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Case 1:09-cv-02017-DAB Document 30 Filed 06/09/11 Page 1 of 170
UNITED STATES DISTRICT COURTSOUTHERN DISTRICT OF NEW YORK
JOEL STRATTE-McCLURE, STATE-BOSTON } No. 09 Civ. 201T(DAB)`. riN
RETIREMENT SYSTEM and, FJARDE } ECF CASEAP-FONDEN, on Behalf of Themselves and all )Others Similarly Situated, ) CLASS ACTION
Plaintiff, )V. ) SECOND AMENDED
CLASS ACTION COMPLAINTMORGAN STANLEY, a Delaware corporation, )JOHN J. MACK, ZOE CRUZ, DAVID )SIDWELL, THOMAS COLM KELLEHER, and ) JURY TRIAL DEMANDEDTHOMAS V. DAULA, )
Defendants. )
KESSLER TOPAZ MELTZER & CHECK, LLP LABATON SUCHAROW LLPDavid Kessler Jonathan M. Plasse (JP-7515)Andrew L. Zivitz (pro hac vice) Joseph A. Fonti (JF-3201)Sharan Nirmul Javier Bleichmar (JB-0435)Lauren Wagner Pederson Joshua Crowell (JC-0914)Richard A. Russo, Jr. (pro hac vice) Kevin Oberdorfer (KO-2376)280 King of Prussia Road 140 BroadwayRadnor, Pennsylvania 19087 New York, New York 10005Telephone: (610) 667-7706 Telephone: (212) 907-0700Facsimile: (610) 667-7056 Facsimile: (212) 818-0477
Counsel for Fjdrde AP-Fonden and Counsel for Lead Plaintiff State-BostonCo-Lead Counsel for the Class Retirement and Co-Lead Counsel for the Class
Case 1:09-cv-02017-DAB Document 30 Filed 06/09/11 Page 2 of 170
TABLE OF CONTENTS
I. SUMMARY OF CLAIMS 1
II. JURISDICTION AND VENUE 13
III. PARTIES 14
A. PLAINTIFFS 14
B. DEFENDANTS 15
1. Defendant Morgan Stanley 15
2. Individual Defendants 16
IV. CONTROL PERSON ALLEGATIONS/GROUP PLEADING 19
V. CONFIDENTIAL WITNESSES 21
VI. BACKGROUND FACTUAL ALLEGATIONS 22
A. John Mack’s Aggressive, Risk-Taking Agenda And The ProprietaryTrading Group 22
B. The Institutional Securities Group Reports Record Results As A Result OfThe Additional Risk Taking 24
C. Defendants Assure Investors Of “Disciplined” Risk-Taking 25
D. Morgan’s Secret Multi-Billion Dollar Bet-The-Bank Proprietary Trade OnThe Movement Of U.S. Subprime Securities 26
1. Overview of Credit Defaults Swaps, Collateralized DebtObligations, and Residential Mortgage Backed Securities 27
2. The Proprietary Trading Group’s Massive Bet on the PriceMovements on Subprime RMBS-Backed CDOs 31
3. The ABX Index Measures ABS CDS Value 32
4. The Long Position’s Value Was Linked To The ABX Index 34
VII. DEFENDANTS’ FRAUDULENT ACCOUNTING VIOLATED GAAP ANDSEC DISCLOSURE REQUIREMENTS 36
A. Morgan Was Required To Comply With GAAP And SEC Regulation S-K 36
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B. In Violation Of GAAP, Defendants Fraudulently Concealed Morgan’sExposure To The Significant Concentration Of Credit Risk Arising FromThe Proprietary Trade 38
1. Overview Of Exposure Claim Allegations 38
2. Well-Established GAAP Required Disclosure Of TheConcentration Of Credit Risk Arising From Morgan’s ProprietaryTrade 39
(a) FAS 107 - Disclosures About Fair Value of FinancialInstruments 39
(b) FASB Staff Position SOP 94-6-1, Terms of Loan ProductsThat May Give Rise to a Concentration of Credit Risk 41
(c) GAAP Duty to Disclose Subsequent Events 41
(d) SEC Regulation S-K 43
3. Objective Evidence: The Long Position Constituted a SignificantConcentration of Credit Risk 43
4. Subjective Evidence: By the Outset of The Class Period,Defendants Knew that the Long Position Was a SignificantConcentration of Credit Risk 53
5. Second Quarter 2007 Results Fraudulently Conceal Exposure ToSignificant Concentration of Risk 56
(a) Defendants Fraudulently Violated FAS 107 ¶15A And SOP94-6-1 56
(b) Defendants Fraudulently Violated Regulation S-K 59
6. Third Quarter 2007: Defendants Continue To FraudulentlyConceal Morgan’s Long Position 60
7. During Morgan’s Third Quarter, Defendants FraudulentlyConcealed The True Exposure Arising From The Long Position 65
8. Fourth Quarter: Defendants Continue to Fraudulently Conceal TheTrue Exposure Arising From The Long Position 66
9. Disclosures Regarding Market Risk Were Materially Incomplete 67
C. Defendants Violated GAAP In Valuing The Long Position 68
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1. FAS 157 Required Defendants To Use Level 2 Inputs To Value theLong Position 68
2. Defendants Fraudulently Did Not Apply the ABX Index, a Level 2Input, In Valuing the Long Positions 70
(a) Write-Down For First And Second Quarter 2007 71
(b) Third Quarter 2007 Disclosures Were Fraudulent 71
(c) Fourth Quarter 2007 Disclosures Were Fraudulent 72
VIII. DEFENDANTS’ MATERIALLY FALSE AND MISLEADING STATEMENTSAND OMISSIONS 74
A. Pre-Class Period Statements In First Quarter 2007 – Morgan Reports ABlockbuster Beginning To Fiscal 2007 74
B. Defendants Fail to Disclose Morgan’s Subprime Risk Exposures InSecond Quarter 2007 75
1. June 20, 2007 Disclosures 75
2. Defendants’ June 20, 2007 Disclosures Were Materially False andMisleading 77
3. Market Reaction to June 20, 2007 Disclosures 78
4. July 10, 2007 Disclosures 78
5. Defendants’ July 10, 2007 Disclosures Were Materially False andMisleading 80
6. Market Reaction to July 10, 2007 Disclosures 83
C. Defendants Manipulate Morgan’s Reported Financial Results For ThirdQuarter 2007 83
1. September 19, 2007 Disclosures 83
2. Defendants’ September 19, 2007 Disclosures Were MateriallyFalse and Misleading 85
3. Market Reaction to September 19, 2007 Disclosures 87
4. October 10, 2007 Disclosures 88
5. Defendants’ October 10, 2007 Disclosures Were Materially Falseand Misleading 89
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6. Defendants Perpetuate Their Fraudulent Scheme With FalseStatements to Analysts in October 2007 93
D. November 2007: Partial Corrective Disclosures And Morgan’s AdditionalFalse Statements 95
1. The Market Learns Of Morgan’s Subprime Exposure And Write-Downs 95
2. Morgan’s November 7, 2007 Confirming Disclosures And FalseAnd Misleading Statements Regarding Valuation 99
(a) November 7 Press Release And Exposure Chart 99
(b) November 7, 2007 Conference Call 103
(c) November 8, 2007 Form 8-K 104
3. Defendants’ November 7, 2007 Disclosures Were Materially FalseAnd Misleading 104
4. Market Reaction To November 7, 2007 Disclosures 106
5. Defendants’ Fraudulent Statements About Morgan Stanley’sSubprime Exposure During The November 13, 2007 InvestorConference 108
6. The Market Learns Of Morgan’s Additional Write-Down 109
7. Defendants Confirm Additional Write-Down And The Market IsRelieved That CDO-Related Losses Have Reached Bottom 110
IX. ADDITIONAL ALLEGATIONS OF SCIENTER 112
A. John J. Mack 120
B. David Sidwell 127
C. Zoe Cruz 135
D. Thomas V. Daula 138
E. Thomas Colm Kelleher 140
X. LOSS CAUSATION 143
A. The Market Learns Of Morgan’s Subprime Exposure And Writedowns 143
B. Defendants’ November 7, 2007 Disclosures Were Fraudulent 147
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C. Market Reaction To November 7, 2007 Disclosures 148
D. The Market Learns Of Morgan’s Additional Write-Down 150
E. Defendants Confirm Additional Write-Down And The Market Is RelievedThat CDO-Related Losses Have Reached Bottom 151
XI. APPLICABILITY OF PRESUMPTION OF RELIANCE: THE FRAUD ON THEMARKET DOCTRINE 153
XII. INAPPLICABILITY OF SAFE HARBOR 154
XIII. CLASS ACTION ALLEGATIONS 156
XIV. COUNTS 158
XV. PRAYER FOR RELIEF 162
XVI. JURY DEMAND
163
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Lead Plaintiff, State Boston Retirement System (“SBRS” or “Lead Plaintiff”), and named
plaintiff, Fjärde AP-Fonden (“AP4” and together with SBRS, “Plaintiffs”), individually and on
behalf of all other persons and entities who from June 20, 2007 to November 19, 2007, inclusive
(the “Class Period”), purchased or otherwise acquired common stock issued by Morgan Stanley
(“Morgan” or the “Company”) and registered and traded on the New York Stock Exchange
(“NYSE”), by their undersigned attorneys, for their Second Amended Consolidated Securities
Class Action Complaint (the “SAC”), allege the following upon personal knowledge as to
themselves and their own acts, and upon information and belief as to all other matters. Plaintiffs’
information and belief are based on their investigation (made by and through their attorneys),
which investigation included, among other things, a review and analysis of: (1) public documents
pertaining to Morgan and the Individual Defendants (as defined herein); (2) Morgan’s filings
with the U.S. Securities and Exchange Commission (“SEC”); (3) Morgan’s press releases; (4)
analyst reports concerning the Company; (5) pleadings in other litigations; (6) interviews with,
inter alia, former Morgan employees; and (7) newspaper and magazine articles (and other media
coverage) regarding Morgan, its business or any Individual Defendant. Many of the facts
supporting the allegations contained herein are known only to Defendants or are exclusively
within their custody and/or control. Plaintiffs believe that substantial further evidentiary support
will exist for the allegations in this Complaint after a reasonable opportunity for discovery.
I. SUMMARY OF CLAIMS
1. This securities class action arises from Defendants’ fraudulent concealment and
valuation of a single proprietary trade that resulted in over $9 billion in losses for Morgan in its
fiscal year 2007 – the largest loss arising from a single trade in Wall Street history (the
“Proprietary Trade”).
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2. Defendants’ liability results from (i) their fraudulent concealment of exposure to
the Proprietary Trade and (ii) their fraudulent valuation of the losses suffered from the trade.
Defendants defrauded investors in these ways despite requirements under the well-settled
Generally Accepted Accounting Principles (“GAAP”) provision Statement of Financial
Accounting Standards (“FAS”) 107, Disclosures about Fair Value of Financial Instruments
(“FAS 107”), and SEC Item 303 of Regulation S–K, 17 C.F.R. § 229.303 (“Regulation S–K”),
both of which required Morgan to disclose its exposure to the significant concentration of credit
risk associated with the Proprietary Trade. Defendants also concealed and misstated at least
$2.5 billion in losses that Morgan suffered as a result of the Proprietary Trade in violation of
GAAP provisions FAS 157, Fair Value Measurements and FAS 115, Accounting for Investments
in Certain Debt and Equity Securities (“FAS 115”).
Morgan’s Risk-Taking Strategy
3. Upon becoming CEO in 2005, Defendant John J. Mack (“Mack”) undertook a
new risk-taking strategy for Morgan. In April 2006, Mack established the Proprietary Trading
Group (“PTG”) within the Company’s Institutional Securities Group (“ISG”). The PTG was
composed of handpicked traders whose mission was to place bets on behalf of Morgan’s own
account – not its customers’ – to improve Morgan’s performance relative to its investment
banking peers.
4. Mack’s “radical shakeup” included placing Defendant Zoe Cruz (“Cruz”) in
charge of this high-risk-taking strategy, as his Co-President and Head of the ISG. According to
Mack, Cruz “shared his healthy appetite for risk taking.” Cruz and Mack, embracing this
business plan, ratcheted up the ISG’s profits in 2005 and 2006. In 2006, Mack earned
$40 million in bonuses – a record on Wall Street – while Cruz pocketed $30 million. Other
traders within the ISG also took home record bonuses.
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5. Mack’s new strategy also included having Tom Daula, the Company’s Chief Risk
Officer, no longer report to Mack, but rather to Cruz. This decision entrusted the ultimate
supervision of risk control to the person whose department was assuming the risks and reaping
lucrative bonuses for doing just that.
Overview Of The Proprietary Trade
6. In December 2006, traders in the PTG took on the Proprietary Trade, which
consisted of two components: a $2 billon short position and a $13.5 billion long position. The
short position resulted from the purchase of Credit Default Swaps (“CDSs”) on Collateralized
Debt Obligations (“CDOs”) backed by mezzanine tranches of Residential Mortgage Backed
Securities (“RMBSs”) (the “Short Position”). The Short Position was essentially an insurance
policy that would be paid out to Morgan if cumulative losses on the underlying subprime
mortgages reached four percent – an event the PTG felt certain would happen in the near term.
Morgan had to make periodic premium payments, akin to a premium for insurance protection,
amounting to $200 million annually to the CDS counterparties. The CDSs also had a market
value, which was based on the perceived risk of the CDS payout provision being triggered.
7. To finance premiums for the Short Position, Morgan sold CDSs ( i.e., sold
insurance) on super-senior tranches of mezzanine CDOs (the “Long Position”). This
arrangement entitled Morgan to receive periodic payments, which in turn it used to pay the
premiums on the Short Position. The collateral backing the Long Position consisted of
mezzanine RMBS tranches linked to high-risk U.S. subprime mortgages. As with the Short
Position, the CDSs making up the Long Position had a market value based on the perceived risk
that the payout provision would be triggered. The Long Position initially exposed Morgan to
$13.5 billion in potential losses in the event of a 100 percent default of the referenced super-
senior CDO tranches. By the end of Morgan’s Second Quarter 2007, however, Morgan had
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secretly written down the value of the Long Position by $300 million, thereby reducing the
exposure to $13.2 billion at the start of the Class Period.
8. In implementing the Proprietary Trade in 2006, Morgan was effectively betting
that subprime mortgage losses would be bad, but not bad enough to impair the value of super-
senior tranches of the CDOs underlying the Long Position. If Morgan were correct in its
strategy, the Company would profit from the Short Position without spending any money on the
Long Position. As detailed herein, if cumulative losses on the loan pools underlying the Long
Position merely rose to roughly eight percent, Morgan would have to pay out the full notional
value of the Long Position, wiping out any gains on the Short Position.
Decline Of Subprime Mortgage Markets
9. By mid-2006, the market understood that subprime mortgage-related markets
were collapsing. Morgan agreed, leading the PTG to create the Short Position in December
2006. Through early 2007, with delinquencies skyrocketing and prominent subprime lenders
collapsing, evidence accumulated that the meltdown was increasing beyond prior expectations.
Morgan’s Long Position was backed by RMBS from 2005 and 2006. At least 35 percent of the
loans collateralizing 2005 and 2006 vintage RMBS were 60 days delinquent or in default by the
start of 2007. These alarming rates caused lenders largely to stop issuing new subprime
mortgages and refinancings. Without the ability to refinance, the market recognized that many
subprime mortgages were sure to default within two years of their issuance.
The ABX Index And Valuation Of The Long Position
10. The fair value of the Long Position, as Defendants would ultimately concede, was
inherently linked to the movement of an index called the ABX, which tracked the cost of
insuring tranches of RMBS. In particular, the fair value of the position was tied to the movement
of the ABX Index for the BBB 06-1 vintage (“ABX.BBB.06-1” or “ABX Index”), which tracked
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the cost of insuring BBB-rated mortgage backed securities originated in the second half of 2005.
As of February 28, 2007, i.e., the end of Morgan’s First Quarter, the ABX Index had
fallen 11.5 percent (from a par of 100). Morgan’s own CDO analysts described the drop as a
“massive meltdown,” pointing to the collapse of subprime origination and lenders. Morgan’s
analyst reports were echoed by a growing consensus of academics and journalists.
11. During the first half of 2007, a number of major subprime lenders declared
bankruptcy, and write-downs on subprime mortgage-backed investments grew to enormous
levels. Indeed, days before Morgan released its Second Quarter 2007 results, Bear Stearns
announced the failure of two separate multi-billion dollar hedge funds with significant subprime
investments, requiring a $3.2 billion bailout.
12. By June 22, 2007, Morgan’s own CDO analysts were declaring that ratings
“downgrades into ABS CDO tranches were more a matter of when and not whether.” Partly this
is because AAA-rated CDO tranches were not comprised of AAA-rated RMBS. Instead, the
rating attributed to the CDO merely reflected the tranche’s priority in receiving the revenue
stream paid out to the note holders. Indeed, Morgan’s interest in super-senior AAA tranches of
CDOs were backed entirely by subprime mortgage-backed RMBSs rated BBB+, BBB, and
BBB-. On June 28, 2007, Morgan’s CDO analysts proclaimed that “[r]atings downgrades for
ABS CDO tranches are inevitable and material – the shoe is still waiting to drop.”
From The Class Period’s Outset, Defendants Deceived Investors
13. On June 20, 2007, the first day of the Class Period, Morgan reported stellar results
for Second Quarter 2007 (ended May 31, 2007). Defendants attributed the results principally to
the ISG’s returns. The results followed record-breaking earnings in First Quarter 2007,
specifically attributed by senior management in large part to “favorable positioning in the
subprime mortgage markets.”
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14. In addition to reporting stellar results during Morgan’s Second Quarter 2007
earnings call, Defendants disavowed significant negative exposure to subprime-backed
securities. When analysts further inquired about Morgan’s subprime exposure, Defendants
responded that Morgan “really did benefit from the market conditions in subprime” in First
Quarter 2007, and “certainly did not lose money in this business” during Second Quarter 2007.
These statements falsely implied that Morgan was net short on subprime mortgage-backed
securities.
15. In view of Defendants’ false statements, Standard & Poor’s (“S&P”) upgraded
Morgan’s credit rating from A+ to AA- on July 30, 2007, stating that “Morgan Stanley’s
exposure to the U.S. subprime mortgage sector and leveraged corporate finance sector is under
control,” and that the Company’s “strong competitive position leaves it better able to withstand
market volatility in comparison to its peers.” Likewise, in an August 1, 2007 analyst report,
Richard Bove of Punk Ziegel wrote that Morgan appears to be “handling the biggest problems
well,” and likely “will experience fewer problems than its peers and possibly no major problems
at all.” Analysts believed that Morgan had limited subprime exposure because of Defendants’
misleading disclosures and because the Company ranked low among its peers in underwriting
RMBSs and RMBS-backed CDOs. Investors had no idea that Morgan had $13.2 billion of
subprime mortgage exposure due to the proprietary Long Position.
Defendants Deliberately ConcealedThe Long Position And Its Inflated Value
16. Defendants were aware of the deterioration of the subprime-related markets, and
by the start of the Class Period, they knew that the Long Position was a significant concentration
of credit risk, had suffered significant losses, and likely would suffer more in the near term.
According to a May 2008 New York Magazine article, by no later than May 2007, senior
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executives at the Company, including Cruz, Morgan’s Co-President, “started to worry” about the
bank’s subprime exposure. (Joe Hagan, “Only the Men Survive: The Crash of Zoe Cruz,” New
York Magazine, May 5, 2008) (“2008 Cruz Article”). Cruz ordered her department to
unwind billions of dollars in subprime mortgage-related positions (apart from the Long Position),
and informed her personal clients that they should avoid taking on mortgage-related positions in
light of the subprime market’s impending collapse.
17. Also in May 2007, Cruz ordered her direct report, Defendant Daula, the
Company’s Chief Risk Officer, to run “stress tests” on the Long Position to calculate the amount
the Company would lose based on various levels of deterioration within the subprime mortgage
market. On July 4, 2007, with the value of the Long Position declining, Daula informed Cruz
that the Company was exposed to an alarming $3.5 billion in potential losses from the Long
Position alone (which ultimately underestimated Morgan’s losses). Although Daula purportedly
told Cruz that a loss of this magnitude was unlikely, Cruz told Daula: “I don’t care what your
view of probability is. Cut the position.” (2008 Cruz Article.)
18. Contemporaneously, in early July 2007, Morgan received a $1.2 billion collateral
call on the Long Position, as Michael Lewis recounts in his 2010 book The Big Short. Deutsche
Bank, one of Morgan’s counterparties to the Long Position, called Morgan to advise that the
trade had declined in value, turning in Deutsche Bank’s favor. As Greg Lipmann, the trader at
Deutsche Bank stated to his counterpart at Morgan: “Dude, you owe us one point two billion.”
(Michael M. Lewis, The Big Short, 212 (2010)).
19. In reaction to Deutsche Bank’s collateral call, Morgan asserted that the position
had declined by only 5 percent – far less than the decline in the ABX Index, which had declined
27 percent from par value at the time. Deutsche Bank called Morgan’s bluff, offering to buy the
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long side of the CDSs at 70 percent of par, or sell Morgan more at 77 percent of par. Defendants
refused Deutsche Bank’s offer.
20. If Defendants thought the CDSs were really worth 95 percent of par, Morgan
would have readily made the bargain and bought more from Deutsche Bank at 77 percent of par,
and then attempted to sell them at 95 percent for a riskless profit. Morgan’s refusal to buy more
demonstrated in the purest market-based terms that Morgan understood no later than early July
2007 that the Long Position’s value had dropped at least below 77 percent of par – a loss of
$3 billion.
The SEC Inquiry Into Morgan’s Exposure To Subprime
21. On August 30, 2007, Morgan received a letter from the SEC probing the
Company’s disclosures concerning its exposure to the U.S. subprime market. The terms of this
inquiry were in line with the requirements of FAS 107. However, Defendants provided no
additional disclosure in the Form 10-Q for Third Quarter 2007 filed weeks after Morgan received
the SEC’s letter. As investors would discover in the coming months, notwithstanding
Defendants’ affirmative denials of subprime exposure and betting the wrong way, Morgan’s
exposure to subprime was not just material, it was massive and toxic. The SEC letter, and the
series of exchanges between Morgan and the SEC that followed, were not available to the
investing public until well into 2008, when the SEC made the correspondence public.
Q3 2007: Morgan Continues To Conceal The Long Position AndFraudulently Values The Trade To Meet Analysts’ Expectations
22. During Morgan’s Third Quarter 2007 (June 1 through August 31, 2007), the ABX
Index fell 32.8 percent from par. Such a drop should have required Morgan to write down the
Long Position by at least $4.4 billion. Because Defendants concealed the Long Position in
violation of, inter alia, FAS 107, and fraudulently under-reported losses on the Long Position,
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investors had no way of knowing that Morgan was subject to the significant concentration of
credit risk arising from the trade, let alone that the Long Position already had declined by more
than one-third in value, as detailed herein.
23. In addition to concealing the existence of the Long Position, Defendants
concealed that they had taken an associated $1.9 billion write-down in Third Quarter 2007.
Rather than using the ABX Index, as FAS 157 required, Defendants used a subjective and, under
the circumstances, inappropriate valuation methodology. The resulting $1.9 billion write-down
amounted to a mere 14.4 percent decline – less than half of the 32.8 percent write-down required
by FAS 157 due to the decline in the ABX Index. Defendants fraudulently manipulated the
write-down to manage earnings. By recording precisely a loss of $1.9 billion, Defendants were
able to report earnings of $1.38 per share, exactly at the low end of analysts’ earnings
expectations for Third Quarter 2007.
November 1-7, 2007: Truth Begins To Be Revealed
24. Between November 1 and November 7, 2007, the market learned for the first time
that Morgan had established a large proprietary CDO position that had suffered billions of
dollars in impairment. In response to this news, investors drove down the price of Morgan’s
common stock as investors realized that Morgan was exposed to billions of dollars of losses
arising from a proprietary subprime trade. ( See Section X for Plaintiffs’ allegations specific to
loss causation.) By the time Defendants confirmed the existence of the Long Position and a
$3.7 billion write-down after the market closed on November 7, the corrective information had
already been incorporated into the price of Morgan’s stock. Between the market close on
October 31 and November 7, Morgan’s stock declined 23.9 percent, from $67.26 to $51.19,
wiping out over $17 billion in market capitalization.
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25. In rapid sequence, news came to the market regarding the existence of the Long
Position and the required write-down.
• On Thursday, November 1, Deutsche Bank issued an analyst report predictingthat Morgan, among other investment firms, would collectively write downmore than $10 billion “due to CDOs/mortgage/etc.” This was the first timethat any analyst had predicted that Morgan would record a write-down due toCDO exposure. In reaction to Deutsche Bank’s report, on November 1,Morgan’s stock price dropped 7.2 percent, from $67.26 to $62.42.
• On Friday, November 2, Morgan fired Howard Hubler, the Managing Directorof the PTG, the team that had established the Long Position. That day,Morgan’s stock price dropped 5.6 percent, from $62.42 to $58.90.
• On Monday, November 5, a CNBC on-air editor predicted that Morgan wouldrecord a write-down of $3 billion, citing unidentified sources. Among othernews sources, Bloomberg News reported on CNBC’s prediction, stating that“Morgan Stanley will have a $3 billion write-down tied to securities.” By theend of the trading day, another Bloomberg News article stated: “MorganStanley fell . . . after CNBC reported that the firm might write down $3 billionof securities, citing unidentified sources.” That day, Morgan’s stock priceagain dropped 5.6 percent, from $58.90 to $55.59.
• By Tuesday, November 6, analysts were predicting Morgan would take awrite-down as big as $6 billion. For instance, Fox-Pitt Kelton issued a reportdowngrading Morgan “given the likelihood that it will take significant writedowns on ABS-CDOs and other mortgage exposures,” estimating a write-down of $4 to $6 billion. The analyst suggested “outright avoidance [ofMorgan’s stock] until either mgmt discloses more specific exposure data andit proves smaller than we thought, or they actually take write-downs bigenough to get beyond this.” That day, Morgan’s stock price declined1.9 percent from $55.59 to $54.51.
