "when-issued" seven-year notes that the state was holding after trade sanctions against Japan were announced and the market "began to fall."

The state entered into reverse repurchase agreements after it found it did not have the cash needed to pay for the "when-issued" notes, Morgan says. The firm advised the state that the transactions would exceed its limit on such investments, but the state chose to engage in the transactions anyway, Morgan says. Under the state's investment guidelines, no more than 15% of the pool's assets can be invested in reverse repurchase agreements.

Morgan claims it stopped doing business with West Virginia in April 1987 because it believed the state had "abandoned their trading discipline and embarked on an uncertain course."

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