• Before U.S. trading started on Wednesday, November 7, both The New YorkTimes and The Wall Street Journal highlighted Fox-Pitt Kelton’s $6 billionprojected write-down. Citing market participants, the November 7 Wall StreetJournal article also stated that Morgan’s subprime exposure was the result ofa proprietary trading position. On that day, Morgan’s stock price droppedanother 6.1 percent, from $54.51 to $51.19. (Emphasis added.)
26. In sum, by the time trading closed on November 7, the market understood that
Morgan had a large, previously undisclosed, proprietary trading position with substantial
exposure to the dramatically deteriorating subprime market, and that Morgan was going to have
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to record a write-down of up to $6 billion relating to that position. These revelations reflected
the materialization of the risk arising from Defendants’ fraudulent, material misstatements and
omissions regarding Morgan’s subprime and CDO exposure and the improper valuation of the
Long Position.
27. After the market closed on November 7, 2007, Defendants for the first time
confirmed the existence of the Long Position, purportedly quantified Morgan’s exposure to the
significant concentration of credit risk associated with the trade, and finally disclosed that
Morgan had secretly taken a $1.9 billion write-down at the end of Third Quarter 2007.
Defendants also disclosed a $3.7 billion write-down for September and October 2007. In view
of the news of November 1 through November 7, analysts concluded that the write-down was “in
line” with estimates, and “manageable.” Reflecting investors’ relief that the write-down was not
the worst-case scenario of $6 billion, Morgan’s stock price actually increased on November 8,
2007 from $51.19 to $53.68 per share by the close of trading.
Defendants’ November 7 Disclosures Were Also Fraudulent
28. While Defendants November 7 disclosure corroborated the information that
entered the market between November 1 and November 7, Defendants statements continued to
conceal the full truth and mislead investors, reinflating Morgan’s share price. In particular,
Defendants fraudulently told investors that the Long Position had declined in value by only
$1.9 billion dollars (instead of $4.4 billion) in Third Quarter 2007. Unknown to investors,
Morgan should have written-down the Long Position by $2.5 billion more.
The Risk Fully Materializes On November 19, 2007
29. During November 2007, the ABX Index declined roughly 23.8 percent. Thus,
investors could expect Morgan to take an additional write-down on the Long Position for the
Fourth Quarter 2007 commensurate with the ABX Index’s decline. But investors did not know
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that, for Third Quarter 2007, Defendants fraudulently had under-reported losses by at least
$2.5 billion on the Long Position, and thus investors could not anticipate that Morgan’s write-
down would be far greater than the ABX Index otherwise indicated.
30. Then, on November 19, MarketWatch issued an article, titled “New Bank Fears
Hit Shares,” reporting that Goldman Sachs was predicting Morgan would take a write-down of
$8 billion shared over Fourth Quarter 2007 and fiscal year 2008. The Financial Times also
reported Goldman Sachs’s conclusions. As both news sources reported, on November 19,
Goldman Sachs had issued an analyst report estimating that Morgan would record CDO-related
write-downs of $5 billion in Fourth Quarter 2007 and $3 billion in fiscal year 2008. This new
information was the materialization of the risk created by Defendants’ concealment of the
unrecognized losses on the Long Position in Third Quarter 2007. The write-down predicted by
Goldman Sachs reflected more than double the rate of decline of the ABX Index during Fourth
Quarter 2007, and reflected the “catch up” Morgan needed to take to compensate for
understating losses in the Third Quarter. On November 19, the price of Morgan’s stock declined
3.3 percent, from $52.90 to $51.13.
31. On November 29, 2007, Mack fired Zoe Cruz. The next day, Richard Bove, a
Punk Ziegel analyst, issued a report consistent with Goldman Sachs’s November 19 analysis.
Bove concluded that in the Third Quarter 2007, Morgan’s write-downs were understated and
should have been “$3.6 billion on a gross basis,” not $1.9 billion.
32. On December 19, 2007, a month after Goldman Sachs, the Financial Times, and
MarketWatch warned investors that Morgan would take an $8 billion write-down, Defendants
officially announced an additional write-down of $3.7 billion on the Long Position, confirming
the Goldman Sachs’s prediction. This $3.7 billion write-down brought Fourth Quarter 2007
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write-downs to $7.1 billion in total, far greater than the $4.3 billion write-down indicated by the
decline in the ABX Index. The $7.1 billion charge included the amount needed to “catch up” for
Defendants’ under-reporting of Third Quarter 2007 losses on the Long Position. This brought
year-to-date losses on the Long Position to $9.3 billion.
33. Also in the December 19 earnings release, Defendants announced a $5 billion
cash infusion from a Chinese sovereign wealth fund, which staved off the risk of credit
downgrades, collateral calls, and a liquidity crunch.
34. Morgan’s additional write-down of $3.7 billion on the Long Position indicated to
the market that the Company’s CDO-related losses had bottomed out. As one Deutsche Bank
analyst stated: “We maintain our Buy, given our view that the worst subprime is behind
[Morgan].” This fact, combined with the $5 billion cash infusion, led investors to react with
relief, and Morgan’s stock price rose from $48.07 the prior day to end at $50.08 on
December 19, 2007.
35. By December 19, 2007, Morgan had fired the senior executives responsible for
the Long Position, including Cruz, Hubler, and Anthony Tufariello (Global Head of Securitized
Products), and demoted Neal Shear (Global Head of Fixed Income Trading and Sales). CFO
David Sidwell (“Sidwell”) “retired” two months earlier than originally announced.
36. Plaintiffs and class members who purchased Morgan stock at any time during the
Class Period have been damaged by Defendants’ misconduct, as set forth herein, and bring this
action to remedy Defendants’ violations of the federal securities laws.
II. JURISDICTION AND VENUE
37. This action arises under Sections 10(b) and 20(a) of the Securities Exchange Act
of 1934 (“Exchange Act”), 15 U.S.C. §§ 78j(b) and 78t(a), and Rule 10b-5 promulgated
thereunder, 17 C.F.R. § 240.10b-5.
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38. This Court has subject-matter jurisdiction over this action pursuant to Section 27
of the Exchange Act, 15 U.S.C. § 78aa, and 28 U.S.C. § 1331.
39. Venue is proper in this District pursuant to Section 27 of the Exchange Act and
28 U.S.C. § 1391. Many of the acts and practices complained of herein, including the
misrepresentations and schemes alleged herein, occurred in part in this District.
40. In connection with the acts, transactions and conduct alleged herein, Defendants,
directly or indirectly, used the means and instrumentalities of interstate commerce, including, but
not limited to, the U.S. Mail, interstate telephone communications and the facilities of a national
securities exchange and market.
III. PARTIES
A. PLAINTIFFS
41. Lead Plaintiff State-Boston Retirement System is an institutional investor that
provides retirement benefits for the employees of the City of Boston, Massachusetts. It has more
than 34,000 active and retired members, representing 106 mandatory retirement systems, and
more than $3.1 billion in assets. SBRS purchased approximately 135,000 shares of Morgan
stock at artificially inflated prices during the Class Period, as set forth in the certification that
was previously filed in this litigation and is incorporated herein by reference, and suffered losses
in an amount to be determined at trial.
42. Plaintiff AP4, or the Fourth Swedish National Pension Fund, is based in
Stockholm, Sweden and manages a portion of the pension assets of the citizens of Sweden. AP4
is part of the Swedish National Pension Fund (“AP Fund”) system and was founded in 1974.
With assets under management of approximately $32 billion and over four million members,
AP4 is one of the largest institutional investors in Scandinavia and one of its most prominent
pension funds. AP4 purchased 46,000 shares of Morgan stock at artificially inflated prices
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during the Class Period, as set forth in the certification that was previously filed in this litigation
and is incorporated herein by reference, and suffered losses in an amount to be determined at
trial.
43. State Boston Retirement System and AP4 are hereinafter referred to collectively
as “Plaintiffs.”
B. DEFENDANTS
1. Defendant Morgan Stanley
44. Defendant Morgan Stanley is a diversified financial services company
incorporated in the state of Delaware and with its principal place of business and headquarters at
1585 Broadway, New York, New York. At all relevant times, Morgan’s common stock traded
on the NYSE under ticker symbol “MS.” Presently, the Company divides its operations into
three primary business segments: Institutional Securities, Global Wealth Management and Asset
Management. A fourth business group, Discover, which operated the Company’s Discover
credit card operations was spun off during the Class Period, on June 30, 2007.
45. As described in more detail below, during the Class Period, approximately
60 percent of the Company’s net revenue was derived from the ISG. The ISG engaged in capital
raising; financial advisory services, including advice on mergers and acquisitions, restructurings,
real estate and project finance; corporate lending; sales, trading, financing and market-making
activities in equity securities and related products and fixed-income securities and related
products, including foreign exchange and commodities; benchmark indices and risk management
analytics; research; and investment activities.
46. During the Class Period, Defendant Morgan, through its officers and directors,
published periodic filings with the SEC and made public statements which, as alleged herein,
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were materially false and misleading when made, and/or omitted to state material information
which served to artificially inflate the price of the Company’s common stock.
2. Individual Defendants
47. Defendant John J. Mack has been the Company’s Chairman since June 2005, and
was the Chief Executive Officer (“CEO”) from June 2005 until December 2009. Defendant
Mack became the Company’s CEO and Chairman of the Company’s Board of Directors in June
of 2005, and remained in both positions throughout the Class Period. During the Class Period,
Defendant Mack participated in the issuance of, signed, and/or certified as accurate, the
Company’s SEC filings including, inter alia, the Company’s Form 10-Qs for Second and Third
Quarter 2007 filed with the SEC on July 10, 2007 and October 10, 2007, respectively, which, as
alleged herein, contained materially false and misleading statements when issued. In addition,
Defendant Mack was a member of the Company’s Management Committee throughout the Class
Period, participated in earnings conference calls and made statements in the Company’s press
releases, which were also, as alleged herein, materially false and misleading when made.
48. Defendant David Sidwell served as the Company’s Executive Vice President and
Chief Financial Officer (“CFO”) from March 2004 through October 11, 2007. Defendant
Sidwell retired from his employment with Morgan on October 31, 2007. During the Class
Period, Defendant Sidwell was a Member of the Company’s Management Committee, and
participated in the issuance of, signed, and/or certified as accurate, the Company’s Form 10-Q
for Second and Third Quarter 2007 filed with the SEC on July 10, 2007 and October 10, 2007,
respectively, which, as alleged herein, contained materially false and misleading statements
when issued. In addition, throughout the Class Period, Defendant Sidwell made statements in
the Company’s press releases and earnings conference calls, which, as alleged herein, were
materially false and misleading when made. Defendant Sidwell’s conduct, statements and
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omissions caused the price of Morgan’s common stock to be artificially inflated during the Class
Period. For fiscal year 2007, Defendant Sidwell was awarded total compensation of
$14.6 million in salary, bonus and other compensation.
49. Defendant Thomas Colm Kelleher was the Company’s Executive Vice President,
CFO, and the Co-Head of Strategic Planning until December 2009. Kelleher assumed those
positions on October 11, 2007 from Defendant Sidwell after shadowing Sidwell for five months
as training to become Morgan’s CFO. Defendant Kelleher joined Morgan in December 2000 as
the Head of Fixed Income Sales Europe, and became Co-head of Fixed Income Europe in May
of 2004. In February of 2006, Kelleher was promoted to Head of Global Capital Markets,
holding that position until October 11, 2007. During the Class Period, Defendant Kelleher was a
Member of the Company’s Management Committee. Also during the Class Period, Defendant
Kelleher personally made statements in the Company’s press releases and earnings conference
calls, which, as alleged herein, were materially false and misleading when made. Defendant
Kelleher also participated in conference calls and interviews with analysts held on September 19,
2007, October 10, 2007, October 24, 2007 and November 7, 2007. During these calls and
interviews, Defendant Kelleher and/or other Defendants made numerous materially false and
misleading statements that, as alleged herein, Defendant Kelleher did not contradict or qualify.
Defendant Kelleher’s conduct, statements, and omissions caused the price of Morgan’s common
stock to be artificially inflated during the Class Period. For fiscal year 2007, Defendant Kelleher
was awarded total compensation of $11.7 million in cash and incentives.
50. Defendant Zoe Cruz was the Company’s Co-President and the executive in charge
of the ISG throughout most of the Class Period until she was fired on November 29, 2007.
Defendant Cruz joined Morgan in 1982, and rose to the Head of its Fixed Income Division by
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September 2000, holding that position through March 2005, when she was appointed Co-
President of the Company upon Mack’s return to Morgan. Cruz was also Director of Morgan
from March of 2005 through June of 2005, and was Acting President from July 2005 through
February of 2006. Defendant Cruz, a control person of the Company, was a Member of the
Company’s Management Committee, and participated in the issuance of the Company’s Form
10-Qs for Second and Third Quarter 2007 filed with the SEC on July 10, 2007 and October 10,
2007, respectively, which, as alleged herein, were materially false and misleading when issued.
In addition, Defendant Cruz participated in and/or prepared information concerning the
Company’s financial performance and operations which was set forth in financial reports which,
as alleged herein, were materially false and misleading when issued. Defendant Cruz’s conduct,
statements and omissions caused the price of Morgan’s common stock to be artificially inflated
during the Class Period.
51. Defendant Thomas V. Daula was the Company’s Chief Risk Officer (“CRO”)
throughout the Class Period and remained so until announcing his retirement from Morgan on
February 22, 2008. Prior to being named CRO in April of 2005, Daula had been the Company’s
Head of Market Risk. As CRO, Daula was responsible for analyzing, developing, and
implementing Morgan’s risk controls. Defendant Daula, a control person of the Company, was a
Member of the Company’s Management Committee throughout the Class Period, and
participated in the issuance of the Company’s Form 10-Qs for Second and Third Quarter 2007
filed with the SEC on July 10, 2007 and October 10, 2007, respectively, which, as alleged herein,
were materially false and misleading when issued. Defendant Daula’s conduct, statements, and
omissions caused the price of Morgan’s common stock to be artificially inflated during the Class
Period.
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52. Hereinafter, Defendants Mack, Sidwell, Kelleher, Cruz, and Daula will be
collectively referred to as the “Individual Defendants.”
IV. CONTROL PERSON ALLEGATIONS/GROUP PLEADING
53. By virtue of the Individual Defendants’ positions of management and control
within the Company, they had access to undisclosed adverse information about Morgan, its
business, operations, operational trends, finances, and present and future business prospects. The
Individual Defendants would ascertain such information through Morgan’s internal corporate
documents, conversations, and connections with each other and corporate officers, employees,
attendance at sales, management, and Board of Directors’ meetings, including committees
thereof, Management Committee Meetings, and through reports and other information provided
to them in connection with their roles and duties as Morgan officers and/or directors.
54. It is appropriate to treat the Individual Defendants collectively as a group for
pleading purposes and to presume that the materially false, misleading and incomplete
information conveyed in the Company’s public filings, press releases and public statements, as
alleged herein was the result of the collective actions of the Individual Defendants identified
above. The Individual Defendants, by virtue of their high-level positions within the Company,
directly participated in the management of the Company, were directly involved in the day-to-
day operations of the Company at the highest levels and were privy to confidential, proprietary
information concerning the Company, its business, operations, prospects, growth, finances, and
financial condition, as alleged herein.
55. The Individual Defendants were involved in drafting, producing, reviewing,
approving and/or disseminating the materially false and misleading statements and information
alleged herein, or knew or recklessly disregarded that materially false and misleading statements
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were being issued regarding the Company, and/or approved or ratified these statements, in
violation of securities laws.
56. As officers, directors and controlling persons of a publicly-held company whose
common stock is registered with the SEC pursuant to the Exchange Act, and is traded on the
NYSE, and governed by the provisions of the federal securities laws, the Individual Defendants
each had a duty to promptly disseminate accurate and truthful information with respect to the
Company’s financial condition and performance, growth, operations, financial statements,
business, markets, management, earnings, and present and future business prospects, and to
correct any previously issued statements that had become materially misleading or untrue, so that
the market price of the Company’s publicly-traded securities would be based upon truthful and
accurate information. The Individual Defendants’ material misrepresentations and omissions
during the Class Period violated these specific requirements and obligations.
57. The Individual Defendants, by virtue of their positions of control and authority as
officers and/or directors of the Company, were able to and did control the day-to-day trading and
attendant risks of the Company’s largest business segment, ISG, and the content of the various
SEC filings, press releases and other public statements pertaining to the Company during the
Class Period. The Individual Defendants were provided with copies of the documents alleged
herein to be misleading prior to or shortly after their issuance and/or had the ability and/or
opportunity to prevent their issuance or cause them to be corrected. Accordingly, they are
responsible for the accuracy of the public statements and releases detailed herein.
58. Each of the Defendants is liable as a participant in a scheme, plan and course of
conduct that operated as a fraud and deceit on Class Period purchasers of the Company’s
common stock. Throughout the Class Period, Defendants disseminated materially false and
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misleading statements and suppressed material adverse facts about Morgan’s exposure to the
Long Position and the fair value of the position. Among other fraudulent conduct, Defendants
concealed losses suffered by Morgan on its exposure to the Long Position and thereby artificially
inflated the price of Company’s common stock.
V. CONFIDENTIAL WITNESSES
59. Confidential Witness #1 (“CW 1”) was an associate at Morgan in the Fixed
Income division’s mortgage pass-through trading desk from July 5, 2005 until August 15, 2007.
CW 1 provided information regarding, inter alia, the PTG.
60. Confidential Witness #2 (“CW 2”) worked within Morgan’s Fixed Income Group
from late 2005 until February 2008. CW 2 provided information regarding, inter alia, the PTG
and the general organizational structure of the Fixed Income Group.
61. Confidential Witness #3 (“CW 3”) worked in Morgan’s securitized products
group as an analyst, dealing primarily with mortgage-backed securities from July 2006 until
April 2008. CW 3 provided information regarding, inter alia, the PTG and the methods used by
Morgan traders to value their trading positions.
62. Confidential Witness #4 (“CW 4”) was a senior-level, long-term employee in
Morgan’s Fixed Income division during the Class Period. During this person’s tenure at
Morgan, CW 4 had direct contact with Defendant Cruz. Prior to leaving Morgan in 2008, CW
4’s responsibilities included assessing risk exposures in connection with a variety of financial
instruments.
63. Confidential Witness #5 (“CW 5”) held a variety of positions within Morgan
between 2002 and January of 2008. Most recently, CW 5 was a Management Reporting CFO in
the equity division, where this person oversaw two proprietary trading groups. CW 5 provided
information regarding, inter alia, the general organizational structure of Morgan’s ISG, the
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manner in which proprietary trading groups operated within Morgan, the Company’s risk
management and valuation review policies, and the circumstances giving rise to the Company’s
2007 losses on the proprietary trade.
VI. BACKGROUND FACTUAL ALLEGATIONS
A. John Mack’s Aggressive, Risk-Taking AgendaAnd The Proprietary Trading Group
64. The events that gave rise to Defendants’ fraud began in June 2005 when
Defendant John Mack became CEO with the stated goal of substantially increasing Morgan’s
risk taking.
65. As recounted in a July 3, 2006 article by Business Week: “In a speech to
[investors] shortly after his arrival [at the Company], Mack said that the firm’s main problem
wasn’t its strategy or its business mix, as was widely believed, but its culture. It had become soft
and timid, missing out on growth opportunities in everything from private equity to mortgages,
junk bonds to equity derivatives.” (“Mack Attack: Buttressed by better earnings, a hungry
Morgan Stanley is winning over critics,” Businessweek, July 3, 2006.) To correct this, Business
Week reported, Mack was “embark[ing] on a radical shakeup of Morgan Stanley.” In November
2005, Mack boldly announced a five-year plan to double Morgan’s 2005 pre-tax profits. Key to
this business plan was aggressive growth in the ISG, which included greater risk taking by the
Fixed Income Sales and Trading Group.
66. A March 27, 2006 Forbes article titled “Upping the Ante” described Morgan’s
new penchant for increased risk:
So-called value-at-risk in the fiscal first quarter was higher thanaverage, said Chief Financial Officer David Sidwell during aconference call. This is a strategic goal. “Over time you’d expectus to be taking more risk, not just in commodities but across theother aspects of our fixed-income and equities business, consistentwith the strategy,” he said.
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Zoe Cruz, Morgan Stanley’s co-president, affirmed this view incomments to European investors, saying, “We must take more riskthan we have been taking in the past.”
* * *
Morgan’s more aggressive stance on trading risk might havesomething to do with the world views of its top managers. JohnMack, who joined as chief executive in June, is an ex-trader, as isCruz. Both came up through the rough and tumble world of fixed-income. “Not taking enough risk is the biggest risk of all,” saysCruz.
[Cruz stated] “The corner stone of our risk management strategyhas always been that we are not going to take risk that willendanger the franchise . . . but I feel there was a lot of room andthere is still a lot of room to take more market risk.”
(Liz Moyer, “Upping the Ante,” Forbes.com, Mar. 27, 2006.)
67. Expanding on this business plan, in April 2006, Morgan created the PTG in an
attempt to improve its reported income relative to the Company’s investment banking
competitors. The Company moved five traders from the securitized products group to the new
PTG. The PTG traded Morgan’s money for the Company’s benefit, and did not serve any
customers. Howard Hubler served as the PTG’s Managing Director. Hubler reported directly to
Anthony Tufariello, the Global Head of Securitized Products, who, in turn, reported to Neal
Shear, Global Head of Fixed Income Trading and Sales. Shear reported to Morgan Co-President
Zoe Cruz and CEO John Mack, both Individual Defendants in this action.
68. The PTG traded structured financial products and secured asset classes, including
mortgage-backed securities, in both cash and derivative markets. While the PTG operated within
the ISG and was located on the 10th floor of the Company’s Manhattan headquarters, the PTG’s
positions and strategies were kept isolated from Morgan’s other trading desks. According to CW
2, Morgan’s internal regulations required that a “Chinese Wall” be erected between the PTG and
other fixed income traders to “keep the [proprietary] strategies and information separate.”
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69. However, given the high importance of the PTG to the ISG’s bottom line, senior
executives, including Tom Daula, Zoe Cruz, and Neal Shear all kept close tabs on the PTG.
70. Before its trading activity led to $9.3 billion in losses in 2007, the PTG helped
lead the Fixed Income and Trading Group to making record profits in 2006 and First Quarter
2007.
B. The Institutional Securities Group ReportsRecord Results As A Result Of The Additional Risk Taking
71. Mack’s focus on taking on more risk in the ISG at first paid dividends.
Throughout 2006 and the first two quarters of 2007, the ISG reported record results:
• For the second quarter of 2006, ended May 31, 2006, Morgan reported,“Institutional Securities achieved record net revenues of $5.7 billion, up71 percent from the same period last year, and record income before taxesof $2.3 billion, up 179 percent.” These revenues accounted for 64 percent ofMorgan’s $8.9 billion of total revenue. As reported by the Company, “Fixedincome delivered sales and trading revenues were $2.4 billion, up 95 percentincrease from the same period last year and the second highest ever.”
• For the third quarter of 2006, ended August 31, 2006, Morgan reported,“Institutional Securities delivered its best third quarter results ever, with netrevenues of $5.0 billion and income before taxes of $2.0 billion, up 55 percentfrom last year.”
• For the fourth quarter and year ended November 30, 2006, Morgan reported“Institutional Securities delivered its best full-year results ever, with recordnet revenues of $21.6 billion and record income before taxes of $8.2 billion,up 72 percent from last year.”
72. On April 6, 2007, in Morgan’s Form 10-Q for First Quarter 2007, Defendants
reported “record results across the board.” These results included record revenues, net income,
and EPS, which largely had outperformed expectations owing to what Defendants described as
“disciplined and balanced” increased risk-taking and strong trading performance. Significantly,
Defendant Sidwell reported that fixed income sales and trading had contributed $3.6 billion in
revenues, which he stated was the Company’s best quarter ever and was attributed in large part
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to results from Morgan’s credit products area and favorable positioning in the subprime
mortgage markets.
73. While reporting earnings for First Quarter 2007, Defendant Sidwell expressly
acknowledged that subprime had been a key focus in the market during early March 2007, and
he stated that the Company managed its risk through a variety of hedging strategies and
proprietary risk positions that had significantly contributed to Morgan’s record results.
Defendant Sidwell further reported that the Company had decreased risk exposure during the
latter part of the First Quarter 2007 to balance Morgan’s level of risk with Defendants’ view of
potential market changes. In response to analysts’ questions, Sidwell acknowledged that its
acquisition of Saxon Capital, Inc. (“Saxon”), a large mortgage originator and servicer, and
increased participation in mortgage origination, had provided key insights into understanding
where investment opportunities were and where the markets were heading.
74. Investors and analysts reacted positively to Defendants’ statements. For instance,
on May 10, 2007, Deutsche Bank issued an analyst report, following their meeting the same day
with Defendant Mack. Reiterating their “Buy” rating on Morgan, the analysts reported that
factors driving the Company’s growth included “better capital allocation/optimization of the
balance sheet” as mandated by the CFO, and “more principal activity” with a “gradual[]
increase” in the amount of trading risk. The research report further stated that Morgan was
looking to take on more risk to try to enhance the Company’s performance.
C. Defendants Assure Investors Of “Disciplined” Risk-Taking
75. Morgan’s blockbuster financial results over the one-year period after Mack had
implemented his new risk-embracing business model raised questions among analysts and
investors as to whether the Company was safely managing its risk. These inquiries were
repeatedly met with assurances that the Company’s risk taking was measured and disciplined.
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76. A power point presentation by Tom Daula to investors on February 14, 2006,
titled “Risk Management at Morgan Stanley An Overview,” outlined the procedures that Morgan
supposedly had in place to monitor trading risks. The “Risk Controls,” identified by the report
included:
• Mark to market discipline• Ensures revenues more closely track economics• Critical components
- Independent review by Controllers- New Model Approval process
• Backtesting (i.e., the comparison of realized trading revenuesagainst Value-at-Risk results)
• New product review processes• Limits
- Established at various levels throughout the Firm fromtrader to business and are defined in terms of risksensitivities, concentrations and portfolio exposures
- Generally set at levels to ensure that a material change inrisk triggers a discussion between the trader or trading deskand management
77. Moreover, the report detailed an elaborate protocol for communicating risks to
risk managers that included: “Daily discussion with trading desks; Daily comprehensive risk
reports, Weekly summary report and risk committee meetings; Quarterly and annual reviews and
regulatory reporting; [and] Reporting to Audit Committee.”
D. Morgan’s Secret Multi-Billion Dollar Bet-The-Bank Proprietary TradeOn The Movement Of U.S. Subprime Securities
78. In December 2006, PTG put on the Proprietary Trade – a $15 billion bet on the
movement of subprime mortgage-backed CDOs. Morgan’s Long Position consisted of CDS
contracts whereby Morgan insured counterparties against losses on AAA-rated super-senior
tranches of CDOs, which were backed by mezzanine tranches of subprime RMBSs. Before
describing the Proprietary Trade in greater detail, immediately below is a brief overview of the
financial instruments involved in the Proprietary Trade.
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1. Overview of Credit Defaults Swaps, Collateralized DebtObligations, and Residential Mort2a2e Backed Securities
79. The U.S. real estate boom, and in particular, the boom in subprime mortgages,
was fueled in large part by mortgage securitization and the structuring and trading of mortgage-
backed financial products. The Long Position was composed of such structured products. In
particular, the Long Position consisted of CDS contracts referencing CDOs that were backed by
mezzanine tranches of RMBSs. Below is an overview of each of these structured products.
Credit Default Swaps
80. A CDS is essentially an insurance contract. The “policy” amount is called the
notional value of the CDS. The “insurance protection” buyer agrees to provide the “insurance
protection” seller with regular premium payments; and, in return, the protection seller agrees to
insure the buyer against the risk of loss on the referenced asset. The buyer pays periodic
premiums to the seller, and the seller pays the buyer the notional value of the CDS if the
referenced asset defaults. The protection seller essentially is taking a long position with respect
to the referenced asset, and the protection buyer is shorting the referenced asset ( i.e., profiting
from the decline in the value of the asset). Morgan’s CDS contracts referenced ( i.e., insured)
super-senior tranches of CDOs backed by mezzanine tranches of RMBSs.
Residential Mort2a2e Backed Securities
81. A RMBS is created by pooling thousands of residential mortgages into a trust.
The trust then issues bonds, which are purchased by investors. The underlying mortgages serve
as collateral for these bonds, and the interest on the bonds derives from the cash flow obtained
from the mortgage payments. RMBSs (and CDOs) are typically divided into hierarchical
classes, called tranches, which each have different rights to the cash flows. Lower tranches
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suffer losses – i.e., do not receive cash flows – before higher tranches in the event that cash flows
from the underlying mortgage pool dry up.
82. As is typical of RMBSs and CDOs, the tranches of the RMBS securing the CDOs
Morgan held were not all of equal size. Indeed, typically, the tranches below the A-rated
tranches made up less than ten percent of an RMBS. The term “mezzanine” refers to tranches
rated BBB+, BBB, and BBB-. The structure of a typical 2006 subprime RMBS securitization is
shown in Figure 1, which highlights two aspects of subprime RMBSs that are important to this
case: (1) the mezzanine tranches’ vulnerability to loss; and, (2) the “thinness” of the mezzanine
tranches.
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Figure 1: Subprime RMBS: Average Structure and Tranche Sizes
Pool of Assets Tranche StructureServing as Of RMBSCollateral Securities Issued
low^
4,000 SubprirneMortaaaes
AAATranche
Large AAA Tranche79% of total securitization
Size of Tranches
M. Trartel—o 3 AA Tranches (AA+, AA, AA-) 6.60%
_ 3 A Tranches (A+, A, A-) 5.40%
_ 3 BBB Tranches (BBB+, BBB, BBB-) 4.30%
891EquityTranches BB and Equity Tranches 4.50%
AS UNDERLYING MORTGAGE POOL LOSSES MOUNT, THEY CLIMB UP THE TRANCHES
1 The lowest tranches -- equity and BB — amount to 4.5% of the entire securitization.
Principal losses experienced by the underlying mortgages will accrue here first.The BB1Equity tranches are written down by the amount of those losses.
2 If principal losses exceed the size of the equityli tranches (4.5%), then losses begin
to accrue against the more senior trenches above.
3 Next above equity area series of thin BBB tranches (BBB+. BBB and BBB-). Each is
about 1% to 1.5% of the entire securitization; in total, 4.3% of the entire securization.
Each is successively written down as underlying mortgage losses mount. If losses
rise above 8.8% (the 4.5% of equity/1313 tranches and the 4.3% of BBB tranches), all
of the BBB tranches are worthless -
4 The process continues, except, at each successive level, the tranches are "thicker'.
The A tranches account for 5.4% of the securitization,
The AA tranches account for 6-6% of the securitization_
The AAA tranches account for 79% of the sacurilization.
83. On average, the tranches below the mezzanine only comprised the first
4.5 percent of the entire structure. The mezzanine tranches comprised the next 4.3 percent.
Because lower tranches are the first to suffer losses when cash flow dries up, if cash flows, called
“cumulative loan pool losses,” exceed 4.5 percent, the mezzanine tranches started suffering
losses – first the BBB-, then the BBB, then the BBB+ tranche bond holders. In this example, if
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cumulative losses in the underlying subprime mortgage pool rose above 8.7 percent (4.4 +
4.3 percent), the tranches rated BBB+ and below were rendered worthless.
Each RMBS Tranche Is Exposed tothe Entire Subprime Mortgage Pool
84. Usually, every RMBS tranche is exposed to the entirety of the underlying pool of
subprime mortgages. The thinness of mezzanine RMBS tranches means that a small
deterioration in the performance of the underlying mortgage pool can quickly eat through the
mezzanine tranches, switching what was a hoped-for 100 percent return for the mezzanine
tranche investors into a 100 percent loss very quickly.
Collateralized Debt Obligations
85. CDOs are investment trusts that issue bonds to investors. The CDOs at issue in
this action were created by pooling mezzanine RMBS tranches together and securitizing that
pool into CDO tranches. CDO tranches are also rated. Importantly, the credit rating of a CDO
(and RMBS) tranche is not reflective of the credit rating of the subprime mortgages that
ultimately back the CDO. For example, the AAA tranche of the CDOs at issue in this case were
not secured by AAA-rated RMBSs or mortgages. In the case of the Long Position, the entire
CDO, including the super-senior AAA tranche Morgan held, was backed by mezzanine
subprime-mortgage backed RMBSs.
The Long Position Under Deteriorating Conditions
86. Akin to the example above, if cumulative subprime loan pool losses reached
roughly eight percent, the mezzanine tranches of the RMBSs underlying the Long Position
became worthless. Because the CDOs underlying the Long Position consisted of those
mezzanine RMBS tranches, the default of the RMBS tranches also rendered the CDO tranches,
including Morgan’s interest in the super-senior AAA CDO tranche, worthless. If the super-
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senior tranches defaulted, Morgan was obligated to pay the CDS counterparties on their
insurance policies, thereby exposing Morgan to losses of $13.2 billion.
2. The Proprietary Trading Group’s Massive Bet on thePrice Movements on Subprime RMBS-Backed CDOs
87. The PTG’s massive bet involved taking a short position in the subprime mortgage
market by purchasing CDS protection against losses in the lowest-rated tranches of subprime-
backed synthetic CDOs. This position would increase in value as the value of lower-rated CDO
tranches declined, thus making payout on the CDSs more likely.
88. In taking this Short Position, Morgan was obligated to make periodic “premium”
payments of approximately $200 million annually to its CDS counterparties. To finance the cash
outlay associated with buying this position, Morgan sold CDS protection on approximately
$13.5 billion worth of AAA-rated, super-senior tranches of CDOs that were synthetically backed
by mezzanine subprime RMBSs. Morgan received periodic premium payments from the CDS
counterparties. That is, the PTG put $13.5 billion at risk – 23 percent more than Morgan’s
$11 billion in pre-tax income for the entirety of fiscal 2006 – to finance a bet that was hoped to
pay $2 billion.
89. Even in the absence of 100 percent default, if the credit worthiness of the super-
senior tranches deteriorated to a contractually agreed-upon amount, the value of the Long
Position would decrease and Morgan would have to post collateral to its CDS counterparties.
90. In taking both long and short positions, Morgan was essentially betting that
subprime mortgage defaults would be significant enough to impair the market value of lower
tranches of CDOs, but not significant enough to impair the value of the super-senior tranches of
the same or similar CDOs. Morgan had to sell six times as much CDS protection as it bought
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because the premium rates paid to Morgan on super-senior tranches (Long Position) were much
lower than the premium rates Morgan paid on the lowest rated tranches (Short Position).
91. During the Class Period, the Long Position began losing value by no later Second
Quarter 2007 as the subprime mortgage-backed CDO market collapsed. Yet, prior to November
7, 2007, Defendants entirely concealed from investors the Long Position, and the substantial
losses taken on it and even then, materially understated the necessary write-downs upon
disclosing the position.
3. The ABX Index Measures ABS CDS Value
92. As stated above, Defendants acknowledged numerous times that the Long
Position’s value was tied to the price of the ABX Index. In January 2006, several investment
banks, including Morgan, collaborated with Markit, a financial information services company, to
create a set of indices known as the “ABX” indices that tracked the value of securities
collateralized by U.S. subprime mortgages. Each ABX index tracked the performance of the 20
most liquid RMBS tranches of a particular vintage and credit rating by monitoring the price of
CDS protection written on those tranches.
93. In 2007, the ABX was (and still is) the key metric used by market participants for
valuing CDSs and CDOs referencing subprime RMBSs. As the Markit website states, the
“ABX.HE index is the key trading tool for banks and asset managers that want to hedge asset-
backed exposure or take a position in this asset class.” Not exaggerating the indices’ prevalence,
the website explains that “[t]he index has become a benchmark for the performance of subprime
RMBS. Its liquidity and standardization allows investors to accurately gauge market sentiment
around the asset-class, and to take short or long positions accordingly.”
94. Statements of other market regulators, participants and analysts confirm that, as of
2007, the ABX indices were an accurate benchmark and bellwether of the value of subprime-
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referenced CDOs. For example, the American Institute of Certified Public Accountants
(“AICPA”) in a release dated October 3, 2007, stated that these indices should be treated as a
reliable index to use in valuing securities backed by subprime mortgage loans. The Bank for
International Settlements, the entity that controls the international CDS market, has stated that
“to obtain estimates of mark to market losses for subprime [R]MBS, ABX prices, by rating and
vintage, can simply be applied to outstanding volumes of these securities.” On July 19, 2007,
Bloomberg.com wrote that the “ABX Indexes have been watched by investors in everything from
U.S. treasuries to foreign stocks as a way to track the collapse of the subprime market.” (Jody
Shann, “Subprime Bonds in 2007 No Better than 2006, ABX Shares” (updated), Bloomberg.com ,
July 19, 2007.)
95. As stated, the ABX indices are distinguished by the vintage ( i.e., the year that the
underlying subprime collateral was issued) and credit rating of the RMBSs. For example, the
ABX.BBB.06-1 index, the index whose price Defendants acknowledged was used to value the
Long Position, tracks CDSs referencing subprime BBB-rated RMBS tranches built from
subprime mortgages originated in the second half of 2005, while the ABX.BBB.06-2 series
tracks CDSs referencing subprime BBB-rated RMBS tranches built from subprime mortgages
originated in the first half of 2006. New indices were rolled out every six months, but the first
BBB index was the 06-1.
96. The ABX indices established coupon rates, which reflected the price of the
premiums paid by the protection buyer to the protection seller. For example, to purchase
$100 million of protection at a coupon rate of 150 cost $1.50 million.
97. Each ABX index is expressed as a price that reflects the relative cost of
purchasing CDS protection. The price is set to a par of 100 on the day the particular index is
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launched. If the index drops below 100, purchasing CDS protection becomes more expensive by
the relative amount by which the index has dropped below 100. If the price goes above 100, the
opposite is the case.
98. By way of example, as of February 23, 2007, the ABX.BBB.06-1 was trading at
88.5. This means that, as of this date, protection sellers were demanding an 11.5 percent up-
front fee from protection buyers in addition to coupon on the CDS protection. In the
$100 million example above, this would translate into an up-front fee of $11.5 million, in
addition to the $1.50 million coupon payment that will be made over the life of the contract.
99. By tracking the level of additional premiums required by protection sellers, the
ABX indices indicate market sentiment as to the likelihood that subprime RMBS-backed CDOs
will experience future losses. The larger the upfront premium required by the protection sellers –
reflected by the amount the price is below par – the more likely the market believes that such
assets will experience future losses.
4. The Long Position’s Value Was Linked To The ABX Index
100. Defendants have admitted that the value of its Long Position in 2007 was
inherently linked to the ABX.BBB.06-1 index (as previously defined, the “ABX Index”), and
was thus a proper observable metric for evaluation purposes. For example, on December 19,
2007, Defendant Kelleher stated that Morgan used the ABX indices to value the Long Position,
and specifically cited the ABX.BBB.06-1 index, which dropped 24 percent during November.
Likewise, on November 7, 2007, Kelleher stated that the decline in the fair value of the
company’s position was “due to the sharp decrease in the BBB ABX price indices.” Similarly,
the Form 8-K Morgan filed that day and the numerical chart detailing Morgan’s subprime
exposure and losses that accompanied that Form 8-K (and that was included in updated form in
numerous subsequent SEC filings) all cited the ABX Index as an observable input for valuing
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Morgan’s subprime-related losses. Additionally, in responding to the SEC’s request for greater
financial disclosure regarding Morgan’s subprime exposure, Defendant Kelleher wrote that
“[o]ne of the key proxies for the move in the fair value of the Company’s super-senior credit
default swaps is the ABX BBB index.” (Kelleher Letter to SEC, Feb. 3, 2008.)
101. Use of the ABX Index to value the Long Position was required because the
collateral underlying the Long Position was rated BBB+, BBB, and BBB-, and Kelleher stated
on Morgan’s December 19 earnings conference call that most of the Long Position’s exposure
was to 2005 vintage RMBSs.
102. As set forth in the chart below, the ABX.BBB 06-1 Index declined sharply during
2007, evidencing the sharp decline in the value of mezzanine subprime RMBS-backed CDOs.
Figure 2: ABX.BBB.06-1 Index
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60.000 r 35o.000
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zo aoom4 P Q 4 P 4 P 4 9 O 4 4
VN ^ N Cl O I[l fp f^ m m O
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VII. DEFENDANTS’ FRAUDULENT ACCOUNTING VIOLATEDGAAP AND SEC DISCLOSURE REQUIREMENTS
A. Morgan Was Required To ComplyWith GAAP And SEC Regulation S-K
103. As a publicly traded company, Morgan’s financial statements filed with the SEC
were required to comply with GAAP and related SEC regulations. GAAP encompasses all of the
standards that govern how to measure, recognize, and disclose transactions and events in
financial statements. The primary source of GAAP is the Financial Accounting Standards Board
(FASB). The SEC requires that the financial statements of a public company be prepared in
conformity with GAAP. The GAAP hierarchy is set forth in the AICPA’s Codification of
Statements on Auditing Standards. Officially established accounting principles have the greatest
authority and consist of FASB Statements of Financial Accounting Standards and Interpretations,
Accounting Principles Board (APB) Opinions, and AICPA Accounting Research Bulletins.
104. SEC Regulation S-X states that financial statements filed with the SEC that are
not prepared in compliance with GAAP are presumed to be misleading and inaccurate (17 C.F.R.
§ 210.4-01(a)(1)). Regulation S-X also requires that quarterly financial statements comply with
GAAP, with certain exceptions not relevant here.
105. GAAP require that financial statements take account of events subsequent to the
end of the most recent reporting period but prior to the filing of the financial statement that
materially impact the financial statement. (17 C.F.R. § 210.10-01(a).) (See, supra, Section
VII.B.2(c).)
106. Morgan’s management (including the Individual Defendants) was responsible for
preparing its financial statements in accordance with GAAP. Morgan explicitly confirmed this
responsibility in its SEC filings that management (including the Individual Defendants) is
responsible for preparing financial statements that conform to GAAP. (See, e.g., 2006 10-K,
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“The Company’s consolidated financial statements are prepared in accordance with U.S.
GAAP”.) Generally Accepted Auditing Standard (“GAAS”) further illustrate this fact (AICPA
AU Section 110, Responsibilities and Functions of the Independent Auditor, ¶ 3 states:
The financial statements are management’s responsibility . . .Management is responsible for adopting sound accounting policiesand for establishing and maintaining internal controls that will,among other things, initiate, record, process, and reporttransactions (as well as events and conditions) consistent withmanagement’s assertions embodied in the financial statements.The entity’s transactions and the related assets, liabilities andequity are within the direct knowledge and control of management. . . Thus, the fair presentation of financial statements inconformity with Generally Accepted Accounting Principles is animplicit and integral part of management’s responsibility.
(Emphasis added.)
107. In Accounting Series Release No. 173, the SEC reiterated the duty of
management to present a true representation of a company’s operations:
[I]t is important that the overall impression created by the financialstatements be consistent with the business realities of thecompany’s financial position and operations.
108. Additionally, SEC Regulation S-K requires that every Form 10-Q filing contain
“Management’s Discussion and Analysis of Financial Condition and Results of Operations”
(“MD&A”), drafted in compliance with Item 303 of Regulation S-K. The MD&A requirements
are intended to provide material historical and prospective textual disclosures which enable
investors and other users to assess the financial condition and results of operations of the
company, with particular emphasis on the company’s prospects for the future.
109. The SEC describes the purposes of MD&A in Financial Reporting Release 36
(“FRR 36”):
The Commission has long recognized the need for a narrativeexplanation of the financial statements, because a numericalpresentation and brief accompanying footnotes alone may be
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insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give investors an opportunityto look at the registrant through the eyes of management byproviding a historical and prospective analysis of the registrant’sfinancial condition and results of operations, with a particularemphasis on the registrant’s prospects for the future.
(emphasis added.) This requirement was reaffirmed in SEC Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements, Dec. 1999.
B. In Violation Of GAAP, Defendants Fraudulently ConcealedMorgan’s Exposure To The Significant Concentration OfCredit Risk Arising From The Proprietary Trade
1. Overview Of Exposure Claim Allegations
110. Under well-established, specific GAAP and SEC regulations, by no later than the
start of the Class Period, Defendants had an affirmative duty to disclose the $13.2 billion
exposure arising from Morgan’s Long Position. In particular, the substantial concentration of
credit risk arising from, and unique to, this specific trade required that Defendants disclose the
exposure in connection with Morgan’s Second Quarter 2007 financial results.
111. Morgan was fully aware that the Long Position constituted a significant
concentration of credit risk. Indeed, Morgan entered into the Proprietary Trade based on
Morgan’s belief that the subprime mortgage market would decline. Morgan used the Long
Position to finance that $200 million in annual premium payments on the Short Position.
112. As detailed below, market events that began no later than mid-2006 evidenced
increasing risk in the subprime mortgage markets – the risk that Morgan sought to profit from in
taking the Short Position. Through early 2007, market consensus, including the views of
Morgan’s own CDO analysts, formed that subprime-backed investments, particularly subprime
RMBSs and subprime RMBS-backed CDOs, constituted significant concentrations of credit
risks.
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113. In addition to market-wide, objective evidence of the concentration of credit risk
associated with Morgan’s Long Position, by no later than the filing of Morgan’s Form 10-Q for
Second Quarter, Defendants had determined that potential losses on the Long Position could
reach $3.5 billion under the assumptions Defendants’ had modeled As a result of this
determination, Defendant Cruz instructed her subordinates to “[c]ut the position.” Rather than
disclose the trade, however, Defendants concealed this known significant credit risk that
ultimately materialized as a $9.3 billion charge to earnings.
2. Well-Established GAAP Required DisclosureOf The Concentration Of Credit RiskArising From Morgan’s Proprietary Trade
114. FAS 107 and FASB Staff Position SOP 94-6-1 (“SOP 94-6-1”), Terms of Loan
Products That May Give Rise to a Concentration of Credit Risk, as well as Regulation S-K,
required Defendants to disclose the existence, extent, and nature of Morgan’s Long Position in
connection with Morgan’s Second Quarter public disclosures. The key language of those GAAP
provisions and Regulation S-K are summarized below, and their application to the facts alleged
herein is set forth in paragraphs 163 through 213.
(a) FAS 107 - Disclosures About Fair Valueof Financial Instruments
115. FAS 107 originally issued in December 1991, relates specifically to financial
instruments such as the CDOs that Morgan was exposed to by virtue of the Proprietary Trade.
Paragraph 15A of FAS 107, entitled “Disclosure about Concentrations of Credit Risk of All
Financial Instruments,” established Defendants’ duty to disclose the Proprietary Trade.
116. Paragraph 15A of FAS 107 states that “an entity shall disclose all significant
concentrations of credit risk arising from all financial instruments, whether from an individual
counterparty or groups of counterparties.” The AICPA Auditing and Accounting Guide for
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Brokers and Dealers In Securities states that “credit risk refers to potential losses arising from
the failure of another party to perform according to the terms of a contract (counterparty
default).”. (Sec. 6.17, May 17, 2007 ed.) Morgan defined “credit risk” in the same way in its
SEC filings during the Class Period.
117. Significant concentrations of credit risk are not assessed on a one-by-one creditor
basis. Rather, paragraph 15A explains that “[g]roup concentrations of credit risk exist if a
number of counterparties are engaged in similar activities and have similar economic
characteristics that would cause their ability to meet contractual obligations [with the credit
issuer] to be similarly affected by changes in economic or other conditions.”
118. A principal credit risk associated with Morgan’s Long Position was the risk that
the subprime mortgages underlying the RMBSs behind Morgan’s Long Position would default.
119. FAS 107 ¶15.a through ¶15.d required Morgan to include the following
information in the disclosure it should have made about significant concentrations of credit risk:
(a) Information about the (shared) activity, region, or economiccharacteristic that identifies the concentration;
(b) The maximum amount of loss due to credit risk that, based onthe gross fair value of the financial instrument, the entity wouldincur if parties to the financial instruments that make up theconcentration failed completely to perform according to the termsof the contracts and the collateral or other security, if any, for theamount due proved to be of no value to the entity;
(c) The entity’s policy of requiring collateral or other security tosupport financial instruments subject to credit risk, informationabout the entity’s access to that collateral or other security, and thenature and a brief description of the collateral or other securitysupporting those financial instruments;
(d) The entity’s policy of entering into master netting arrangementsto mitigate the credit risk of financial instruments, informationabout the arrangements for which the entity is a party, and a briefdescription of the terms of those arrangements, including the extent
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to which they would reduce the entity’s maximum amount of lossdue to credit risk.
(b) FASB Staff Position SOP 94-6-1, Terms of Loan ProductsThat May Give Rise to a Concentration of Credit Risk
120. FASB Staff Position SOP 94-6-1, issued on December 19, 2005, expressly
pertains to the application of FAS 107, providing guidance on the circumstances when “terms of
loan products give rise to a concentration of credit risk as that term is used in FAS 107 ¶15A.”
(Id. ¶7.) SOP 94-6-1, ¶7 states that “[t]he terms of certain loan products may increase a
reporting entity’s exposure to credit risk and thereby may result in a concentration of credit risk
as that term is used in FAS 107.” SOP 94-6-1 specifically identifies loan terms generally
associated with subprime loans – such as interest-only loans, negative amortizing loans, high
loan-to-value ratios, adjustable rate mortgages, below-market teaser rates, balloon payments, and
other payment deferment mechanisms – as sources of enhanced credit risk.
121. FAS 107 and SOP 94-6-1 together require entities that hold financial instruments
with significant exposure to subprime loans to disclose such concentrations of credit risk when,
objectively viewed, those concentrations are significant. The SEC, in its August 30, 2007
Comment Letter (see pp. 2-4 ), targeted Morgan’s subprime disclosures for lack of transparency
and requested further clarity from Morgan on its related holdings and risk concentrations.
(c) GAAP Duty to Disclose Subsequent Events
122. In addition to disclosures based on the events that occur during a company’s
pertinent quarter, in certain circumstances, GAAP and Generally Accepted Auditing Standards
(“GAAS”) obligate companies to base their SEC disclosures on certain events that occur after the
end of the issuer’s fiscal quarter but prior to the filing of the company’s financial statements with
the SEC.
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123. Auditing Standard Section 560, Subsequent Events, (“AU 560”), issued in
November 1972, provides guidance on events occurring “subsequent to the balance-sheet date,
but prior to the issuance of the financial statements.” AU 560 ¶1 also emphasizes the importance
of disclosing or adjusting for events that will “have a material effect on the financial statements.”
AU 560 ¶5 also states that:
[E]vents that provide evidence with respect to conditions that didnot exist at the date of the balance sheet being reported on butarose subsequent to that date . . . should not result in adjustment ofthe financial statements. Some of these events, however, may be of such a nature that disclosure of them is required to keep the financial statements from being misleading. Occasionally such anevent may be so significant that disclosure can best be made bysupplementing the historical financial statements with pro formafinancial data giving effect to the event as if it had occurred on thedate of the balance sheet.
(Emphasis added.)
124. Addressing an issuer duty to update issuer’s filings based on subsequent events,
FASB has stated:
[T]he SEC staff observed that Rules 1 0b-5 and 12b-20 under theSecurities Exchange Act of 1934 and General Instruction C(3) toForm 10-K specify that financial statements must not bemisleading as of the date they are filed with the Commission. Forexample, assume that a registrant widely distributes its financialstatements but, before filing them with the Commission, theregistrant or its auditor becomes aware of an event or transactionthat existed at the date of the financial statements that causes thosefinancial statements to be materially misleading. If a registrantdoes not amend those financial statements so that they are free ofmaterial misstatements or omissions when they are filed with the Commission, the registrant will be knowingly filing a false andmisleading document. In addition, registrants are reminded oftheir responsibility to, at a minimum, disclose subsequent events. . .
FASB, Emerging Issues Task Force (“EITF”) Topic D-86, Issuance of Financial Statements
(“EITF D-86”) (discussed Jan. 19-20, Sept. 7, 2006) (emphasis added and footnotes omitted).
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EITF D-86 has been interpreted to apply to Form 10-Qs to the same extent it applies to Form
10-Ks.
(d) SEC Regulation S-K
125. Item 303 of SEC Regulation S-K together with SEC Staff Accounting Bulletin
No. 101 required Defendants to disclose in the MD&A section of its quarterly filings “unusual
or infrequent transactions, known trends, or uncertainties that have had, or might reasonably be
expected to have, a[n] . . . unfavorable material effect on revenue, operating income or net
income and the relationship between revenue and the costs of the revenue.”
126. To determine if a transaction, known trend, or uncertainty must be included in the
MD&A, the SEC has stated that companies should determine whether a trend, demand,
commitment, event, or uncertainty is presently known to management, and whether it is
reasonably likely to have a material effect on the registrant’s financial condition or results of
operations.
3. Objective Evidence: The Long PositionConstituted a Significant Concentration of Credit Risk
127. While the Class Period begins on June 20, 2007, the day Morgan announced its
Second Quarter 2007 results, events beginning no later than mid-2006 evidenced the collapse of
the subprime-mortgage-related markets and the significant concentration of credit risk arising
from Morgan’s Long Position.
Housing Bubble Had Burst
128. By mid-2006, the biggest housing bubble in U.S. history had popped. For
example, indicative of reports being published in sources nationwide, on August 23, 2006,
MarketWatch wrote:
July was dry for the U.S. real estate market, as sales of existinghomes plunged 4.1 percent to a two-year low, prices stagnated and
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the number of homes on the market soared to a 13-year high,according to a report from the National Association of Realtorsreleased Wednesday.
The report shows a continued implosion in the housing market,with inventories up sharply while prices are softening. Sales aredown 11.4 percent in the past year . . . .
(“Existing-home sales plunge to a two-year low; Inventories of unsold homes rise to 13-year
High,” MarketWatch, Aug. 23, 2006.) Likewise, Barron’s reported that “the national median
price of new homes has dropped almost 3% since January. . . . Existing-home inventories are
39% higher than they were just one year ago. Meanwhile, sales are down more than 10%. . . .
By any traditional valuation, housing prices at the end of 2005 were 30% to 50% too high.”
(Lon Witter, “The No- Money Down Disaster, A Housing Crisis,” Barron’s, Aug. 21, 2006.)
129. In a December 15, 2006 analyst report, Morgan’s CDO analysts sarcastically
wrote that the “‘substantial cooling’ in U.S. housing, to quote Chairman Bernanke, is no longer a
matter of debate.” (Morgan Stanley, “2007 Outlook: A Tale of Two Markets,” CDO Market
Insights, Dec. 15, 2006.)
130. During the summer of 2006, for the first time in several decades, U.S. home
prices dropped, and continued dropping until the beginning of 2009.
Delinquency And Defaults Soar
131. Also by mid-2006, subprime mortgage lenders had loaned their way all the way
down the credit ladder, having made loans to successively less and less credit-worthy borrowers.
Industry participants observed the impact of the decreasing credit quality of each successive
year’s vintage of subprime mortgages. For instance, between the middle and end of 2006, the
rate of “first payment defaults” – the failure to make even the first mortgage payment – increased
ten-fold. By the end of 2006, three percent of all newly made U.S. subprime mortgages
defaulted immediately.
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132. As Figure 3 shows, sixty-day plus delinquencies in the subprime mortgages
backing RMBS were rising at alarming rates, especially among mortgages issued in 2006.
Figure 3: 60+ Day Delinquencies in US Subprime ABS
60+ Day Deli nquencies
8%_
7%-
6%-
4%-
3%-
2%- _ - --
196
2002 —2D(13 2004 — zoos 2oo60%
1 2 3 4 5 6 7 8 9 10 91 12 13 14 15 16 1T 18Loan Age (Months)
Source: Morgan Stanley, Moody's
Collapse Of Subprime Lending Precludes Subprime Loan Refinancing
133. Eighty percent of subprime loans originated in 2005 and 2006 were hybrid
adjustable rate mortgages (“ARMs”). As analysts predicted, many of those borrowers would be
unable to pay their mortgages when the teaser fixed rate reset to a much higher adjustable rates
after two years, and would need to refinance. However, nearly 40 percent of subprime borrowers
obtained loans in 2005 and 2006, when home prices were at their zenith, and were unable to
refinance when the rates reset. By then, their home values had dropped, and thus they could not
borrow additional amounts against their homes.
134. These events impacted the credit risk associated with Morgan’s Long Position
because it was backed by 2005 and 2006 vintage RMBS. By late 2006, the market understood
that both 2005 and 2006 subprime vintages would turn toxic when the interest rates reset in 2007
and 2008, and that institutions carrying investments would suffer. Indeed, 35 percent of the 2005
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loans were at least 60 days delinquent or in default within six months of resetting in 2007. The
2006 vintage, reflecting the highest percentage of the least credit-worthy borrowers of any
vintage, was toxic from the start. As stated above, no payment was ever made on 3 percent of
2006 subprime loans, and the delinquency rates for that vintage were significantly higher than
prior vintages. Without the ability to refinance, most of these borrowers were predicted to
default when their teaser interest rates increased after two years.
Collapse Of Subprime Mortgage Origination
135. When delinquencies and defaults began to skyrocket in early 2007, financial
institutions, such as Morgan, reacted by withdrawing credit lines they had previously granted to
subprime mortgage originators. Since the originators had relied on these credit lines to make
loans, the banks’ actions stopped new subprime lending and caused the collapse of over thirty
originators – including subprime giants Fremont General Corporation, Peoples Choice Home
Loan, and New Century – between January and June 2007.
136. For example, in mid-March, Citigroup withdrew $710 million in financing from
New Century Financial Corp., the second largest U.S. subprime lender. New Century
temporarily escaped bankruptcy because Morgan promised a $265 million credit line. However,
after additional due diligence into New Century’s loan portfolio and liabilities, Morgan’s
negotiations broke down and Morgan withdrew the line of credit. New Century filed for
bankruptcy in April, owing at least $8.5 billion to its creditor banks.
137. The rising defaults forced banks to set aside additional loan loss reserves. For
example, on February 7, 2007, HSBC, the world’s biggest bank and largest originator of 2006
vintage subprime mortgages, issued a huge wake-up call to the market when HSBC announced
that it was doubling its subprime loan loss reserves to $10.6 billion. Also in late February,
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Freddie Mac announced it would no longer buy the most risky types of subprime mortgages, a
signal that such mortgages were highly toxic.
February 2007 - Morgan Analysts to Investors:Subprime Meltdown Is Now Underway
138. On February 12, 2007, Morgan economist Richard Berner wrote that “[s]oaring
defaults signal that the long-awaited meltdown in subprime mortgage lending is now
underway . . .” (Richard Berner, “Will the Subprime Meltdown Trigger a Credit Crunch?,”
Morgan Stanley, Global Economic Forum, Feb. 12, 2007 (“Morgan February 12 Report”).)
Likewise, Morgan’s CDO market analysts were closely attuned to the increasing market turmoil
and credit risk. Morgan’s February 16, 2007 report identified market-wide developments that
further evidenced the significant risk of mezzanine ABS CDOs, including: (i) the “substantial
cooling in US housing,” (ii) “soaring defaults” in subprime mortgages, (iii) the “meltdown in
subprime mortgage lending,” and (iv) the collapse of the subprime mortgage origination
industry. (Morgan Stanley, “Subprime in Primetime,” CDO Market Watch, Feb. 16, 2007.)
139. Given the subprime meltdown underway, the Morgan analysts stated that it was
not “news that the evolution of collateral performance in recent vintage subprime ABS pools,
(particularly in the 2006 vintage) has been significantly worse” than prior vintages at comparable
points in loan age. These “recent vintage, sub-prime ABS pools,” including the 2006 vintage,
that were doing so poorly were the same vintages underlying Morgan’s Long Position.
140. By February 28, 2007, the ABX Index, which Defendants belatedly
acknowledged reflected the value of its Long Position, had dropped 11.5 percent in one month.
Morgan’s CDO analysts described the February drop in the ABX as a “massive meltdown,” and
cited as key reasons for the meltdown the collapse of numerous subprime loan originators, the
loan loss announcement by HSBC, and the increasing defaults in recent subprime vintages.
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Growing Consensus Regarding Massive and ImminentLosses On Subprime RMBS-backed Securities
141. During the first half of 2007, a growing number of analysts and academics added
to the growing consensus regarding the risk associated with subprime mortgages and related
investments like the undisclosed exposure to the CDO that Morgan held. For instance:
• February 18, 2007 – The New York Times, front page of the Business Section,reports that two noted analysts conclude that given the recent events in thesubprime mortgage market “it is only a matter of time before [the defaults inRMBS mortgage pools] accumulate to levels that will threaten ratedmezzanine RMBS,” and that “[g]iven the high proportion of CDO investmentsin mezzanine RMBS” “even investment grade rated CDOs will experiencesignificant losses.” The analyst also reported that RMBS and CDO creditratings had yet to incorporate these conclusions, were thus invalid, and wouldrequire downgrading.
• March 13, 2007 – Bloomberg quotes Mark Adelson, Head of StructuredFinance Research at Nomura Securities in New York, as saying “investorsneed to worry” about subprime deterioration affecting investment gradetranches. The “scenario where the BBBs all blow up is a reasonably possiblescenario” – meaning that it was reasonably possible that the BBB-ratedRMBS tranches could be wiped out, which would largely wipe out mezzanineABS CDOs (such as those backing the Long Position). (Caroline Sales &Darrell Hassler, “CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt(updated), Bloomberg.com , Mar. 13, 2007.)
• March 18, 2007 – Los Angeles Times reports that the BBB RMBS trancheswere on the verge of suffering actual principal losses and that CDO creditratings bore little relation to reality, according to Janet Tavakoli, a renownedstructured finance textbook author and consultant quoted in the article.
• March 28, 2007 – At the American Enterprise Institute’s conference titled“Mortgage Credit and Subprime Lending: Implications of a DeflatingBubble,” all four distinguished panelists agreed that mezzanine grade RMBStranches, particularly BBB– and lower tranches, would suffer significantlosses as subprime mortgage delinquencies increased, especially when theinterest rates on adjustable-rate mortgages from 2005 and 2006 started to resetin 2007 and 2008. (Tom Petrumo, Getting a Handle on CDOs is a ComplexChallenge, Los Angeles Times, Mar. 18, 2007.)
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Moody’s Identifies Downgrade Risk Of CDOs
142. As discussed above, the credit rating agency ratings on various CDO tranches had
nothing to do with the credit quality or underwriting standards associated with the underlying
subprime mortgages that made up the tranches. Instead, the ratings reflected the relative
superiority of the tranche’s right to cash flow. A AAA-rated tranche did not mean that it was
collateralized by loans that were of higher quality, less risky, or subject to more stringent
underwriting standards. It merely meant that the lower tranches all suffered losses before the
AAA tranche did.
143. On March 23, 2007, Moody’s published a report titled “The Impact of Subprime
Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A
Preliminary Review” (“Moody’s March 23 Report”) that measured the potential effects of
RMBS credit deterioration on CDOs. Moody’s concluded that for Mezzanine CDOs with above-
average exposure to subprime RMBS “the potential downgrade impact on the SF [ i.e., Structured
Finance] CDO Notes was severe – in some cases 10 or more notches.” A Moody’s “notch”
represents the difference between a plain letter rating (such as BBB) and its modifiers “plus” or
“minus” ( i.e., BBB versus BBB+). A ten notch downgrade moves an asset from the highest
rating, triple-A, all the way to BB+, which is below-investment grade. Thus, Moody’s was
saying that under the conditions applied by the tests, CDOs with high exposure to subprime
RMBS would shift from investment grade to junk status. (Moody’s March 23 Report, pp. 1-2).
Bear Stearns Asset Management Subprime CDO Hedge Funds Collapse
144. On June 17, 2007, two hedge funds managed by Bear Stearns Asset Management
(“BSAM”) collapsed. This collapse had serious implications for Morgan’s Long Position.
These BSAM funds, which had $45.6 billion in assets under management, were heavily invested
in subprime-backed securities that were similar to those backing Morgan’s Long Position. The
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precipitous decline in the credit value of subprime-backed instruments in the first half of 2007
led to the collapse of the BSAM funds. Concluding that the funds irreversibly were underwater,
the BSAM funds managers announced on June 5 that BSAM was barring client redemption
requests, an unmistakable signal to the public that the funds had collapsed. Indeed, they closed
on June 17.
June 22, 2007, Morgan CDO Analysts to Investors:“Downgrades Into ABS CDO Tranches Is Morea Matter of When and Not Whether”
145. In Morgan’s June 22, 2007 edition of CDO Market Insights, titled “CDO Ratings
Actions: Past, Present and Future,” (“Morgan June 22 Report”), Morgan’s primary CDO analysts
concluded “the exposure of ABS CDOs to the downgraded subprime RMBS is significant,
suggesting that a progression of these downgrades into ABS CDO tranches is more a matter of
when and not whether.” (Emphasis added.) This was consistent with the prior Morgan reports.
The Morgan June 22 Report reaffirmed a highly negative outlooks arising from objective market
events:
The outlook for 2006 vintage subprime securitization pools goingforward is not encouraging, with a number of factors aligningagainst the performance of subprime pools. These includeweakening HPA, rising interest rates and tightening underwritingstandards making it harder for subprime borrowers to refinancetheir existing loans as a way out for resolving credit problems.The continuing decline in 2006-2 and 2007-1 series of ABXindices suggests that the market implied outlook is consistent withthe above.
146. Pointing to the “significant pickup in [ratings] downgrades in subprime RMBS
transactions, particularly in the 2006 vintage collateral,” the Morgan June 22 Report concluded
that the downgrades resulted from the agencies long-overdue decision to implement a rating
methodology for subprime RMBS that more realistically reflected subprime RMBS’s poor credit
quality. The result was, on average, a four notch rating downgrade for RMBS tranches rated
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BBB+ (under S&P’s rating system) and Baa1 (under Moody’s rating system) or below. This
adjustment more accurately reflected the poor credit quality of the underlying loans by which
these RMBSs were backed.
147. According to the Morgan June 22 Report, the “key takeaway is that the
downgrade activity in 2006 vintage RMBS collateral underlying ABS CDOs is significant,
which we expect to result in downgrades in ABS CDO tranches.” That is, the downgrades in the
RMBSs would cause downgrades in the type of CDOs underlying the Long Position. The
Morgan analyst further observed that Moody’s analysis “illustrates the sensitivity of ABS CDO
tranche ratings to underlying subprime RMBS downgrades.” As the Morgan June 22 Report
explained, that “AAA tranches of 2006 vintage subprime RMBS have already been downgraded
does tarnish their ‘sanctity.’”
June 28, 2007, Morgan CDO Analysts to Investors:“an already poor picture in subprime pools is getting markedly worse”
148. Just six days later, in another report, the Morgan analysts exclaimed that
“[r]atings downgrades in ABS CDO tranches are inevitable and material – the shoe is still
waiting to drop.” ( CDO Market Insights, “Armageddon or Necessary Market Correction?”
(June 28, 2007) (emphasis added) (hereinafter “Morgan June 28 Report”).)
149. Clear in their outlook, the Morgan analysts wrote, “[w]e expect ABS CDOs to
remain under severe pressure, as neither fundamentals nor technicals are poised to improve.”
(Id. (emphasis added).) That is, both long-term value assessment metrics and short-term trading
pattern metrics would continue to decline.
150. The analysts wrote that the “large float of super senior risk in the market, and its
potential valuation implications across ABS CDO capital structures remain our biggest concern
now.” That is, there were more desirous sellers of super-senior CDO tranches than desirous
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buyers in the market, creating an estimated $50 to $60 billion in excess supply. This meant that
the value of super-senior CDO tranches was dropping and liquidity was drying up. Thus, not
only were the loss levels rising, but the market was pressing down on the top of the RMBS
capital structure, essentially eating away its value at both ends. Notably, Morgan’s obligation to
pay out over $13 billion on its CDS Long Position turned on the value of the super-senior CDO
tranches the Morgan analysts were discussing.
151. The Morgan analysts concluded that the 2006 vintage, which constituted much of
RMBS underlying the Long Position, would lose the most:
The continuing deterioration of subprime ABS collateral, reflectingpoor lending standards in 2006 and aggravated by flat to negativeHPA [ i.e., “home price appreciation”], suggests that losses in these pools will be significantly worse than any previous vintage. Thishas led to a second re-pricing in ABS, reflected in ABX price levels.
(Emphases added). The Morgan analysts described the losses projected to occur because of
decline in US home prices and poor subprime lending standards ( i.e., low credit quality of
borrowers) especially present in the 2006 vintage of subprime mortgages. These factors together
with the resetting of adjustable rate mortgages and the tightening of subprime lending standards
imposed after 2006 meant that cumulative losses on 2006 vintage loans were projected to be
worse than in prior vintages. Increased cumulative loan losses decreased cash flow, increasing
the likelihood that the mezzanine tranches of the RMBS would be wiped out. If that happened,
mezzanine ABS CDOs, such as those underlying Morgan’s Long Position, would suffer losses.
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152. Accentuating their points, Morgan’s analysts included the following graph
showing the “New Lows in ABX” which reflected the declines in ABS CDO values and
Morgan’s Long Position during Morgan’s Second Quarter:
New Lows in ABX
110 -
100
saj.,
ABX 06-180 -
—ABX 06-2
ASH 07.1
60
50
Jan-06 May-06 Sep-06 Jan-07 May-07
Source: Markit
153. As set forth in greater detail below in Section VII.B.5(a), the above facts
demonstrate that as of June 20, 2007, viewed objectively, Morgan’s Long Position was a
significant concentration of credit risk due to its size, its structure, and the worsening economic
conditions of 2007. Once again, however, this material information was lost on investors who
remained entirely in the dark that Morgan even had taken such a position.
4. Subjective Evidence: By the Outset of The Class Period,Defendants Knew that the Long PositionWas a Significant Concentration of Credit Risk
154. While the standard imposed under GAAP is an objective one, as detailed below,
the Individual Defendants personally knew of and attempted to quantify, measure, and conceal
the significant concentration of credit risk.
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Cruz “started to worry”
155. As events unfolded in the subprime-related market place, beginning in May 2007,
Defendant Zoe Cruz “started to worry” that the subprime mortgage market was primed for
disaster, according to the 2008 Cruz Article. Apart from the Proprietary Trade, Cruz
acknowledged that she began overseeing the unwinding of billions of dollars in mortgage-related
investments held by the ISG. Cruz also began informing certain Morgan clients that they should
avoid taking on mortgage-related positions in light of the subprime market’s impending collapse.
May 2007, Cruz Ordered Daula To Perform Stress Tests
156. Also in May 2007, in view of the market events, Cruz ordered Defendant Daula,
the Company’s CRO, to run “stress tests” on the subprime CDOs acquired by the PTG. Cruz
stated that the stress tests were designed to calculate the amount of money the Company would
lose based on various levels of deterioration within the mortgage market.
157. After an unexplained delay, in June, Daula ordered Howard Hubler, the Managing
Director of the PTG, to stress test the Short and Long Position based on the assumption that the
underlying, subprime loan pool cumulative losses reached ten percent. Previously, the PTG had
only stress tested at loss levels of six percent. But, by April 2007, Moody’s was reporting that
subprime cumulative loan pool losses on 2006 loans had reached 6-8 percent and were rising.
Hubler dragged his feet for ten days, before reporting the grim results. Whereas at six percent
the net result of the positions was a $1 billion gain, at ten percent the net result was a $2.7 billion
loss. (The Big Short, supra, p. 212.)
July 4, 2007 – $3.5 billion Stress Test; Cruz to Daula: “Cut the position”
158. On July 4, 2007, after conducting an additional round of stress tests on the Long
Position, Defendant Daula informed Defendant Cruz that Morgan could lose $3.5 billion on the
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Long Position. Having quantified the significant concentration of credit risk, Cruz directed
Daula and Neal Shear (Global Head of Fixed Income Trading and Sales):
“I don’t care what your view of probability is. Cut the position.”
Deutsche Bank to Morgan: “Dude, vou owe us one point two billion”
159. Also in early July, confirming Morgan’s own assessment of the significant
concentration of credit risk associated with the trade, Morgan received a call from Deutsche
Bank, one of the two primary counterparties on Morgan’s Long Position (Goldman Sachs was
the other, with approximately $4 billion worth). As Michael Lewis writes, the Deutsche Bank
CDO trader, Gregg Lippman, and his bosses called Hubler to tell Morgan that:
[T]he $4 billion in credit default swaps Hubler had sold DeutscheBank’s CDO desk six months earlier had moved in DeutscheBank’s favor. Could Morgan Stanley please wire $1.2 billion toDeutsche Bank by the end of the day? Or, as Lippman actually putit – according to someone who heard the exchange – Dude, youowe us one point two billion.
(The Big Short, p. 212).
160. Deutsche Bank told Morgan that the Long Position’s value had dropped
thirty percent, in line with the decline in the ABX Index. Morgan disagreed, claiming it had
dropped only five percent, meaning the position was valued at 95 (where par is 100).
161. According to The Big Short, Lippman, calling the bluff, offered to buy back the
CDOs at 70 percent of par, or sell Morgan more at 77 percent of par. If Morgan thought the
CDOs were really worth 95 percent of par, Morgan readily would have bought more from
Deutsche Bank at 77 percent of par, and, in turn, sold them for 95 percent of par for a riskless
profit. Morgan refused to buy more.
162. Morgan’s reaction to Lippman’s offer demonstrated in the purest market-based
terms that the managers of PTG understood no later than July 2007 that the Long Position’s
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value had dropped at least below 77 percent of par. Put differently, Defendants understood that
the Long Position, whose total notional value (including the part that Deutsche Bank held) was
roughly $13.2 billion, had lost at least $3.13 billion.
5. Second Quarter 2007 Results Fraudulently ConcealExposure To Significant Concentration of Risk
163. Despite all the forgoing objective evidence and Defendants’ personal knowledge
that the Long Position constituted a significant concentration of credit risk, in violation of GAAP
and Regulation S-K, Defendants fraudulently failed to disclose the existence, extent, or nature of
the Long Position in Morgan’s Form 10-Q for Second Quarter 2007, filed on July 10, 2007.
164. Following on record 2006 and First Quarter 2007 results, Defendants reported
record income from continuing operations of $2.6 billion for the three months ended May 31,
2007, which was an increase of 41 percent from the second quarter of 2006. Morgan also
reported record net revenues of $11.5 billion for its fiscal Second Quarter 2007, which was an
increase of 32 percent from the second quarter of 2006. The Company also reported record net
revenues of $7.4 billion for its ISG, which was a 39 percent increase over second quarter 2006,
and record pretax income in the amount of $3 billion.
(a) Defendants Fraudulently ViolatedFAS 107 ¶15A And SOP 94-6-1
165. The Long Position was a significant concentration of credit risk arising from a
group of financial instruments, within the meaning of FAS 107. SOP 94-6-1 identifies subprime
mortgages as financial instruments that may create a substantial concentration of credit risk, and
the collateral underlying the Long Position was subprime mortgages. Because the Long Position
was structured such that Morgan would have to pay out on the CDSs if the subprime collateral
experienced sufficient credit deterioration, Morgan held credit risk due to the Long Position.
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166. The credit risk was a significant concentration. Morgan’s potential loss exposure
of over $13 billion due to the Long Position was undoubtedly significant in monetary terms.
Indeed, the $7.8 billion in losses Defendants reported for Fourth Quarter 2007 resulted in
Morgan’s first-ever quarterly losses in company history, even though, as Mack reported during
the Fourth Quarter earnings call, “almost every other business at Morgan Stanley continued to
perform exceptionally well th[at] quarter.”
167. Defendants knew the Long Position was a significant concentration of credit risk
when viewed objectively given its structure and the economic events of the first half of 2007, as
discussed above and articulated by Morgan’s own analysts. By July 2007, Defendants and the
market understood that subprime RMBS-backed mezzanine CDOs – especially ones like the
Long Position that were backed by 2005 and 2006 mortgage vintages – presented a grave risk of
credit downgrades and significant losses. This is because, inter alia, by April 2007, Moody’s
was predicting cumulative subprime pool losses of 6 to 8 percent for 2006 mortgages, the top
end of which, if reached, would inflict serious losses on Long Position. Moreover, given that
subprime RMBS pool loss expectations had been rising all spring 2007 in conjunction with rising
delinquency and default rates, no later than July 10, when Defendants filed Morgan’s Form 10-Q
for Second Quarter, it was clear that the Long Position was a significant concentration of credit
risk that GAAP required be disclosed. In mid-July, S&P predicted cumulative mortgage loss
rates on 2006 vintage RMBS pools would rise to 11 to 14 percent, an amount that promised to
destroy the value of the Long Position.
168. Moreover, Defendants’ own actions demonstrated they understood the Long
Position was a significant concentration of credit risk. Defendants purposely shorted the
subprime market. Although they put on the Long Position because they initially did not think the
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subprime market implosion would devalue CDO super-senior tranches, by July 10 they certainly
understood that circumstances had deteriorated dramatically. Cruz has acknowledged that she
became “worried” about the Long Position in May, ordered it to be stress tested, and then
ordered the position to be cut, all before July 10. In June, Daula stress-tested the position and
determined Morgan might lose $3.5 billion on it if cumulative subprime RMBS pool losses rose
to ten percent. He told Cruz this very fact on July 4 according to Cruz’s own account. Such
actions and knowledge are consistent with the belief that the Long Position is a significant
concentration of credit risk.
169. Additionally, in early July, Deutsche Bank told Hubler and his bosses at Morgan
that the Long Position had declined in value by 30 percent, that Morgan owed it $1.2 billion.
Morgan tacitly agreed with that valuation by not buying more from Deutsche Bank at 77.
170. Notwithstanding the above, in Morgan’s Form 10-Q for Second Quarter 2007, in
violation of GAAP, Defendants fraudulently concealed the existence of the $13.2 billion Long
Position.
171. As discussed in Section VII.B.2(c), GAAP required Defendants to include
information in Morgan’s financial statements based upon material events that occur subsequent
to the end of the quarter but prior to the reporting date. Given the magnitude of the Long
Position, events causing substantial changes in its value were material subsequent events, and
should have been factored into Morgan’s Form 10-Q for Second Quarter 2007.
172. Because disclosure under FAS 107 ¶15A was required, that section required
Defendants to disclose, inter alia:
(a) That the “maximum amount of loss” in the event of a 100 percent loss on
the Long Position between January and November 2007 was at least $13.2 billion. This
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maximum amount is what Morgan eventually revealed to investors as “Net Exposure” in the
November 7, 2007 chart that accompanied Morgan’s press release, see, infra, Figure 5,0 and
similar charts that appear in all of Morgan’s quarterly and annual filings through 2008;
(b) That the economic characteristics of the concentration from Morgan’s
Long Position was subprime RMBS from 2005 and 2006;
(c) That because Morgan was essentially acting as an insurer of
counterparties’ credit risk, the counterparties did not need to post any collateral; and
(d) That there was no mitigation or hedging mechanisms used in connection
with the Long Position because Morgan was using the Long Position to finance its $2 billion
Short Position.
173. Of course, Morgan did not disclose any of the above required information until
November 7, 2007. Morgan’s failure to do so constituted a fraudulent omission in violation of
the securities laws and rendered several statements made during the Class Period materially false
and misleading as discussed herein. Significantly, Defendants’ November 7 disclosure complied
with the above content guidelines, showing that Defendants knew how to comply with FAS 107,
but chose not to do so.
(b) Defendants Fraudulently Violated Regulation S-K
174. Defendants’ failure to disclose the Long Position in Morgan’s Second Quarter
Form 10-Q also violated Regulation S-K because the Long Position was precisely the type of
“unusual” transaction, and the subprime meltdown that happened in the first half of 2007 was
precisely the type of “material” and “unusual event” and “significant economic change” that
“had, or . . . reasonably [was] expected to have, a[n] . . . unfavorable material effect on revenue”
that must be disclosed in MD&A.
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175. By July 4 at the latest, Defendants knew that the Long Position was reasonably
expected to have an unfavorable material effect on revenue because Daula’s stress testing
predicted up to a $3.5 billion loss if subprime pool loss estimates reached 10 percent, and a loss
of even a quarter of that magnitude was material in the context of a company that had income of
$11 billion the prior year.
176. In sum, Morgan was required to make the disclosures required by Item 303 of
Regulation S-K and related guidance. However, the MD&A section of Morgan’s SEC filings
during the Class Period failed to comply with SEC regulations because: (1) Defendants failed to
disclose the existence and extent of Morgan’s Long Position; (2) Defendants did not timely
disclose in Morgan’s Second or Third Quarter filings that it had suffered material losses on its
Long Position; and (3) Defendants did not disclose the likelihood that Morgan would have
significant future losses from the Long Position due to then-current and predicted economic
conditions and market illiquidity.
6. Third Quarter 2007: Defendants Continue ToFraudulently Conceal Morgan’s Long Position
177. Following Defendants’ fraudulent disclosures relating to Second Quarter 2007,
the subprime related markets only got worse, and the duty to disclose created by GAAP and
Regulation S-K only became even more obvious to Defendants. Rather than disclose the truth in
Morgan’s Third Quarter Form 10-Q, Defendants continued to defraud investors.
Market Events Prior To Morgan’s Third Quarter DisclosuresFurther Evidence The Significant Concentration Of Credit Risk
178. Between July 10 and October 10, when Morgan filed its Form 10-Q for Third
Quarter, the subprime-backed CDO market completely imploded, and the ABX Index dropped
from 84 to 60 percent of par. In July, S&P predicted that cumulative subprime loan pool losses
would be between 11 and 14 percent.
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July 16, 2007, Morgan’s CDO Analysts To Investors:“outlook for RMBS, particularly 2006 vintage, remains poor”
179. Published only a week after Morgan issued its Form 10-Q for Second Quarter
2007, Morgan’s CDO analysts issued a report titled Ratings Actions: Something Had to Give
(“Morgan July 16 Report”), concluding that more rating down-grades were imminent:
[T]he rating agencies are finally catching up to what the underlyingasset markets have been saying for some time, rating agencyactions carry significant implications, as we have highlighted inthis report. We think the outlook for RMBS, particularly 2006vintage, remains poor, thus, we expect more ratings actions tofollow in the underlying subprime RMBS, as well as ABS CDOs.Stay tuned.
(Morgan July 16 Report, p. 7 (emphasis added).)
180. The July 16 Report described the dynamic, set in motion at least eight months
prior, that would wipe out the $13.2 billion Long Position by year’s end. The analysts explained
that the “[t]iny equity slices on ABS CDOs, and the corresponding lower attachments [ i.e.
starting point] in rated tranches, mean small changes in expected losses can quickly cause
“investment grade” tranches to be underwater.” (Id. at p. 5.) “The thin subordination levels for
the[se] tranches leave little margin for error.” (Id.) The report concluded that:
The cumulative losses in subprime pools in this period could be inthe range of 11-14% . . . We think this implies that in typical sub-prime RMBS deals, the entire BBB stack could be wiped out, andwrite-downs may even bleed into parts of the A stack.
The implications for mezzanine ABS CDOs of the suggested rangeof possible ultimate cumulative losses are profound. Significantpotential exists for write-downs of rated tranches.
(Id. at p. 4 (emphases added).) The CDOs underlying the Long Position were comprised mostly
of these “BBB stacks” of RMBSs. When those mezzanine RMBS tranches were wiped out, the
super-senior tranches of the CDOs underlying the Long Position would become worthless.
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181. The Morgan July 16 Report further observed that CDO tranches were losing value
due to the market’s realization that nationwide performance of subprime loans of similar
vintages were highly correlated, and therefore so too was the performance of lower and higher-
rated RMBS-backed CDO tranches. Morgan’s analysts wrote:
[I]f the behavior of the TABX tranches is any indication of theextent of correlation in mezzanine ABS CDO portfolios, we thinkthe correlation is fairly high. [ . . . ]
The ABS CDO market storm is not just a story of weakeningsubprime collateral – it is also a tale of a massive repricing of the implied correlation of this collateral, which has applied a lethalblow to senior risk in ABS CDOs. . . . [T]he market implies highercorrelation than rating agencies have assumed and shifted more risk up the capital structure. . . . While certainly much lessdiversified than a typical ABS CDO, the convergence trancheprices [in TABX CDOs] illustrates the market’s perception ofcorrelation perfectly: if one goes, they all go.
(Id. at p. 6 (emphases added).) Morgan’s analysts were saying that the widespread subprime
meltdown created high correlations in the movement of differently-rated RMBS and CDO
tranche values: Because the meltdown was so severe, when the low-rated ones collapsed, the
higher-rated ones did too.
182. As detailed above, by mid-July, in addition to the above observable objective
evidence, Defendants actually knew that the Long Position had been impaired because the ABX
had dropped so significantly.
Further Rating Downgrades
183. Between May and July 16, 2007, there were a 1,342 downgrades of subprime
RMBSs (compared with just 36 downgrades in all of 2006). Over 86 percent of the downgraded
tranches were previously rated BBB+ or below. Those were the tranches that made up, on
average, 67 to 77 percent of mezzanine ABS CDOs like those underlying Morgan’s Long
Position. In other words, the vast majority of 2006 vintage RMBS tranches had been
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downgraded from, at most, BBB+ to BB, which was below investment grade. These
downgraded 2006 vintage RMBS tranches made up much of the CDOs underlying the Long
Position.
Morgan Assembles “Super Task Force” toReduce the Subprime Exposure
184. When interviewed, CW 4, a senior level employee within the Company’s Fixed
Income division, stated that during the summer of 2007, Anthony Tufariello, the Global Head of
the Securitized Products Group, and immediate supervisor of Howard Hubler, convened a
meeting of forty to fifty key, senior employees in the Fixed Income Division. Tufariello told the
meeting participants that the meeting was convened at the explicit direction of Zoe Cruz.
According to CW 4, Tufariello informed the meeting participants, whom he referred to
collectively as a “super task force,” that Morgan had a “large position” with exposure to the
subprime mortgage market, and that there was a need to develop “creative strategies” to sell the
“assets at risk.” CW 4 recalled that during the meeting, the discussion of the assets at risk
included references to CDSs, super-senior CDO tranches, and subprime mortgages.
185. According to CW 4, shortly after this meeting, a senior member of the Company’s
structuring and modeling group instructed Michael Jensen, a trader who worked in the PTG, to
meet with fixed income securities analysts to assess the PTG’s subprime positions. Specifically,
CW 4 believes the individuals were tasked with determining the “range of how bad things could
get.” CW 4 was told that this weeklong assessment of the potential downside risk to the
Company was prepared for Defendants Cruz and Mack as part of a larger report analyzing the
PTG’s positions.
186. All Defendants were involved in these meetings and events because of the
enormity of Morgan’s subprime exposure, particularly as a result of the Long Position, and the
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role each Defendant played in the company. CW 4 states that Mack and Cruz were involved; as
CFO and “shadow” CFO of the company and the executives charged with financial oversight of
the PTG, Sidwell and Kelleher, respectively, were involved; as CRO, Daula was involved
because the meetings and work were all about risk assessment and mitigation.
187. The “all-hands-on-deck” nature of the meetings and work described by CW 4
shows that all Defendants were extremely concerned about Morgan’s subprime exposure
situation. Defendants’ extreme concern shows that Defendants knew at this time that the Long
Position was a significant concentration of credit risk.
August 30, 2007 SEC Letter Requesting Additional Disclosure
188. In view of the market turmoil, the SEC observed Morgan’s lack of disclosure on
subprime exposure in its financial statements. Consistent with Morgan’s disclosure obligations
under GAAP and Regulation S-K, in an August 30, 2007 letter from John Hartz, SEC Senior
Assistant Chief Accountant, to David Sidwell (the “August 30 SEC Letter”), the SEC stated that
Morgan’s public disclosures had failed to provide key information to investors regarding the
Company’s subprime-related positions:
We note from the disclosures on page 4, 127 and 162 that youoriginate, trade, make markets and take proprietary positions in,and act as principal with respect to, mortgage related and realestate loan products. We further note on page 4 that in December2006 you acquired Saxon Capital, Inc., a servicer and originator ofsubprime residential mortgage loans. We also note that youprovide financing to customers for residential real estate loanproducts. It is unclear from your document the exposure you have to subprime loans.
* * *
Based on your current public disclosures, it is possible that moreclarity about your exposure to any subprime loans could behelpful. Regardless of the materiality of your exposure, werespectfully request that you provide us with supplemental information about your involvement in sub-prime loans.
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189. Specifically, the SEC requested that the Company quantify “the principal amount
and nature of any retained securitized interests in subprime residential mortgages,” its
“investments in any securities backed by subprime mortgages,” “current delinquencies in
retained securitized subprime residential mortgages,” and “any write-offs/impairments related to
retained interests in subprime residential mortgages.”
190. The August 30 SEC Letter requested that Defendants provide this information “as
of the end of [Morgan’s] last full fiscal year and as of the most recent date practicable.” Thus,
the SEC was requesting this information as of November 30, 2006 and May 31, 2007. But
Morgan ignored this request even for purposes of Third Quarter 2007, which ended the following
day, on August 31, 2007.
191. Despite the explicit instructions from the SEC and the significant concentration of
credit risk Morgan faced on its Long Position during its Third Quarter, Defendants still did not
disclose Long Position in the Company’s Form 10-Q filed on October 10, 2007.
7. During Morgan’s Third Quarter, Defendants Fraudulently ConcealedThe True Exposure Arising From The Long Position
192. For the same reasons stated in Section VII.B.5 that Defendants were required by
GAAP to disclose the Long Position in Morgan’s Second Quarter disclosures, Defendants were
required to do so in Morgan’s Third Quarter For 10-Q. The convening of the 40 to 50 person
“super task force” of key, senior personnel from the Fixed Income division demonstrates that
Defendants were extremely concerned about the incurred and imminent losses resulting from
Morgan’s subprime exposure, including the Long Position. This extreme concern shows that
Defendants understood that the Long Position was a significant concentration of credit risk, and
that Defendants failure to disclose the Long Position in violation of their known duty to comply
with GAAP and Regulation S-K only could occur intentionally or recklessly.
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193. Additionally, the SEC’s letter, the across-the-boards ratings downgrades of
subprime RMBSs, the continued demise of the subprime-backed CDO and the CDS markets, and
the deep drop in the ABX Index reinforced that the Long Position was significant concentration
of the credit risk, and Defendants’ knowledge of the securities law violations they were
committing by failing to disclose the Long Position. The SEC’s letter explicitly was phrased in
terms of satisfying FAS 107 ¶15A and Regulation S-K, clearly demonstrating that Defendants
had a duty to disclose Morgan’s subprime exposure. Instead of complying with GAAP and
Regulation S-K, Defendants continued fraudulently to conceal from investors and the SEC the
existence, size, nature, and value of the Long Position.
8. Fourth Quarter: Defendants Continue to Fraudulently Conceal TheTrue Exposure Arising From The Long Position
194. Notwithstanding the worsening economic conditions and rising losses on the
Long Position, Defendants failed to make the requisite disclosures (by restating prior Forms
10-Q or through a Form 8-K) between October 10 and November 7. During that period,
cumulative loan pool loses and subprime delinquency rate projections continued to rise to
alarming levels. For example, in October, as S&P had done earlier that year, Fitch raised its
estimation of subprime pool losses to 10 percent for 2006 vintages and 9.4 percent for all
subprime mortgages.
195. Likewise, during October and November 2007, the ABX Index dropped to all
time lows. By November 6, the ABX Index was 58 percent off par. By October 31, if marked to
market using only the ABX Index, cumulative year-to-date losses on Morgan’s $13.2 billion
Long Position totaled $7.5 billion. Yet, until November 7, Defendants fraudulently concealed
from investors the very existence of the Long Position.
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9. Disclosures Regarding Market RiskWere Materiallv Incomplete
196. In their disclosures regarding Morgan’s Second and Third Quarter 2007 financial
results, Defendants provided investors various information and data about the Company’s trading
risk. Yet, having chosen to speak at length on Morgan’s trading risk, Defendants failed to
disclose the single largest risk facing the Company – the precipitous impairment of its
$13.2 billion Long Position.
197. In the Forms 10-Q that Morgan filed for Second Quarter and Third Quarter 2007,
under Item 3 (“Quantitative and Qualitative Disclosures About Market Risk”), Defendants
provided information and data about the Company’s market risk and credit risk. In the section
on credit risk, Defendants purported to disclose Morgan’s credit exposure to derivatives. But
nowhere did Defendants specifically disclose the Company’s $13.2 billion credit exposure to the
Long Position.
198. In the disclosures of market risk, for example, Defendants provided an analysis of
Morgan’s “value at risk” (“VaR”), which purportedly measures the potential loss in the value of
Morgan’s trading portfolio. In particular, daily VaR is meant to provide an indication of how
much money a firm might lose in a single day. VaR is a widely used tool for risk assessment,
especially in financial services firms, and executives and investors alike rely on it as a
measurement of a firm’s trading risk. The New York Times Magazine, in an article issued on
January 2, 2009, titled “Risk Management,” explained the use of VaR as follows:
Another reason VaR is so appealing is that it can measure bothindividual risks – the amount of risk contained in a single trader’sportfolio, for instance – and firmwide risk, which it does bycombining the VaRs of a given firm’s trading desks and coming upwith a net number. Top executives usually know their firm’s dailyVaR within minutes of the market’s close.
(Emphasis added.)
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199. In the Forms 10-Q filed for Second Quarter and Third Quarter 2007, Defendants
chose to disclose this quantitative measurement of Morgan’s trading risk. Under GAAP and
Regulation S-K, Defendants were required also to disclose the fact that the Company’s trading
portfolio was imperiled by a single $13.2 billion trading position that had declined in value by
$300 million in Second Quarter 2007 and $4.4 billion in Third Quarter 2007. This fact was
meaningful information that investors needed to know about Morgan’s trading risk, and it was
materially misleading to withhold it from investors.
C. Defendants Violated GAAP In Valuing The Long Position
200. In addition to failing to disclose the Long Position during the Class Period,
Defendants, in violation of GAAP, also fraudulently misstated the losses resulting from the Long
Position in disclosures pertaining to Morgan’s Third and Fourth Quarter 2007.
1. FAS 157 Required Defendants To UseLevel 2 Inputs To Value the Long Position
201. On December 1, 2006, the first day of Morgan’s 2007 fiscal year, Morgan
adopted FAS 157, Fair Value Measurements. FAS 157 was issued by FASB in September 2006
to increase consistency and comparability in fair value measurements. FAS 157 defines “fair
value” as “the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants,” other than in a forced or liquidation sale.
202. FAS 157 established a framework, referred to as the “fair value hierarchy,” that
Morgan claimed to use to measure the “fair value” of its trading positions, including the CDS
positions held by the PTG. The hierarchy categorizes types of valuation metrics, or “inputs” in
accounting terms, into Levels 1, 2, and 3. Generally, as one moves from Level 1 to 2 to 3, one
moves from using “observable” inputs to using “unobservable” inputs, from valuations that can
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be determined by looking to an exchange to valuations requiring more estimation and judgment.
Morgan described its hierarchy in its Form 10-Q for First Quarter 2007 as follows:
• Level 1 inputs utilize quoted prices (unadjusted) in activemarkets for identical assets or liabilities that the Company has theability to access. Financial assets and liabilities utilizing Level 1inputs include active exchange-traded equity securities, listedderivatives, most U.S. Government and agency securities, andcertain other sovereign government obligations.
• Level 2 inputs utilize inputs other than quoted pricesincluded in Level 1 that are observable for the asset or liability,either directly or indirectly. Level 2 inputs include quoted pricesfor similar assets and liabilities in active markets, and inputs otherthan quoted prices that are observable for the asset or liability, suchas interest rates and yield curves that are observable at commonlyquoted intervals. Financial assets and liabilities utilizing Level 2inputs include restricted stock, infrequently-traded corporate andmunicipal bonds, most over-the-counter derivatives and certainmortgage loans.
• Level 3 inputs are unobservable inputs for the asset orliability, and include situations where there is little, if any, marketactivity for the asset or liability. Financial assets and liabilitiesutilizing Level 3 inputs include real estate funds, private equityinvestments, certain commercial mortgage whole loans andcomplex derivatives, including certain foreign exchange optionsand long dated options on gas and power.
203. Morgan explained that when the inputs to value an asset or liability:
fall into different levels of the fair value hierarchy . . . the level inthe fair value hierarchy within which the fair value measurement inits entirety falls has been determined based on the lowest levelinput that is significant to the fair value measurement in itsentirety.
Importantly, FAS No. 157 requires maximizing the use of observable inputs to value assets and
liabilities and minimizing the use of unobservable inputs by requiring that the most observable
inputs be used when they are available.
204. Pursuant to FAS 115, Accounting for Investments in Certain Debt and Equity
Securities (“FAS 115”), securities that are bought and held principally for the purpose of being
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sold in the near term are to be classified as “trading securities.” GAAP requires such trading
securities to be carried at fair value in the statement of financial condition and all mark-to-market
(unrealized) gains and losses on trading securities be recognized in the current period’s income
statement. “Fair value” has the same meaning in FAS 115 as in FAS 157. FAS 157 states that
determining “fair value is a market-based measurement, not an entity-specific measurement.
Therefore, a fair value measurement should be determined based on the assumptions that market
participants would use in pricing the asset or liability.” In other words, fair value is best
evidenced by an “exit price,” meaning the price Morgan could expect to receive if it were to
enter into a transaction on the measurement date. (See FAS 157, ¶7.)
205. Other than certain subprime positions not at issue here that were owned by the
Company’s subsidiary banks, the majority of Morgan’s subprime positions were identified in
SEC filings as “trading positions.” Morgan reported changes in the fair value of its trading
securities as a component of its reported revenue.
2. Defendants Fraudulently Did Not Apply the ABXIndex, a Level 2 Input, In Valuing the Long Positions
206. As stated in Section VI.D.4, Defendants belatedly acknowledged that the Long
Position could be valued based on the ABX Index. Because the ABX Index was a Level 2 input
and was the most appropriate, observable input available, and because Morgan claimed to use
fair value and mark-to-market accounting, FAS 157 required Morgan to maximize use of the
ABX Index over the use of Level 3, unobservable inputs in valuing its CDS position throughout
2007. Instead of complying with Morgan’s reporting obligations and FAS 157, however,
Morgan improperly valued the Long Position based on unobservable Level 3 inputs.
207. From trading at par value in December 2006, when Morgan established its long
CDS position, the ABX Index cumulatively was down 33 percent by the end of Morgan’s Third
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Quarter (August 31, 2007), down 58 percent by October 31 (the reporting date used in Morgan’s
8-K), and down 66 percent by the end of Morgan’s Fourth Quarter (November 30, 2007). This
means that during Morgan’s Third Quarter, the ABX Index dropped 32.8 percent, between
September 1 and October 31 it dropped 32.2 percent, and between November 1 and November
30, it dropped another 23.8 percent.
(a) Write-Down For First And Second Quarter 2007
208. As previously stated, by the end of Second Quarter 2007, Defendants secretly had
written down the Long Position by $300 million. (This fact was not disclosed to investors until
November 7, 2007.) Thus, by the end of Morgan’s Second Quarter, the Long Position
purportedly had been marked to market and valued at $13.2 billion.
(b) Third Quarter 2007 Disclosures Were Fraudulent
209. During Morgan’s 2007 Third Quarter (June 1 through August 31, 2007), when the
ABX Index dropped by 32.8 percent, Defendants belatedly disclosed only a 14.4 percent write-
down on its Long Position. Because the Long Position’s notional value was $13.2 billion, a
32.8 percent decrease in value would equate to a loss of $4.4 billion. However, Morgan
fraudulently recognized only a $1.9 billion loss on the Long Position for Third Quarter. Had
Defendants not fraudulently valued Morgan’s Long Position, the write-down for Third Quarter
2007 would have been $2.5 billion greater.
210. Defendants ignored the ABX Index, fraudulently claimed to apply unobservable
Level 3 inputs instead, and wrote down the Long Position only as much as was needed to
“manage earnings” such that Morgan met the low end of analysts’ earnings expectations for
Third Quarter. According to Businessweek.com, the consensus earnings estimate based on
fifteen analysts was $1.54 per share, with the high end of the range at $1.86 and the low end at
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$1.38. In a too-good-to-be-true manner, by marking down its subprime losses by only
$1.9 billion, the Company was able to report earnings per share of exactly $1.3 8.
(c) Fourth Quarter 2007 Disclosures Were Fraudulent
211. To attempt to conceal their fraud, Defendants reported manipulated losses on the
Long Position for Fourth Quarter 2007. In the Form 8-K issued on November 7, Defendants
reported that between September 1 and October 31, 2007, the Long Position decreased in value
by $3.4 billion. On December 19, 2007, Defendants reported that between November 1 and
November 30, 2007, the Long Position lost an additional $3.7 billion. The write-down of $3.7
billion, which amounted to 44.6 percent of the Long Position remaining market value, was more
than twice the write-down indicated by the ABX Index, which fell only 23.3 percent during
November 2007. Defendants took greater losses than those indicated by the ABX decline during
this period because they had to “catch up” on losses that they had under-reported in Morgan’s
Third Quarter 2007 financials before filing their 2007 Form 10-K, which would have been
thoroughly scrutinized by Morgan’s auditors.
212. For the entire Fourth Quarter, Defendants reported that the Long Position lost
$7.1 billion ($3.4 bn + $3.7 bn). This loss would mean that during that period, the ABX Index
had dropped 62.3 percent. However, during that period, the ABX Index actually dropped only
roughly 50 percent. That is, Defendants recorded a greater loss for Fourth Quarter than the ABX
Index’s decline otherwise indicated. See Figure 4 below.
213. This apparent inconsistency is explained by Defendants’ fraud. Defendants over-
stated the write-down for November in their attempt to conceal the prior fraudulently understated
valuation of the losses to the Long Position during Third Quarter. Defendants claimed Morgan
had only suffered a $1.9 billion loss on the position during Morgan’s Third Quarter. This
allowed Defendants just barely to meet earnings expectations for Third Quarter. However,
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unbeknownst to investors, in reality, the Third Quarter loss should have been $4.4 billion. That
is, a willing buyer would have only paid $8.8 billion ($13.2 - $4.4) for the Long Position, not
$11.3 ($13.2 - $1.9). To make up for this under-reporting, Defendants over-reported the loss
incurred in November in an attempt to conceal their fraud. Instead of coming clean and restating
Third Quarter earnings, they chose to add most of the unreported losses from Third Quarter on to
the actual losses incurred during Fourth Quarter. As such, Defendants fraudulently violated
GAAP and misstated Morgan’s financials during Morgan’s Third and Fourth Quarter 2007.
Figure 4: Comparison of ABX Index to Defendants’ Write-Downs
Reporting Period Quarter over Loss onQuarter percent Long Position
Decline ofABX.BBB.06-1
3Q 2007 32.8% $1.9 billion: 14.4% write-down on$13.2 billion notional value
November 2007 23.3% $3.7 billion: 44.6% write-down on
(equivalent to a $13.2 billion notional value*
$1.4 billion loss on theLong Position )
4Q 2007 50% $7.1 billion: 62.3% write-down on$13.2 billion notional value*
3Q + 4Q 2007 65.1% 68.2%
*Calculations for November 2007 and Fourth Quarter 2007 account for the $1.9 billion write-down on the notional value of $13.2 billion.
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VIII. DEFENDANTS’ MATERIALLY FALSE ANDMISLEADING STATEMENTS AND OMISSIONS
A. Pre-Class Period Statements In First Quarter 2007 –Morgan Reports A Blockbuster Beginning To Fiscal 2007
214. Morgan entered into the Second Quarter 2007 (March through May 2007)
reporting “record results across the board.” These results included record revenues, net income,
and EPS for First Quarter 2007, which largely had outperformed expectations owing to what
Defendants described as “disciplined and balanced” increased risk taking and strong trading
performance. Defendant Sidwell reported $3 billion in profit attributable to net revenues of $7.6
billion by the ISG and that fixed income sales and trading had contributed $3.6 billion in
revenues, which he stated was the Company’s best quarter ever and in large part due to results
from Morgan’s credit products area and “favorable positioning in the subprime mortgage
markets” from an increase in securitized products.
215. Prior to the start of the Class Period, at the time that the U.S. subprime mortgage
loan market was collapsing, Defendants presented Morgan as resistant to the growing crisis.
Morgan reported record profits from Defendants’ self-described well-balanced risks. While
reporting earnings for First Quarter 2007, Defendant Sidwell acknowledged that subprime had
been a key focus in the market during early March 2007, and he stated that the Company
managed its risk through a variety of hedging strategies and proprietary risk positions that had
significantly contributed to Morgan’s record results. Defendant Sidwell further reported that the
Company had decreased risk exposure during the latter part of the First Quarter 2007 to balance
Morgan’s level of risk to comport with Defendants’ view of potential market changes. In
response to analysts’ questions, Sidwell acknowledged that Morgan’s acquisition of Saxon and
increased participation in mortgage origination had provided key insights into understanding
where investment opportunities were and where the markets were heading.
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216. As a result of Morgan’s positive statements in the face of a deteriorating subprime
market, analysts viewed Morgan favorably. For example, on April 11, 2007, Deutsche Bank
initiated coverage on Morgan with a “Buy” rating and a 12-month price target of $101 per share.
Based on the Company’s self-proclaimed positive outlook, Deutsche Bank noted that Morgan
had taken more risk with trading and principal investments, while also stating that the Company
was not “betting the bank” with its investments. The Deutsche Bank analysts reported that
Morgan was “hedged properly” in the face of difficulties in the subprime segment in February
2007. The analysts further stated that Morgan’s higher level of risk needed to be monitored and
emphasized that the Company’s CEO had focused on “taking additional risk when there is a
reasonable return.”
217. One month later, on May 10, 2007, Deutsche Bank issued another research report
following its analysts’ meeting with Mack on that day. Reiterating its “Buy” rating on Morgan,
Deutsche Bank reported that factors driving the Company’s growth included “better capital
allocation/optimization of the balance sheet” as mandated by the CFO, and “more principal
activity” with a “gradual[] increase” in the amount of trading risk.
B. Defendants Fail to Disclose Morgan’sSubprime Risk Exposures In Second Quarter 2007
1. June 20, 2007 Disclosures
218. At the beginning of the Class Period, on June 20, 2007, Morgan issued a press
release and reported its financial results for Second Quarter 2007 (March through May 2007).
Defendants reported record income from continuing operations of $2.6 billion for the three
months ended May 31, 2007, which was an increase of 41 percent from the second quarter of
2006. Morgan also reported that fixed income sales and trading revenues increased 34 percent to
$2.9 billion, which the earnings release touted was “the second-best quarter ever in this
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business.” The Company attributed increases in income from fixed income sales and trading to
strong results from credit products, with trading revenues driven by corporate credit and
structured products, although it reported “lower securitized products revenues, primarily in
residential mortgage securities.” Morgan reported an EPS of $2.45 for the quarter, which met
the higher end of analysts’ expectations.
219. In the June 20, 2007 earnings release, Defendant Mack stated that “Morgan
Stanley delivered record revenues and earnings in the second quarter and first half of the year”
and he further emphasized that the Company was well on its way to “reaching [its] goal of
doubling 2005 earnings over five years.”
220. During the Second Quarter 2007 earnings conference call held on June 20, 2007,
Defendant Sidwell made specific statements regarding Morgan’s positions in the subprime
mortgage market. Sidwell opened the call by claiming that “concerns early in the quarter about
whether issues in the sub-prime market were going to spread dissipated.”
221. Defendant Sidwell stated on the Second Quarter 2007 earnings conference call
that results from credit products had declined 24 percent from the First Quarter 2007, when the
Company reported “record securitized products revenues driven by favorable positioning in the
sub-prime mortgage market.” Given this decline, Roger Freeman, an analyst from Lehman
Brothers, specifically asked Defendant Sidwell to characterize Morgan’s positioning in the
mortgage market during the Second Quarter 2007, and also questioned whether the Company’s
fixed income revenues were “down just more as a function of sort of a decline in activity in the
market in some marks or was there sort of negative positioning, i.e., betting the wrong way?”
Sidwell responded that Morgan “really did benefit” from market conditions in subprime in First
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Quarter 2007. Sidwell emphasized, however, that “[Morgan] certainly did not lose money in this
business” during the Second Quarter. (Emphasis added.)
2. Defendants’ June 20, 2007 Disclosures WereMaterially False and Misleading
222. In their earnings release and during their conference call on June 20, 2007,
Defendants made materially false and misleading statements and omissions. Defendants
concealed the existence of the Long Position, which had already been secretly written down by at
least $300 million by June 20, 2007, as later disclosed by Morgan on November 7, 2007, and
was poised to lose significantly more. The ABX Index, of which Defendants were aware and
should have been using to value the Long Position, had already declined 10.5 percent by the time
Defendants reported results for Second Quarter 2007. Moreover, by this time, Defendant Cruz
had already sounded the alarms internally at Morgan regarding the impending implosion of the
subprime mortgage market, demanding that the Proprietary Trade be stress tested and counseling
certain Morgan clients not to invest in subprime-related securities.
223. These facts rendered materially misleading Sidwell’s statement during the June 20
conference call that Morgan “certainly did not lose money in this business.” Mack’s statement
that Morgan was well on its way to “reaching [its] goal of doubling 2005 earnings over five
years” also was materially false and misleading. Given that stress tests were performed on the
Long Position, Sidwell and Mack made these statements without any reasonable basis.
Additionally, Sidwell’s responses to analyst Roger Freeman’s inquiry, which indicated that the
Company had not “bet[] the wrong way” in the subprime mortgage market, were also materially
false and misleading when made. To the contrary, Sidwell concealed the fact that the Company
had $13.2 billion in downside exposure to the subprime mortgage market and a position that was
already impaired by $300 million at the time he made this misleading statement.
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3. Market Reaction to June 20, 2007 Disclosures
224. On June 20, 2007, Deutsche Bank analysts issued a research report reiterating
their “Buy” rating. The report noted that Morgan’s reported Second Quarter 2007 EPS of $2.45
was above the consensus of $2.01, due to, among other things, “record institutional securities.”
Indeed, Defendants reported Morgan’s EPS at the very top end of analysts’ projections.
225. Likewise, on June 21, 2007, analysts at KBW issued a research report on Morgan,
stating that the Company’s Second Quarter 2007 results were strong and that EPS was well
ahead of the analysts’ estimate. The report also stated that the Company’s ISG was an “out
performer.” The KBW analysts focused on “record” net revenues of $11.5 billion, which
“handily” beat analysts’ estimates of $9.5 billion and was up 32 percent from the same period in
2006. The analysts noted that fixed income sales and trading were down 16 percent for the
quarter compared to first quarter 2007, but that they were up 34 percent year-over-year.
“[G]iven the stronger than expected results” in the Second Quarter, the analysts raised their 2007
EPS estimate from $8.15 to $8.79 and reiterated their “Outperform” rating, KBW’s highest core
rating. Finally, the analysts noted that Morgan’s reported results were excellent relative to the
reported performance of its peer companies, such as Lehman Brothers, Goldman Sachs, and Bear
Stearns.
4. Julv 10, 2007 Disclosures
226. On July 10, 2007, Morgan filed its Form 10-Q with the SEC for Second Quarter
2007. In the Form 10-Q, Defendants repeated the record financial results reported in Morgan’s
earnings release on June 20, 2007.
227. In the Form 10-Q for Second Quarter 2007, Defendants repeatedly represented
that financial instruments used in trading were recorded at “fair value” and that a substantial
percentage of the fair value of the Company’s financial instruments used for trading were based
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on “observable market prices, observable market parameters, or is derived from such prices or
parameters.” The Company also reported that it had adopted FAS 157 on December 1, 2006,
and that its assets and liabilities recorded at fair value “have been categorized based upon a fair
value hierarchy in accordance with [FAS 157].”
228. Additionally, the Company falsely assured investors in the Second Quarter Form
10-Q that its reported fair valuation of Morgan’s exposures overstated the true risk of loss
associated with such positions:
Aggregate market risk limits have been established, and marketrisk measures are routinely monitored against these limits. TheCompany also manages its exposure to these derivative contractsthrough a variety of risk mitigation strategies, including, but notlimited to, entering into offsetting economic hedge positions. TheCompany believes that the notional amounts of the derivative contracts generally overstate its exposure.
(Emphasis added.)
229. Also in the Form 10-Q for Second Quarter 2007, under Item 3 (“Quantitative and
Qualitative Disclosures About Market Risk”), Defendants provided information and data about
Morgan’s risk exposures. The section on market risk contained an analysis of the Company’s
VaR (which is explained in Section VII.B.9). And the section on credit risk included a
discussion of Morgan’s credit exposure to derivatives in particular. But nowhere did Defendants
specifically disclose Morgan’s $13.2 billion credit and market exposure to the Long Position.
230. Defendant Sidwell signed, and Defendants Mack and Sidwell certified, the Form
10-Q for Second Quarter 2007 as required under the Sarbanes-Oxley Act of 2002 (“Sarbanes-
Oxley”). Defendants Mack and Sidwell each certified that the Company’s SEC filing did not
contain any untrue statement of material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements were made, not
misleading. They further certified that the financial statements, and other financial information
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included in the SEC filings, fairly presented in all material respects the financial condition,
results of operations and cash flows of the Company.
5. Defendants’ July 10, 2007 Disclosures WereMaterially False and Misleading
231. Defendants’ statements and reported results for the quarter and six months ended
May 30, 2007, as set forth in the Form 10-Q for Second Quarter 2007, were materially false and
misleading when made and omitted to disclose material facts necessary to make the statements
made not misleading because they failed to disclose materially adverse facts that Defendants
knew and/or deliberately or recklessly disregarded.
232. The Form 10-Q for Second Quarter 2007 omitted material information that
Defendants were required to disclose pursuant to: (1) Regulation S-K, Item 303 (requiring the
disclosure of material trends and uncertainties); (2) Regulation S-X and FAS 107 (requiring the
disclosure of significant concentrations of credit risk); and (3) EITF D-86 and AU 560 (requiring
the disclosure of material events that arise between the issuance of a financial statement and a
filing with the SEC).
233. Specifically, in violation of FAS 107 and Regulation S-K, and as alleged in
Section VII.B.5(a), Defendants knowingly or recklessly failed to disclose the Company’s
massive subprime exposure ( i.e., the Long Position) and how the deteriorating subprime market
had materially adversely affected that exposure. By the time the Form 10-Q for Second Quarter
2007 was filed on July 10, 2007: (1) Defendant Cruz had begun to raise serious concerns
internally regarding the risk exposure associated with the Long Position in light of the declining
subprime mortgage market and ordered that the Long Position be stress tested; (2) Defendant
Daula had informed Cruz, after performing the stress test, that the Company stood to lose
$3.5 billion on the Long Position, leading Cruz to order Daula to “cut the position”; (3) the ABX
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Index had declined approximately 16 percent since December 2006, when the Long Position was
established; and (4) Morgan had received a $1.2 billion collateral call from Deutsche Bank
related to fair value declines of the Long Position.
234. In light of Morgan’s massive subprime exposure and the rapidly deteriorating
subprime market, Defendants knowingly or recklessly violated FAS 107 and Regulation S-K by
failing to specifically disclose the Long Position in the Form 10-Q for Second Quarter 2007. As
alleged in detail in Section VII.B.5(a), at the time the Form 10-Q was filed, the $13.2 billion
Long Position constituted a “significant concentration of credit risk” under FAS 107, requiring
disclosure. Likewise, Defendants violated Regulation S-K, which mandated the disclosure of all
trends, demands, events, transactions, commitments or uncertainties that were known to
management and were reasonably likely to have a material effect on the registrant’s financial
condition or results of operations.
235. Further, GAAP subsequent event rules (EITF D-86 and AU 560) obligated
Defendants to disclose the material events impacting Morgan that had occurred between the end
of Second Quarter 2007 (May 30, 2007) and the filing of the Form 10-Q for Second Quarter
2007 (July 10, 2007). As alleged in detail herein, by the time the Form 10-Q for Second Quarter
2007 was filed on July 10, 2007: (1) Defendant Cruz had begun to raise serious concerns
internally regarding the risk exposure associated with the Long Position in light of the declining
subprime mortgage market and ordered that the Long Position be stress tested; (2) Defendant
Daula had informed Cruz, after performing the stress test, that the Company stood to lose
$3.5 billion on the Long Position, leading Cruz to order Daula to “cut the position”; (3) the ABX
Index had declined approximately 16 percent since December 2006, when the Long Position was
established; and (4) Morgan had received a $1.2 billion collateral call from Deutsche Bank
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related to fair value declines of the Long Position. Given that these events had a material impact
on the valuation of the $13.2 billion Long Position and therefore on Morgan’s financial
condition, Defendants were required to disclose the position in the Form 10-Q for Second
Quarter 2007.
236. Defendants’ sections in the Form 10-Q addressing Morgan’s risk exposures gave
rise to a duty by Defendants to speak fully and truthfully about Morgan’s true risk exposure to
the subprime CDO market. As alleged in detail in Section VII.B.9, having chosen to discuss
Morgan’s market and credit risks, Defendants were required also to disclose the substantial
concentration of credit and market risk arising from the Long Position.
237. In addition, as Defendants would belatedly admit on November 7, 2007, Morgan
had already secretly taken a $300 million write-down that had not been specifically disclosed in
its financial statements for Second Quarter 2007.
238. Furthermore, Defendants’ representation that Morgan’s reported exposures
“overstated” the Company’s risk of loss was materially false and misleading when made
because, as set forth herein, Morgan had in fact materially understated and concealed its
exposure to the substantial concentration of credit risk arising from the notional value of the
Long Position.
239. Finally, the statements contained in both Mack’s and Sidwell’s Sarbanes-Oxley
certifications in the Form 10-Q for Second Quarter 2007 were materially false and misleading
when made because Morgan’s financial statements failed to disclose materially adverse facts
relating to the Company’s growing catastrophic subprime-related exposure, impairment, and
write-downs.
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6. Market Reaction to Julv 10, 2007 Disclosures
240. Analysts expressed optimism about Morgan’s outlook as a result of Defendants’
materially false and misleading statements and omissions. For example, based on information
released in the Second Quarter 2007 10-Q, KBW analysts stated that Morgan’s results have
“reflected a constructive operating environment,” the Company had the “right leadership to make
investments,” and its “results over the past few quarters are crystal clear validation of the
successful turnaround story at Morgan Stanley.” Emphasizing a discrete mark of success, the
analysts stated that the Company’s ROE in institutional securities had increased to 34 percent in
the first half of fiscal 2007, as compared to 22 percent in 2004 and 31 percent in 2006. They
further reported that the Company was well able to manage the increased risk from increased
principal trading.
C. Defendants Manipulate Morgan’s ReportedFinancial Results For Third Quarter 2007
1. September 19, 2007 Disclosures
241. On September 19, 2007, Morgan reported its financial results for Third Quarter
2007 (June through August 2007). Defendants held an earnings conference call the same day,
reporting income from continuing operations of $1.5 billion for the three months ended
August 31, 2007, a decrease of 7 percent from the third quarter of 2006, and EPS from
continuing operations of $1.38. Morgan reported net revenues of $8.0 billion for Third Quarter
2007, an increase of 13 percent from the third quarter of 2006. The Company also reported net
revenues of $5.0 billion for ISG, a 2 percent increase over the third of quarter 2006, although
“down from the record second quarter.” Pretax income for ISG in Third Quarter 2007 was
reported at $1.5 billion, down 22 percent from the third quarter of the prior year.
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242. In addition, Morgan reported that fixed income sales and trading revenues in the
amount of $2.2 billion had decreased 3 percent from the third quarter of 2006. The Company
attributed the decrease to “significantly lower credit revenues as spread widening, lower liquidity
and higher volatility resulted in lower origination, securitization and trading results across most
products.”
243. For the first nine months of fiscal 2007, Morgan reported income from continuing
operations of $6.2 billion, a 41 percent increase over the same period in 2006. Defendants
reported year-to-date EPS from continuing operations at a record $5.79 and net revenues of a
record $28.5 billion, a 29 percent increase over the same period in 2006.
244. In the September 19 earnings release, Defendant Mack stated: “Even with these
turbulent markets, Morgan Stanley still delivered strong performances across many core
businesses. . . . In addition, we continued making progress in executing our growth plans. . . .”
245. On the September 19 earnings conference call, Defendant Sidwell falsely stated
that “[t]he disclosure provides our assets and liabilities that [ ] are recorded at fair value.” Later
during the call, Sidwell added:
“[O]ur valuation models are calibrated to the market on a frequentbasis. The parameters and inputs are adjusted for assumptionsabout risk, and in all cases if market data exists, that data will beused to price the assets or liabilities. The valuation of theseinstruments are [sic] reviewed by an independent valuation groupoutside of the business units, and subject to the scrutiny of ourauditors. So we are confident that we have appropriately valuedthese positions.”
246. Also during the September 19 earnings call, Defendant Kelleher, the incoming
CFO stated that: “[W]e remain exposed to risk exposures through a number of instruments
[including] CDOs. . . . We believe it will take at least a quarter or two for the credit markets to
return to a more normal extension of credit and provision liquidity. . . .” After making this
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general disclosure about Morgan’s subprime exposure, Kelleher added, “we believe turbulent
times like this are an opportunity for Morgan Stanley to distinguish itself and outpace our peers.”
Despite generically stating, for the first time, that Morgan had CDO risk exposure, Defendants
failed to disclose that the Company had established a $13.2 billion Long Position.
2. Defendants’ September 19, 2007 DisclosuresWere Materially False and Misleading
247. In their earnings release and during their conference call on September 19, 2007,
Defendants made materially false and misleading statements and omissions. Defendants
continued to conceal the existence of the $13.2 billion Long Position, which had become even
further impaired during Third Quarter 2007. As alleged in detail in Section VII.B.6, the ABX
Index had declined 32.8 percent during Third Quarter 2007, requiring a write-down of
$4.4 billion on the Long Position for the quarter. Defendants instead recorded a write-down of
just $1.9 billion in Third Quarter 2007, understating losses on the Long Position by $2.5 billion.
This is in addition to the $300 million write-down Defendants had secretly taken in Second
Quarter 2007. Yet Defendants failed to disclose either of these material write-downs to
investors.
248. In the earnings release and during conference call, because Defendants failed to
write down the value of the Long Position by the full $4.4 billion in the Third Quarter to account
for fair value declines in the ABX Index, they knowingly or recklessly overstated Morgan’s
assets, revenues, income, and EPS figures, and understated Morgan’s liabilities. Had Defendants
recognized the full $4.4 billion impairment, Morgan’s earnings for Third Quarter 2007 would
have flipped from a reported EPS of $1.38 to a loss of $(0.17) per share.
249. Defendants’ failure to record adequate write-downs on the Long Position also
belied Defendant Sidwell’s statements during the September 19 conference call attesting to the
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accuracy of Morgan’s asset valuations. Particularly given that Defendant Daula was “very
vocal” in August 2007 about Morgan’s lack of appropriate models, Defendant Sidwell’s
statements that the Company’s “assets and liabilities [ ] are recorded at fair value,” and “we are
confident that we have appropriately valued these positions,” were materially false and
misleading when made, and/or made without a reasonable basis.
250. As alleged in detail herein, by the time of the September 19 earnings release and
conference call: (1) Defendants had already secretly written down the value of the Long Position
by $1.9 billion in Third Quarter 2007, in addition to the $300 million write-down in Second
Quarter 2007 (as later disclosed by Defendants on November 7, 2007); (2) Defendant Cruz had
raised serious concerns internally regarding the risk exposure associated with the Long Position
in light of the declining subprime mortgage market and ordered that the Long Position be stress
tested; (3) Defendant Daula had informed Cruz, after performing the stress test, that the
Company stood to lose $3.5 billion on the Long Position, leading Cruz to order Daula to “cut the
position” (by the end of Third Quarter 2007, Morgan had actually lost $4.4 billion); (4) Daula
had concluded that Morgan’s valuation models were inadequate; (5) Morgan had received a
$1.2 billion collateral call from Deutsche Bank due to fair value declines of the Long Position;
(6) Tufariello had convened a “super task force” of 40 to 50 senior employees, at Cruz’s
direction, to develop “creative strategies” for disposing of a “large position” with exposure to the
subprime mortgage market; and (7) the SEC had requested that Morgan provide additional
disclosure on its subprime exposure.
251. In light of these events, Defendants’ statements in the September 19 earnings
release that Morgan (1) “delivered strong performances” despite “turbulent markets,” and (2) had
“significantly lower credit revenues as spread widening, lower liquidity and higher volatility
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resulted in lower . . . trading results,” gave rise to a duty by Defendants to speak fully and
truthfully about Morgan’s true exposure to the subprime CDO market by disclosing the Long
Position and its $4.4 billion impairment. This impairment accounted for more than half of the
Company’s reported net revenues for Third Quarter 2007.
252. Further, Kelleher’s statement during the September 19 conference call that “we
remain exposed to risk exposures through a number of instruments [including] CDOs” did not
provide investors any material, corrective information, but was itself false and misleading. At
this time, the market knew that Morgan had risk exposure to CDOs through its underwriting of
such securities. However, analysts and investors had been led to believe that such risk exposure
was limited because of Morgan’s low ranking as an underwriter of CDOs compared to other
investment banks. Of course, investors were not aware that Morgan had taken on additional
CDO risk exposure through a $13.2 billion proprietary trade, or that Defendants had secretly
recognized a total of $2.2 billion in losses on that trade. Despite choosing to discuss the
Company’s risk exposure to CDOs, Kelleher failed to provide complete information by
disclosing the Long Position and its impairment. Kelleher’s statement constituted an additional
false and misleading statement that was designed to and did mislead the market.
3. Market Reaction to September 19, 2007 Disclosures
253. Defendants’ September 19, 2007 disclosures continued to conceal Morgan’s true
exposure to subprime and CDOs. For example, Meredith Whitney of CIBC World Markets
issued a report noting the “sizable mark-to-market valuation adjustments from loan
commitments, structured debt products, and losses from quantitative trading strategies,” but
added, “17% ROE is commendable given recent credit market dislocation.” Susan Roth Katzke
of Credit Suisse also noted the losses “against LBO financing commitments and . . . quant
strategies,” but her “Bottom Line” was that “it’s hard to complain with a 17% ROE in so
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challenging an environment.” Deutsche Bank’s Mike Mayo issued a report stating that while
“[f]ixed income trading declined by 1/4th due to weakness in credit products,” “[p]arts of fixed
income (record interest rates, currencies, derivatives)” were “[p]ositives.” (Emphasis added).
And David Trone at Fox-Pitt Kelton stated, “the big picture is that Morgan Stanley also took its
medicine and wrote down leveraged loans and mortgage, and we see a stronger 4Q07 ahead, as
the credit crunch begins to crumble.” Thus, in no way had analysts equated Kelleher’s generic
mention of Morgan’s exposure to CDOs with the massive size and declining value of the Long
Position.
4. October 10, 2007 Disclosures
254. On October 10, 2007, Morgan filed with the SEC its quarterly report on Form
10-Q for Third Quarter 2007, repeating the financial results set forth in the September 19, 2007
earnings release and conference call. In the Form 10-Q, the Company reported that its financial
statements were prepared in accordance with GAAP and stated that the “Company believes that
the estimates utilized in the preparation of the condensed consolidated financial statements are
prudent and reasonable.” Defendants also made extensive “Fair Value Disclosures” and reported
that the Company had adopted FAS 157, which required the Company’s assets and liabilities to
be “measured at fair value.” Morgan also described the “framework” for measuring fair value
and how its assets and liabilities “recorded at fair value have been categorized based upon a fair
value hierarchy in accordance with [FAS 157].” In the Form 10-Q, Defendants indicated that
“[t]he Company’s financial instruments owned and financial instruments sold, not yet purchased
are recorded at fair value.”
255. In the Form 10-Q for Third Quarter 2007, under Item 3 (“Quantitative and
Qualitative Disclosures About Market Risk”), Defendants provided information and data about
Morgan’s risk exposures. The section on market risk contained an analysis of the Company’s
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VaR (which is explained in SectionVII.B.9). And the section on credit risk included a discussion
of Morgan’s credit exposure to derivatives in particular. But nowhere did Defendants
specifically disclose Morgan’s $13.2 billion credit and market exposure to the Long Position.
256. Defendant Sidwell signed, and Defendants Mack and Sidwell certified, the Form
10-Q for Third Quarter 2007 as required under Sarbanes-Oxley. Defendants Mack and Sidwell
each certified that the Company’s SEC filing did not contain any untrue statement of material
fact or omit to state a material fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not misleading. They further certified
that the financial statements, and other financial information included in the SEC filings, fairly
presented in all material respects the financial condition, results of operations and cash flows of
the Company.
5. Defendants’ October 10, 2007 DisclosuresWere Materially False and Misleading
257. Defendants’ statements and reported results for Third Quarter and nine months
ended August 31, 2007, as set forth in the Form 10-Q for Third Quarter 2007, were materially
false and misleading when made and omitted to disclose material facts necessary to make the
statements made not misleading because they failed to disclose materially adverse facts that
Defendants knew and/or deliberately or recklessly disregarded.
258. Defendants continued to conceal the existence of the $13.2 billion Long Position,
which, unknown to investors, was substantially impaired during the Third Quarter 2007. As
alleged in detail in Section VII.B.9, the ABX Index had declined 32.8 percent during the Third
Quarter 2007, requiring a write-down of $4.4 billion on the Long Position for the quarter.
Defendants instead secretly recorded a write-down of just $1.9 billion, understating losses on the
Long Position by $2.5 billion.
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259. Because Defendants failed to write down the value of the Long Position by the
full $4.4 billion in the Third Quarter to account for fair value declines in the ABX Index, they
knowingly or recklessly caused Morgan’s assets, revenues, income, and EPS figures to be
overstated, and its liabilities to be understated, in the Form 10-Q for Third Quarter 2007. Had
Defendants recognized the full $4.4 billion impairment, Morgan’s earnings for Third Quarter
2007 would have flipped from a reported EPS of $1.38 to a loss of $(0.17) per share.
260. Defendants’ extensive references to reporting assets at fair value, including, inter
alia, their representation that the Company’s assets and liabilities were “measured at fair value”
and had been “categorized based upon a fair value hierarchy in accordance with [FAS 157],”
were materially false and misleading when made. Contrary to Defendants’ representations and
in direct violation of FAS 157, Defendants failed to record adequate writedowns on the Long
Position to account for fair value declines in the ABX Index during the Third Quarter 2007.
261. In addition, the Form 10-Q for Third Quarter 2007 omitted material information
that Defendants were required to disclose pursuant to: (1) Regulation S-K, Item 303 (requiring
the disclosure of material trends and uncertainties); and (2) Regulation S-X and FAS 107
(requiring the disclosure of significant concentrations of credit risk).
262. As alleged in detail herein, by the time the Form 10-Q for Third Quarter 2007 was
filed on October 10: (1) Defendants already had written down the value of the Long Position by
$1.9 billion in the Third Quarter 2007, in addition to the $300 million write-down in Second
Quarter 2007 (as later disclosed by Defendants on November 7, 2007); (2) Defendant Cruz had
raised serious concerns internally regarding the risk exposure associated with the Long Position
in light of the declining subprime mortgage market and ordered that the Long Position be stress
tested; (3) Defendant Daula had informed Cruz, after performing the stress test, that the
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Company stood to lose $3.5 billion on the Long Position, leading Cruz to order Daula to “cut the
position” (by the end of Third Quarter 2007, Morgan had actually lost $4.4 billion); (4) Daula
had concluded that Morgan’s valuation models were inadequate; (5) Morgan had received a
$1.2 billion collateral call from Deutsche Bank due to fair value declines of the Long Position;
(6) Tufariello had convened a “super task force” of 40 to 50 senior employees, at Cruz’s
direction, to develop “creative strategies” for disposing of a “large position” with exposure to the
subprime mortgage market; and (7) the SEC had requested that Morgan provide additional
disclosure on its subprime exposure.
263. In light of Morgan’s massive subprime exposure and the rapidly deteriorating
subprime market, Defendants knowingly or recklessly violated FAS 107 and Regulation S-K by
failing to specifically disclose the Long Position in the Form 10-Q for Third Quarter 2007. As
alleged in detail in Section VII.B.5(a), the $13.2 billion Long Position constituted a “significant
concentration of credit risk” under FAS 107, requiring disclosure. Likewise, Defendants
violated Regulation S-K, which mandated the disclosure of all trends, demands, events,
transactions, commitments or uncertainties that were known to management and were reasonably
likely to have a material effect on the registrant’s financial condition or results of operations.
264. Defendants’ sections in the Form 10-Q addressing Morgan’s risk exposures gave
rise to a duty by Defendants to speak fully and truthfully about Morgan’s true risk exposure to
the subprime CDO market. As alleged in detail in Section VII.B.9, having chosen to discuss
Morgan’s market and credit risks, Defendants were required also to disclose the substantial
concentration of credit and market risk arising from the Long Position.
265. Lastly, the statements contained in both Mack’s and Sidwell’s Sarbanes-Oxley
certifications in the Form 10-Q for Third Quarter 2007 were materially false and misleading
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when made because Morgan’s financial statements failed to disclose materially adverse facts
relating to the Company’s growing catastrophic subprime-related exposure, impairment, and
write-downs.
266. Defendants’ materially false and misleading statements and omissions in
Morgan’s Form 10-Q for Third Quarter 2007 are further demonstrated by Defendant Kelleher’s
February 1, 2008 letter to the SEC explaining the valuation of the Company’s 2007 subprime
positions. As part of the SEC’s ongoing inquiry into Morgan’s subprime exposure and related
disclosures, on January 3, 2008, the SEC requested additional information from Defendants
regarding the MD&A disclosures in the Third Quarter 2007 10-Q, as follows:
We note in your Form 10—Q for August 31, 2007 you disclose inthe MD&A that the US economy was experiencing signs ofslowing during the third quarter 2007, primarily reflecting difficultconditions in the residential real estate and credit markets and thatconcerns about the impact of subprime loans caused the broadercredit markets to deteriorate considerably over the quarter. In lightof the economic slowing in the residential real estate and creditmarkets and your impairment of trading portfolio that included realestate securities, tell us how you determined that there were nodecreases in fair value of your US subprime related balance sheetexposures during the third quarter 2007.
(Emphasis added.)
267. In Kelleher’s response to the SEC, he stated the following:
The Company’s primary exposure to the U.S. subprime market isassociated with “super senior” credit default swaps that referencesynthetic asset backed security (“ABS”) collateralized debtobligations (“CDOs”) that themselves hold or are referenced to“mezzanine” collateral with ratings of BBB+, BBB, orBBB—....One of the key proxies for the move in the fair value ofthe Company’s super senior credit default swaps is the ABX BBBindex .... During the third quarter of 2007, the ABX BBB indices,on average, declined by 50%.
268. Kelleher thus admitted privately to the SEC that Defendants’ relevant benchmark
was the ABX Index, which had declined, on average, by 50 percent in Third Quarter 2007. This
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information was available to Defendants at the time the Third Quarter 2007 disclosures were
made, further demonstrating that Defendants knowingly or recklessly ignored the “key proxies”
for valuing the Long Position. By ignoring the ABX index publicly, Defendants were able to
reduce the Long Position by a mere 14 percent, which allowed Defendants to manipulate
Morgan’s reported financial results for Third Quarter 2007. Defendants even failed to disclose
the material fact that the Company had taken an insufficient $1.9 billion write-down on the Long
Position in the first place, just as they failed to disclose the $300 million write-down in the
previous quarter. Had Defendants properly valued the Long Position and recorded losses
commensurate with the decline in the ABX Index, the market would have been fully aware of the
existence of the Long Position and the Company would have recorded at least a $4.4 billion loss
on the position in Third Quarter 2007 (which was not offset by gains on other U.S. subprime
positions as Kelleher erroneously indicated to the SEC).
6. Defendants Perpetuate Their Fraudulent SchemeWith False Statements to Analysts in October 2007
269. On October 10, Mike Mayo of Deutsche Bank issued an upbeat analyst report on
Morgan based on a meeting with Defendant Kelleher, the Company’s incoming CFO. Kelleher,
of course, said nothing about Morgan’s toxic Long Position during the meeting. Instead,
Kelleher succeeded in giving Mayo “additional comfort that the 3Q07 shortfall stemmed from
bad [trading] execution [rather than] bad [trading] systems and that, with more normal markets,
performance should mostly recover.” That is, Morgan had not made bad bets in the imploding
subprime market and was correctly positioned, and it would reap benefits when the market
“normalized.” This information, which was directly attributed to Kelleher and relayed to the
market, constituted additional false and misleading statements.
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270. As explained herein, due to economic conditions and the nature and size of the
Long Position, Kelleher’s statements to Mayo could not have been further from the truth, and
Kelleher knew or recklessly disregarded the falsity of his statements at the time they were made.
Specifically, Kelleher knew that Morgan’s Long Position had already been secretly written down
by $1.9 billion in Third Quarter 2007, in addition to the $300 million write-down in Second
Quarter 2007. Of course, Kelleher also knew or recklessly disregarded that these write-downs
understated the true impairment of the Long Position by $2.5 billion as of August 31, 2007.
Kelleher also knew that the Company received a $1.2 billion collateral call from Deutsche Bank
in July 2007 due to fair value declines of the Long Position.
271. Similarly, CIBC World Markets analyst Meredith Whitney interviewed Kelleher,
and, on October 24, 2007, issued a positive report on Morgan. According to Whitney, Kelleher
“[did] not see further write-downs to MS’s carrying values over the near term,” and “[he] was
very comfortable with the marks taken as-of the end of August.” This information, which was
directly attributed to Kelleher and relayed to the market, constituted additional false and
misleading statements when made. Defendants already secretly had written down a total of $2.2
billion on the Long Position for the first nine months of 2007, which still understated the
Company’s Third Quarter losses on the Long Position by $2.5 billion, in violation of FAS 157.
Kelleher knew or recklessly disregarded that GAAP required these write-downs and additional
losses to be reported at least by the end of the quarter.
272. Due to Defendants’ material misrepresentations and omissions, continuing into
late October 2007, the market still believed that Morgan had limited subprime exposure. Morgan
ranked low among its peers in subprime ABS and CDO underwriting and had emphasized its
positive positioning in the subprime market. Analyst reports echoed Defendants’
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misrepresentations. For example, on October 30, 2007, Susan Roth Katzke of Credit Suisse
issued an analyst report praising Morgan’s purportedly limited subprime CDO exposures,
stating, “[I]t should not be viewed as accidental that Morgan Stanley is ranked as low as 9th in
the CDO underwriting league tables.” Katzke concluded: “MS managed through the challenging
markets of 3Q07 faring just fine; the firm remains well positioned to post better than average
returns going forward.”
273. In sum, prior to November 1, 2007, the market was wholly unaware that Morgan
had huge subprime exposure resulting from its undisclosed $13.2 billion Long Position or that it
had already secretly taken billions in write-downs related to that very same Long Position.
D. November 2007: Partial Corrective Disclosures AndMorgan’s Additional False Statements
1. The Market Learns Of Morgan’sSubprime Exposure And Write-Downs
274. Over the course of a week, from November 1 through November 7, 2007, the
market learned that Morgan had taken a large proprietary CDO position that had suffered billions
of dollars in impairment. This new information about Morgan’s CDO exposure and related
necessary write-downs caused investors to drive down the price of Morgan’s common stock as
investors reassessed Morgan’s true financial condition. By the time Defendants officially
confirmed the existence of the Long Position after the market closed on November 7, 2007, the
corrective information had already been incorporated into the price of Morgan’s stock. Yet
Defendants continued to mislead investors by understating the fair value declines of the Long
Position, thereby reinflating Morgan’s stock price after November 7.
275. The market began learning about the true extent of Morgan’s CDO exposures on
Thursday, November 1, when Deutsche Bank’s Mike Mayo issued an analyst report predicting
that various securities firms, including Morgan, would collectively write down more than
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$10 billion “due to CDOs/mortgage/etc.” This was the first time that an analyst had predicted
that Morgan would record a significant writedown due to CDO exposure. In reaction to Mayo’s
report, on November 1, Morgan’s stock price dropped $4.84 per share (7.2 percent), from $67.26
to $62.42.
276. The following day, November 2, 2007, Morgan fired Howard Hubler, the
Managing Director of PTG, the group that had established the Long Position. On that day,
Morgan’s stock price dropped $3.52 per share (5.6 percent), from $62.42 to $58.90.
277. On Monday, November 5, 2007, a CNBC editor predicted on the air that Morgan
would record a write-down of $3 billion, citing unidentified sources. A Bloomberg News article
picked up CNBC’s prediction, stating that “Morgan Stanley will have a $3 billion writedown tied
to securities, CNBC reported, citing unidentified ‘sources.’” The article further stated: “The
company is ‘eyeballing’ that amount right now, CNBC on-air editor Charles Gasparino
reported.” By the end of the trading day, another Bloomberg News article stated: “Morgan
Stanley fell . . . after CNBC reported that the firm might write down $3 billion of securities,
citing unidentified sources.” That day, Morgan’s stock price dropped $3.31 per share (5.6
percent), from $58.90 to $55.59.
278. By Tuesday, November 6, 2007, analysts were predicting Morgan would take a
write-down as big as $6 billion. In this respect, analyst David Trone of Fox-Pitt Kelton issued a
report that day downgrading Morgan “[g]iven the likelihood that it will take significant write
downs on ABS-CDOs and other mortgage exposures.” Trone stated, “[W]e believe forthcoming
write-downs could be around $4 billion,” but “[w]e wouldn’t be surprised to see $6 billion in
total write-downs.” Further, Trone questioned whether Morgan’s disclosures were accurate,
stating that the Company’s “[e]stimated ‘maximum exposures’ as listed in the 10Q may be
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outdated or flawed.” For these reasons, Trone suggested “outright avoidance [of Morgan’s
stock] until either mgmt discloses more specific exposure data and it proves smaller than we
thought, or they actually take write-downs big enough to get beyond this.”
279. Picking up on Trone’s projection, on November 6, Bloomberg issued an article
titled “Morgan Stanley Writedowns May Reach 6 Billion, Fox-Pitt Says.” Meanwhile, Deutsche
Bank’s Mike Mayo increased his prior estimate of the writedown, now suggesting that it could
be as large as $3 billion and $4 billion. On that day, Morgan’s stock price declined another
$1.08 per share (1.9 percent) from $55.59 to $54.51.
280. In articles issued before U.S. trading started on Wednesday, November 7, 2007,
both The New York Times and The Wall Street Journal highlighted Fox-Pitt Kelton’s $6 billion
projected write-down. The New York Times article, titled “Write-Down Expected for Morgan
Stanley,” stated that the projection had come “amid intense speculation that the Company might
announce a write-down next month of $2 billion to $4 billion.” The Wall Street Journal article,
titled “Storm May Hit Morgan Stanley After Its Calm – Write-Downs Projected By Two
Analysts; More Firms Face Risks,” reported that analysts had projected a writedown for Morgan
of between $3 billion and $6 billion. The Wall Street Journal attributed Morgan’s recent stock
price drops to the Deutsche Bank and Fox-Pitt Kelton analysts’ projections, which had caused
investors to be “increasingly nervous.”
281. Citing market participants, the November 7 Wall Street Journal article stated that
Morgan’s subprime exposure was the result of a proprietary trading position. The market was
led to believe that Morgan’s subprime exposure was limited largely because the Company
ranked low among its peers in underwriting subprime ABS and CDO issuances; investors had no
idea that Morgan was creating massive subprime exposure by establishing proprietary trading
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positions in such securities. As the Wall Street Journal article explained: “Of all the blue-chip
Wall Street securities firms, Morgan Stanley seemed one of the least likely to get thumped by the
subprime-mortgage crisis.” Accurately assessing what had, in fact, happened, the article stated:
“While the firm may not have underwritten as many CDOs, . . . Morgan Stanley may have been
involved in transactions with other firms that left it with exposure to CDO risks, market
participants say.”
282. The November 7 New York Times article further explained the market’s surprise
about the write-down, stating: “While Morgan Stanley joined the Wall Street rush into
underwriting pools of securities tied to subprime mortgages, or collateralized debt obligations, in
2006 and 2007, it ranked far behind market leaders Merrill Lynch and Citigroup. Accordingly,
the view has been that Morgan Stanley would not experience as big a loss.” The New York
Times further reported: “The loss came as a surprise to analysts who were led to believe that the
firm’s low rank as an underwriter of C.D.O.’s would not lead to a major write-down.” As this
article makes clear, the market had not given any credit to Defendant Kelleher’s statement that
the Company had “risk exposure through . . . CDOs, ” given the strongly negative reaction to the
true extent of the exposure and the fact that it was a proprietary trading position, rather than
underwriting of CDOs, that had caused massive write-downs.
283. By the close of trading on November 7, 2007, Morgan’s stock price had dropped
another $3.32 per share (6.1 percent), from $54.51 to $51.19. As these corrective disclosures
emerged between November 1 and November 7, the new information was incorporated into the
price of Morgan’s stock. As reported by Bloomberg on November 7, “[c]oncerns about potential
writedowns at Morgan Stanley [had] pushed the stock lower” that week. All told, between the
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market close on October 31 and the market close on November 7, the Company’s stock declined
$16.07 per share (23.9 percent), from $67.26 to $51.19 as a result of these corrective disclosures.
284. In sum, by the time the market closed on November 7, the market finally
understood that Morgan had a large proprietary trading position with substantial exposure to the
dramatically deteriorating subprime-backed ABS markets, and that Morgan likely was going to
have to record a multi-billion-dollar write-down relating to that position. These revelations
corrected Defendants’ fraudulent, material misstatements and omissions regarding Morgan’s
subprime and CDO exposure as of that date. However, while confirming the existence of the
Long Position, Defendants continued to misrepresent the true fair value of the Long Position.
2. Morgan’s November 7, 2007 Confirming Disclosures AndFalse And Misleading Statements Regarding Valuation
(a) November 7 Press Release And Exposure Chart
285. The corrective disclosures and resulting price drops between November 1 and 7,
along with increasing market concerns and uncertainty going forward, forced Defendants to
make an announcement regarding its interim Fourth Quarter 2007 financial results. After the
close of trading on November 7, Morgan issued a long-overdue press release entitled “Morgan
Stanley Provides Information Regarding Subprime Exposure.” The press release stated the
following:
Morgan Stanley (NYSE: MS) today provided additionalinformation about the Firm’s U.S. subprime related exposures,which have declined in value as a result of continued marketdeterioration since August 2007.
At the end of Morgan Stanley’s fiscal third quarter onAugust 31, 2007, the Firm had $12.3 billion in U.S. subprimerelated balance sheet exposures representing $10.4 billion in netexposures, as indicated in the attached table. Net exposure as ofOctober 31, 2007 is $6.0 billion. Net exposures are defined aspotential loss to the firm in a 100 percent loss default scenario,with zero recovery.
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Since that time, the fair value of these exposures has declined as aresult of the continued deterioration in market data, as reflected bythe sharp decline in the ABX Indices, and other marketdevelopments, including updates to mortgage remittance data andcumulative loss forecasts. The declines in value are outlined in theattached table as of August 31, 2007 and October 31, 2007.
As a result of these declines in value, Morgan Stanley’s revenuesfor the two months ended October 31, 2007, were reduced by$3.7 billion (representing a decline of approximately $2.5 billion innet income on an after-tax basis). The actual impact on the Firm’sfourth quarter financial results, which will include results for themonth of November, will depend on future market developmentsand could differ from the amounts noted.
While these writedowns will negatively impact the fourth quarterresults in the Firm’s fixed income business, Morgan Stanleyexpects to deliver solid results in each of its other businesses,including Investment Banking, Equities, Global WealthManagement and Asset Management – subject to marketconditions through the end of the year.
Valuation of Subprime Exposures
In determining the fair value of the Firm’s ABS CDO-relatedexposures—which represent the most senior tranches of the capitalstructure of subprime ABS CDOs—Morgan Stanley took intoconsideration observable data for relevant benchmark instrumentsin synthetic subprime markets. Deterioration of value in thebenchmark instruments as well as the market developmentsreferred to earlier have led to significant declines in the estimatesof fair value. These declines reflect increases in impliedcumulative losses across this portfolio. These loss levels areconsistent with the cumulative losses implied by ABX Indices inthe range between 11-19 percent. At a severity rate of 50 percent,these levels of cumulative loss imply defaults in the range of 40-50percent of outstanding mortgages for 2005 and 2006 vintages.
In calculating the fair value of the Firm’s U.S. subprime mortgagerelated exposures—including loans, total rate-of-return swaps,ABS bonds (including subprime residuals) and ABS CDS—Morgan Stanley took into consideration observable transactions,the continued deterioration in market conditions, as reflected bythe sharp decline in the ABX Indices, and other marketdevelopments, including updated cumulative loss data. The fairvalue of the ABS Bonds declined significantly, which was drivenby increases in implied cumulative loss rates applied to subprime
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residuals at levels consistent with those implied by current marketindicators.
It is expected that market conditions will continue to evolve, andthat the fair value of these exposures will frequently change andcould further deteriorate. Given these anticipated fluctuations,Morgan Stanley does not intend to update this information until itannounces its fourth quarter 2007 earnings in December 2007.Investors also should not expect the Company to provideinformation about the results of future quarters in advance ofscheduled quarterly earnings announcement dates.
286. The press release attached a chart entitled “Morgan Stanley Subprime Analysis
2007,” which set forth additional details of the writedown. The chart is reproduced below:
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Figure 5: Subprime Analysis 2007” Chart from Morgan’s November7, 2007 Form 8-K
Morgan StanleySubprime Analysis 200710/3112007
8131107 10/31/07Profit Profit Profit Profit
Statement Statement and and and andof of (Loss) (Loss) (Loss) (Loss) Net Net
Financial Financial Three Nine Two Eleven Exposure Exposure
Condition Condition Months Months Months Months (1) (1)
(in billions) 8131107 10/31/07 Ended Ended Ended Ended 08/31/07 10/31/07
Super Senior ExposureHigh- Grade $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0Mezzanine ($1.8) ($5.2) ($1.9) ($2.2) ($3.4) ($5.6) $11.4 $8.3CDO-Squared $0.0 ($0.0) $0.0 $0.0 S0.0 $0.0 $0.0 $0.1Total ABS CDOSuper SeniorExposure (S1.8) ($5,2) ($1.9) ($2.2) ($3.4) ($5.6) $11.4 $8.4
Other Retained and WarehouseExposure
ABS CDO CDS $1.1 $1.7 $0.8 $1.0 $0.5 $1.5 ($2.9) ($3.1)ABS CDO Bonds $1.6 $1.7 ($0.4) ($0.3) ($0.0) ($0.3) $1.6 $1.7CDO Warehouse $0.0 $0.0 ($0.0) ($0.0) $0.0 ($0.0) $0.0 $0.0Total Other Retained andWarehouse Exposure $2.7 $3.4 $0.4 $0.7 $0.5 $1.2 ($L3) ($1.4)
Subtotal ABS CDO RelatedExposure (:) $0..9 ($1.8) (51.5) ($1.5) ($2.9) ($4.4) $1011 $7.0
US. SubprimeMortgage RelatedExposure
Loans $2.9 $1.5 ($0.0) ($0.1) ($0.0) ($0.1) $2.9 $1.5Total Rate ofRct unSwaps $0.1 ($0.0) So.0 $0.1 $0.0 $0.1 ($0.7) ($0.0)ABS Bonds $4.2 $3.0 ($0.7) ($0.9) ($1.9) ($2.S) $4.0 $3.0ABS CDS $4.2 $6.6 $2-3 $3.4 SIA $4.5 ($5.9) ($5.5}
Subtotal U.S. SubprimeMortgage Related Exposure (3) $11.4 $11.1 $1.6 $2.5 ($0.8) $1.7 $0.3 ($1.0)Total ABS CDO 1 SubprimeExposure $12.3 $9.3 $0.1 $1.0 ($3.7) ($2.7) $10.4 $6.0
Notes:
(1) Net Exposuue is defined as potential loss to the Finn in an event of 100% default. assuming zero recovery Positive anioimts indicatepotential loss (long position) in a default scenario. Negative annotimts indicate potential gain (short position) in a default scenario.
(2) In determining the fai r value of the Finn's, A13S CDO-related exposures - which represent the most senior tranches of the capital strictureof subpiimre ABS CDOs - Morgan Stanley took into consideration observable data for relevant benchmark instruments in synthetic subprune markets. Deterioration of value in the benchmark instr merits as well as the market developments referred to above have led tosignificant declines in the estimates of fai r value. These declines reflect increase in implied losses across this portfolio. These implied losslevels are consistent with the losses in the ranee between 11% - 19% implied by the ABX indices. These cumulative loss levels. at aseverity rate of 50%. imply defaults it the range of 40 - 50% for 2005 and 2006 outstandin g mortgages.
(3) In calculating the fair value of die Finn's U. S. sub-prime mortga ge related exposures - including loans, total rate-of-reta m swaps. ABSbonds (including subprinic residuals) and ABS CDS -Morgan Stanley took into consideration observable transactions. the continueddeterioration in market data. as reflected by the sharp decline in the ABX indices, and other market developments. including updatedcumulative loss data. The fair value of the ABS Bonds declined significantly, which were driven by increases in implied cumulative lossesfor subprime residuals to levels equivalent to those now seen in the nnarket.
287. As the press release and chart indicate, Defendants focused on the $3.7 billion
writedown of Morgan’s “Total ABS CDO / Subprime Exposure” just in the two months ended
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October 31, 2007 (i.e., the two months after the end of Third Quarter 2007). For the eleven
months ended October 31, 2007, the reported impairment of Morgan’s “Total ABS CDO /
Subprime Exposure” was $2.7 billion. According to the chart, the “Total ABS CDO / Subprime
Exposure” was calculated by netting the fair value of the Long Position—labeled “Mezzanine”
“Super Senior Exposure”—against other types of CDO, ABS, and subprime exposures.
288. Defendants’ November 7 “Subprime Analysis” chart states that the fair value of
the Long Position declined $0.3 billion prior to the start of Third Quarter 2007, $1.9 billion in
Third Quarter 2007, and $3.4 billion in the two months ended October 31, 2007. Thus,
according to Morgan, as of October 31, 2007, the total impairment of the Long Position was $5.6
billion. This chart, for the first time, informed investors that Morgan had massive subprime
exposure and already had secretly taken subprime-related write-downs in previous quarters,
including on the Long Position.
(b) November 7, 2007 Conference Call
289. In conjunction with Morgan’s after-trading press release on November 7,
Defendant Kelleher convened a conference call with analysts to explain these massive U.S.
subprime exposures. During the conference call, Kelleher stated: “[S]ince the end of our third
quarter in August, the fair value of these exposures has declined due to the sharp decrease in the
BBB ABX price indices. . . .” He added: “[A]s a result of the rigorous processes we have in
place, the [marks] we took back in August appropriately reflect fair value at that time. The
[marks] we are announcing today appropriately reflect the fair value as of October 31. . . .”
290. During the November 7, 2007 conference call, Kelleher acknowledged that
Morgan had not specifically disclosed the Long Position in any of its previous Form 10-Qs. An
analyst from Merrill Lynch asked, “if we had wanted to try to find these exposures in your
second quarter Q and we had looked at the VIE [ i.e., section on Variable Interest Entities] asset
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and maximum exposure to loss data on page 28 and 29 of the Q would have them within the
mortgage and asset backed securitization of the structured transactions categories or am I kind of
looking in the wrong place?” Kelleher responded that the Long Position could not have been
found in one place in Morgan’s financial reports, but stated vaguely that “it’s all over the place.”
In other words, Kelleher admitted that Morgan had not disclosed the Long Position in its
financial statements and had concealed the write-downs, all in violation of GAAP.
(c) November 8, 2007 Form 8-K
291. The day after issuing the press release, on November 8, 2007, Defendants filed a
Form 8-K with the SEC with the following explanation:
On November 7, 2007, Morgan Stanley (“the Company”) issued apress release announcing significant declines sinceAugust 31, 2007 in the fair value of its U.S. subprime relatedexposures as a result of the continued deterioration in the marketand other market developments. As of August 31, 2007, theCompany had $12.3 billion in U.S. subprime related balance sheetexposures representing $10.4 billion in net exposures. Netexposure as of October 31, 2007 was $6.0 billion. Net exposuresare defined as potential loss to the Company in a 100 percent lossdefault scenario, with zero recovery. As a result of the decline inthe fair value of these exposures, the Company has determined thatthe reduction in revenues for the two months endedOctober 31, 2007 attributable to the decline was $3.7 billion(representing a decline of approximately $2.5 billion in net incomeon an after-tax basis). The impact on the Company’s fourthquarter financial results from changes in the fair value of theseexposures will depend on future market developments and coulddiffer materially from the amounts noted. It is expected thatmarket conditions will continue to evolve, and that the fair value ofthese exposures will frequently change and could furtherdeteriorate.
3. Defendants’ November 7, 2007 DisclosuresWere Materially False And Misleading
292. Although Defendants finally confirmed Morgan’s CDO exposure, they made
additional materially false and misleading statements regarding the timing and amount of the
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impairment of the Long Position. In deliberate or reckless disregard for the truth, Defendants
misrepresented to investors that: (1) the Long Position had declined in value by only $1.9 billion
dollars in Third Quarter 2007; and (2) the write-downs taken on the Long Position were
sufficient to reflect its fair value.
293. Defendants misstated the cumulative and period losses on the Long Position as of
August 31 and October 31, 2007. As explained in detail herein, GAAP required Defendants to
record a $4.4 billion impairment on the Long Position in Third Quarter 2007 and an additional
$3.4 billion impairment for the two months ending October 31, 2007. However, in the
November 7, 2007 press release, while Defendants disclosed a $3.4 billion impairment for the
two months ending October 31, they disclosed only a $1.9 billion impairment for Third Quarter
2007. In doing so, Defendants deceptively concealed $2.5 billion in losses on the Long Position.
And rather than inaccurately reporting cumulative year-to-date losses on the Long Position of
$5.6 billion as of October 31, Defendants should have reported a fair value write-down of $5.9
billion for the Fourth Quarter to date to correct the false marks from the Third Quarter, and
cumulative losses of $8.1 billion year to date.
294. The insufficiency of Defendants’ reported impairment for Third Quarter 2007 is
demonstrated by Morgan’s 2007 fiscal year-end financial results (announced December 19,
2007), which included a $7.1 billion write-down on the Long Position in Fourth Quarter 2007.
As alleged in detail herein, Morgan’s December 19 valuation and disclosures indicate that
Defendants recorded an insufficient impairment of the Long Position in Third Quarter 2007 to
avoid turning a disappointing EPS gain into a substantial operating loss during that reporting
period. Then, to catch up with the true fair value of the Long Position, Defendants recorded a
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much larger impairment in Fourth Quarter 2007 than was indicated by the quarterly decline in
the ABX Index.
295. In their November 7 disclosures, Defendants failed to disclose that Morgan should
have recognized an additional $2.5 billion in losses for Third Quarter 2007, which would later
require additional mark-to-market losses to catch up for those unrecognized losses. Because
Defendants knew and deliberately or recklessly disregarded this materially adverse fact, their
statements regarding the true extent of the write-down and the valuation of the Long Position
were materially false and misleading when made.
296. Further, in view of the fact that Defendants had understated the impairment of the
Long Position by $2.5 billion, Defendants knew or recklessly disregarded that Defendant
Kelleher’s statements during the November 7 conference call that “the [marks] we took back in
August appropriately reflected fair value at that time,” and “[t]he [marks] we are announcing
today appropriately reflect the fair value as of October 31,” were materially false and misleading
when made.
4. Market Reaction To November 7, 2007 Disclosures
297. Defendants’ partially misleading November 7 disclosures achieved the objective
of containing the damage resulting from the November 1-7 corrective disclosures from analyst
publications and reinflating Morgan’s stock price. Following Defendants’ material
misrepresentations on November 7, 2007, the immediate consensus among securities analysts
and the market was that Morgan’s $3.7 billion write-down that fell within estimated ranges was
“manageable.” In an analyst report issued on the evening of November 7, Deutsche Bank’s
Mike Mayo stated that the $3.7 billion write-down was “in line with our estimate of $3-4B.” He
added that “[w]hile this is bad news, we believe it will be manageable for Morgan Stanley.”
That same evening, Credit Suisse analyst Susan Roth Katzke stated in a report that the write-
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down was “Not Good, But Manageable.” As reported by Bloomberg, “[i]nvestors sent [the
Company’s] shares higher in after-hours trading on comfort that Morgan Stanley identified the
total losses it might suffer – the first Wall Street investment bank to do so.”
298. On the first trading day after Morgan issued its subprime-related valuations and
disclosures, November 8, 2007, Citigroup analyst Prashant Bhatia wrote, as reported by
Bloomberg, “We now have a much better understanding of maximum loss exposure, which in
our view is very manageable.” That day, Wachovia analyst Douglas Sipkin stated “MS Comes
Clean” and reiterated his “Market Perform” rating.
299. The market’s positive reaction to Defendants’ November 7, 2007 valuation and
disclosures was due to the fact that: (1) from November 1-7, 2007, the market had already
punished Morgan’s stock price upon the revelation of the exposure to billions in subprime losses
and in anticipation of Morgan’s write-down; and (2) Defendants partially reversed the stock’s
decline by issuing additional material misstatements and omissions on November 7, which
understated the impairment of the Long Position by $2.5 billion in Third Quarter 2007. By
fraudulently reporting an impairment of only $1.9 billion for Third Quarter 2007, instead of $4.4
billion, which would have resulted in a sizeable quarterly loss, Defendants accomplished two
things: (1) they left intact Morgan’s EPS from continuing operations for that quarter, which
exactly matched the lower bound of analysts’ earnings estimates; and (2) they were able to
announce a net write-down on subprime-related exposures that was less than $6 billion, the
worst-case scenario projected by analysts.
300. On November 8, 2007, Morgan’s common stock price rose 4.9 percent from
$51.19 to $53.68.
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5. Defendants’ Fraudulent Statements AboutMorgan Stanley’s Subprime ExposureDuring The November 13, 2007 Investor Conference
301. On November 13, 2007, Cruz and Kelleher participated in a presentation at the
Merrill Lynch Banking and Financial Services Investor Conference (“Merrill Lynch
Conference”). Kelleher fielded questions from investors regarding Morgan Stanley’s recently
disclosed multi-billion-dollar losses, and in emphasizing the need for full disclosure to reduce
any uncertainty arising from fair value accounting, he stated as follows:
I have consistently said the fact that we reduced our positionproves to the robustness of the risk management model because weaddressed that issue rather than rolling the dice that some peopledid do. . . . On the second trade, we actually had a riskmanagement model that told us what was happening because Ithink, as I explained last week, the nature of the trade itself waschanging because basically our [ ] money positions were rapidlybecoming into the money, and our risk management systems werealerting us to the fact what we thought was a structural short tradeevolved into a flat trade, evolved into us being wrong, coincidingwith a market where there was no liquidity to get out. I think therewere a few things we’ve learned from that trade in terms oflooking back on it. And obviously, we will address those issuesaccordingly in our risk management model and within the firmitself. . . . I don’t think our risk management models upfrontwould have pointed out what was happening on these trades.These were incredibly stressed markets. . . .
302. Kelleher’s statements at the Merrill Lynch Conference were materially false and
misleading when made. First, his comments gave the false impression that Morgan’s losses from
the Long Position were fully disclosed when, in fact, billions of additional losses were still being
concealed. Second, he materially misrepresented the nature and timing of the information
known to Defendants based on the stress tests (ordered by Cruz in May 2007) on Morgan’s
subprime exposures. And third, Kelleher concealed the fact that Defendants knew or recklessly
disregarded that PTG had “bet the wrong way” with the $13.2 billion Long Position. Cruz did
not qualify or contradict these false statements.
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6. The Market Learns Of Morgan’s Additional Write-Down
303. On November 7, 2007, Defendants disclosed that its remaining net exposure on
the Long Position was $8.3 billion. The market did not know, however, that Defendants had
already fraudulently concealed $2.5 billion in unrecognized losses on the Long Position in Third
Quarter 2007. To catch up with these unrecognized losses, Defendants would have to report a
much larger write-down than that indicated by the decline of the ABX Index in November 2007.
On December 19, 2007, Morgan announced a write-down for November that doubled the rate of
decline of the ABX Index.
304. On the last day of the Class Period, November 19, 2007, the market was informed
that a much larger Morgan write-down indeed was coming. On that day, in an article titled
“New bank fears hit shares,” MarketWatch reported that Goldman Sachs expected a write-down
of $8 billion at Morgan, shared over the final quarter of 2007 and 2008. The same news was
reported in a Financial Times article titled, “Credit squeeze could last until next Christmas.”
305. As reported, on November 19, 2007, Goldman Sachs issued a report estimating
that Morgan would record CDO write-downs of $8 billion ($5 billion in Fourth Quarter 2007 and
$3 billion in fiscal year 2008). By projecting the write-downs on Morgan’s CDO-related
exposure, Goldman Sachs informed investors to expect more than double the write-down in
Fourth Quarter 2007 than was indicated by the decline in the ABX Index. This larger write-
down was a materialization of the risk created by Defendants’ concealment of the unrecognized
losses on the Long Position in Third Quarter 2007.
306. On November 19, 2007, the price of Morgan’s stock dropped $1.77 per share (3.3
percent), from $52.90 to $51.13, reflecting investors’ expectation of a further multi-billion-dollar
write-down of Morgan’s Long Position far in excess of the drop in the ABX Index. This
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outcome already had been priced into the market by the time Defendants confirmed the write-
down on December 19, 2007.
307. On November 30, 2007, analyst Richard Bove of Punk Ziegel issued a report
confirming Goldman Sachs’s November 19 analysis. Bove concluded that the actual Third
Quarter 2007 write-downs at Morgan were higher than those disclosed by Defendants.
Specifically, in stark contrast to Morgan’s contention that it took a $1.9 billion write-down for
Third Quarter 2007, Bove stated: “I estimate that in the third fiscal quarter the company had
write-downs and write-offs of $3.6 billion on a gross basis.” In part for this reason, Bove rated
Morgan a “sell.”
7. Defendants Confirm Additional Write-Down And TheMarket Is Relieved That CDO-Related Losses Have Reached Bottom
308. On December 19, 2007, a month after Goldman Sachs had informed the market to
expect an additional, multi-billion-dollar write-down that exceeded the decline in the ABX
Index, Defendants confirmed the market’s expectations when they released Morgan’s financial
results for the fiscal year ended November 30, 2007. In Morgan’s earnings release, Defendants
disclosed an additional write-down of $3.7 billion on the Long Position. This brought year-to-
date losses on the Long Position to $9.3 billion.
309. For Fourth Quarter 2007, Defendants reported a pre-tax loss of $6.5 billion for the
ISG, down from $2.2 billion of pre-tax income in Fourth Quarter 2006. For fiscal year 2007, the
ISG reported pre-tax income of $817 million, an 89 percent decrease from 2006. Company-
wide, “[n]et revenues decreased 24 percent to $16.1 billion” and “[f]ixed income sales and
trading revenues were $0.7 billion, down 93 percent from 2006 reflecting significant losses in
credit products resulting from the mortgage related writedowns.”
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310. On December 19, 2007, Mack and Kelleher held an earnings conference call with
analysts. During this call, Kelleher responded to questions from analysts regarding the
Company’s Level 3 assets and liabilities, though he avoided describing what the biggest
“component” was of Level 3. Kelleher would state only that, “obviously there was one very big
mark that ran through Level 3, which we’ve just announced.”
311. As Fourth Quarter 2007 ended, facing $6.8 billion in net losses from subprime-
exposure, Morgan sought and obtained a financial life-line from overseas. On December 19,
along with confirming the expected write-down, Defendants also unexpectedly announced that
they had secured a $5 billion cash infusion from the China Investment Corporation (“CIC”),
which gave the CIC a 10 percent share in Morgan. Analysts were encouraged by the CIC
investment, as it provided Morgan additional capital cushion and financial stability.
312. Analysts were also heartened by Morgan’s December 19 disclosures regarding
subprime losses because they correctly believed that the Company’s once-hidden mezzanine
ABS CDO problems were now fully disclosed, enabling a balance sheet catharsis and a
collective look to the future. For example, on December 19, Meredith Whitney of CIBC World
Markets wrote that “MS’s 4Q marks on its exposures were severe, thus it is not likely in our
opinion that anything similarly disruptive could occur again given its current exposure levels.”
Whitney also indicated that Morgan’s stock had “bottomed out.” Similarly, on the same day,
Mike Mayo of Deutsche Bank stated: “We maintain our Buy, given our view that the worst
subprime is behind [Morgan].” And a Bloomberg News article reported: “The ‘significant capital
raise’ and writedowns suggest to investors that Morgan Stanley has put the worst of its subprime
losses behind it, Jeffrey Harte, an analyst at Sandler O’Neill & Partners LP, wrote in a note
today.”
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313. As supported by contemporaneous news accounts, the additional subprime write-
downs already had been impounded into the price of Morgan’s stock. For example, on
December 19, a Bloomberg News article quoted the president of South Beach Capital Markets:
“‘The stock was sold down and all the bad news has been out. Today was just a verification of
the numbers – bigger than anyone thought, but most people already knew. The cash coming in –
significant 10 percent ownership in Morgan Stanley . . . heartened the investors.’” Thus, major
investors had been expecting the additional write-down announced on December 19, and they
were now relieved that the CDO losses had bottomed out.
314. Accordingly, after Morgan announced its annual financial results and the CIC
cash infusion on December 19, Morgan’s stock price rose from a close of $48.07 on the prior day
to a close of $50.58 per share.
IX. ADDITIONAL ALLEGATIONS OF SCIENTER
315. Defendants Mack, Cruz, Daula, Sidwell and Kelleher, by virtue of their receipt of
information reflecting the improper and fraudulent conduct described above and/or their failure
to review information they had a duty to monitor, their actual issuance of materially false and
misleading statements and/or their control over Morgan’s materially false and misleading
statements, and their associations with Morgan and each other, which made them privy to
confidential proprietary information concerning Morgan, were active, culpable, and primary
participants in the fraud alleged herein. Defendants Mack, Cruz, Daula, Sidwell and Kelleher
knew and/or recklessly disregarded the materially false and misleading nature of the information
they caused to be disseminated during the Class Period to the investing public.
316. Defendants Mack, Cruz, Daula, Sidwell and Kelleher knew and/or recklessly
disregarded that the materially false and misleading statements and omissions contained in
Morgan’s public statements would adversely affect the integrity of the market for Morgan’s
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common stock and would cause the price of Morgan’s common stock to be or to remain
artificially inflated. Defendants Mack, Cruz, Daula, Sidwell and Kelleher acted knowingly
and/or in such a reckless manner as to constitute a fraud and deceit upon Plaintiffs and other
members of the Class.
317. In addition to the foregoing allegations, the following facts support a strong
inference that Morgan and Defendants Mack, Cruz, Daula, Sidwell and Kelleher knew and/or
recklessly disregarded that the challenged statements set forth herein were materially false and
misleading when made.
318. By virtue of their professional positions and obligations, access to information,
and careers, each of these Defendants was keenly aware of the deteriorating conditions in the
U.S. subprime mortgage market and the effect of these conditions on the value of securities
linked to these mortgages, including the Long Position. For example, as a consequence of
Morgan’s acquisition of Saxon Capital in December 2006, the collapse of numerous subprime
mortgage originators in the first and second quarters of 2007, the demise of the BSAM hedge
funds, skyrocketing subprime mortgage default and delinquency rates, rating agency markdowns
of RMBSs, and the drop in the ABX indices, the Defendants knew that the mortgage market was
under intense scrutiny by investors and that Morgan’s exposures to the subprime market were
key areas of focus for the investment community.
319. Defendants knew and/or recklessly disregarded that the Long Position constituted
a significant concentration of credit risk due to its size and the significant degradation of the
subprime RMBS-backed CDO market. Furthermore, by nature of the reporting structure
amongst the Defendants and their professional positions and responsibilities, by no later than
early July 2007, each Defendant knew and/or recklessly disregarded that a stress test
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commissioned by Cruz and reported on by Daula had demonstrated that Morgan could lose up to
$3.5 billion on the Long Position under the assumptions of the tests. The strong inference of
scienter that Defendants knew and/or recklessly disregarded that the Long Position was a
significant concentration of credit risk is demonstrated also by Defendant Cruz’s instruction to
Daula and Shear to “cut the position.”
320. A strong inference of scienter also is apparent based on the call in early July of
2007 between Deutsche Bank and Morgan, wherein Deutsche Bank requested that Morgan post
$1.2 billion in collateral because the Long Position had lost 30 percent of its value. As alleged
above, Morgan’s refusal to buy more CDS protection at a price of 77 percent of par, even though
Morgan claimed the market price was 95 percent of par, further shows Defendants’ scienter
because present on the call were the managers of the ISG, who reported to Defendants Cruz,
Daula, Sidwell, and Mack.
321. For the same reasons, the Deutsche Bank call also demonstrates that Defendants
understood that by no later than July 2007, that the Long Position’s value had dropped at least
below 77 percent of par. As such, Defendants also understood that the Long Position, the
notional value of which was roughly $13.2 billion, required a write-down of at least $3.0 billion.
322. A strong inference of Defendants’ scienter is also established by the fact that
Morgan’s CDO analysts were, by July 2007, predicting that subprime RMBSs would suffer
significant losses in the near term, which would have “profound” negative implications for the
value of ABS CDOs, such as those underlying the Long Position. Specifically, Defendants knew
the content of the February 12, June 22, June 28, and July 16, 2007 Morgan Analyst Reports
and/or had access to these reports and to the analysts themselves, and intentionally or recklessly
disregarded their content and/or Defendants recklessly failed to make themselves aware of the
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Reports’ content. As such, Defendants knew and/or recklessly disregarded that the Long
Position was a significant concentration of credit risk, and, due to their involvement in the core
functions of the Company (including financial reporting), knew that GAAP and Regulation S-K
required Defendants to disclose the Long Position to investors.
323. Defendants’ failure to use the ABX Index to calculate losses on the Long Position
and Defendants’ use of inaccurate Level 3 inputs instead further establishes Defendants’ scienter
because Defendants acknowledged orally and in SEC filings on several occasions during the
Class Period that valuation of the Long Position was based on the ABX Index.
324. A strong inference of Defendants’ scienter also is established by the fact that,
according to CW 4, during the “summer” of 2007, Defendant Cruz ordered the Global Head of
Securitized Products, Anthony Tufariello, and Howard Hubler, the manager of the PTG, to
convene a “super task force” of 40 or 50 key, senior traders from Morgan’s Fixed Income
division. According to CW 4, Tufariello informed the meeting participants that Morgan had a
“large position” with exposure to the subprime mortgage market, and that there was a need to
develop “creative strategies” to sell the “assets at risk.” CW 4 recalled that during the meeting,
the discussion of the assets at risk included references to CDSs, super-senior CDO tranches and
subprime mortgages.
325. According to CW 4, shortly after this meeting, a senior member of the Company’s
structuring and modeling group instructed Michael Jensen, a trader who worked in the PTG, to
meet with a fixed income securities analysts to assess the PTG’s subprime positions.
Specifically, CW 4 believes the individuals were tasked with determining the “range of how bad
things could get.” CW 4 was told that this weeklong assessment of the potential downside risk to
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the Company was prepared for Defendants Cruz and Mack as part of a larger report analyzing
the PTG’s positions.
326. CW 4’s recounting of the events described in paragraphs 325 and 324 establishes
that Cruz and Mack both were directly involved with the events described by CW 4.
327. CW 4’s recounting of these events also establishes that Defendants Sidwell,
Kelleher, and Daula were directly involved in the events described by CW 4. As CFO and
“shadow” CFO of the Company at that time, respectively, Sidwell and Kelleher were involved in
the meetings and work described by CW 4 due to the monetary enormity of the Long Position
and these Defendants’ positions within the Company at that time. Likewise, as the CRO at that
time, Daula was involved in these meetings and related work because they were intended to
assess the risks posed by Morgan’s massive subprime exposure and develop strategies to
mitigate that risk.
328. A strong inference of scienter is established as to all Defendants based on the
events described by CW 4 because the events and Defendants’ involvement in them demonstrate
that Defendants were extremely concerned about Morgan’s subprime exposure, including the
Long Position, and understood that it was a significant concentration of credit risk, that it was
rapidly decreasing in value, and that only “creative strategies” could enable Morgan to sell off
these positions because the market had turned steeply against Morgan. In short, Defendants and
Fixed Income managers were in an “all hands on deck” mode about the losses incurred and soon-
to-occur on the Long Position and Morgan’s other subprime exposures. Given Defendants’
extremely worried state of mind, a strong inference of scienter is established that Defendants
intentionally or recklessly failed to disclose the existence, extent, and nature of the Long Position
in contravention of the duty they knew they each had pursuant to GAAP and Regulation S-K.
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329. By August 2007, each of the Defendants knew and/or recklessly disregarded that
the Company’s risk controls relating to the pricing and reporting of the Company’s exposures to
subprime were deficient, as demonstrated by Daula’s “vocal” concerns that “there were no
proper pricing models for [subprime related] . . . trades, that positions were not being properly
measured, and that the history traders used in their models was not a reliable guide.” Thus,
Defendants had, at best, no reasonable basis for making the statements they made.
330. Moreover, each of the Defendants was aware of and/or recklessly disregarded the
SEC’s request for greater clarity and transparency of the Company’s U.S. subprime exposures by
virtue of the letter directed to Defendant Sidwell on August 30, 2007.
331. Defendants’ knowledge and/or recklessness is also evident from the rapid firings,
resignations, and concessions following the disclosure to shareholders of the Long Position. For
example, John Mack said on the earnings conference call on December 19, 2007, “the results we
announced today are embarrassing for me, for our firm, this loss was the result of an error in
judgment that occurred on one desk, in our Fixed Income area, and also a failure to manage that
risk appropriately. Make no mistake, we’ve held people accountable. We’re moving
aggressively to make the necessary changes.”
332. Howard Hubler was fired on November 2, 2007, Cruz, was fired on November
29, 2007, and Anthony Tufariello, Hubler’s immediate supervisor, was fired on November 30,
2007. Neal Shear, once the second highest paid individual at the Company, was demoted on
November 29, 2007; he would later resign in March 2008. Daula also resigned in March 2008.
David Sidwell, who had announced that he would retire at the end of the financial year, resigned
early, on October 31, 2007, leaving Kelleher, in his first appearance as CFO, to face investors
about the Company’s losses.
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333. The chart below shows the individuals who were fired, demoted, or resigned in
connection with the Company’s disclosures of its losses.
Figure 6: Morgan Relevant Personnel ChangesAfter November 7 2007
John MackChairman
} ChiefExectdiveOfficer }
f David Sidwell: RESIGNED OCT. 31, 5 Gary Lynch2007 Chief Legal Officer
ti ChiefFimncialOfrer
Zoe C=: FIRED: NOV. 29, 2007Co-Presiderd
'Thomas Dm3la: RESIGNED: FEB. 26,2008
4 Chief Risk Officer
Neal Shear: DEMOTED, NOV. 30,2007
Global Head of FixedIncaxre
1 f Arthow Tu axxllo: FIRED NOV. 29,'2007
s Global Head— SecuritizedPnadmts
Howard Hubler: FIRED: NOV. 2, 2M'PriEtTig
4
334. Defendants were also motivated to conceal Morgan’s $13.2 billion Long Position
and the proper valuation thereof to effectuate a $1 billion offering of highly rated “Aa3” notes, to
meet quarterly earnings projections by analysts and to maintain Morgan’s credit ratings to
decrease the cost of borrowing by the investment bank. During the Class Period, the Company
had announced and was issuing to the public $1 billion worth of Fixed Rate Senior Notes
(“Senior Notes”). Defendants completed this much needed cash infusion just one week prior to
Defendants’ November 7, 2007 disclosure of the Long Position and the massive losses it had
suffered. In fact, in addition to other strong motivations, Defendants were motivated to
perpetuate their fraud throughout the Class Period so as not to derail the $1 billion offering. The
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Company issued an amended prospectus on July 24, 2007 and a pricing supplement on October
30, 2007; therefore, disclosure of the Long Position could not occur until after those events.
When the Notes were publicly issued in late October 2007, the Company, Mack, and Sidwell
knew and/or recklessly disregarded that Morgan’s true financial condition and prospects had not
been fairly presented in the Company’s SEC filings, which were incorporated by reference into
the Registration Statement and Prospectuses for the Notes.
335. Defendants’ motivation to conceal the Long Position was further evidenced by
their concealment of the June 30, 2007, $300 million write-down and the September 30, 2007,
$1.9 billion write-down on the Long Position. Although Defendants recorded the write-downs
during the Class Period, they did not disclose these write-down figures to the market until they
were effectively forced to on November 7, 2007, after a full week of speculative reports by
analysts had battered the Company’s stock price. Had Defendants disclosed the Second and
Third Quarter write-downs earlier, as GAAP and Regulation S-K required Defendants to do,
Defendants would have had no choice but to disclose the Long Position, which would have
alerted the market to the fact that Morgan was exposed to billions of dollars in subprime-related
losses, when the Company had articulated and/or suggested that it had no such material
exposure.
336. A strong inference of scienter is also established because Morgan, while Mack
was its President and Chief Operating Officer of the Company, demonstrated a propensity to
fraudulently value assets and overstate its earnings and financial condition in the past. In
November 2004, the Company agreed to a cease and desist order in which the SEC found that
Morgan had overvalued certain high-yield bonds by failing to properly value the bonds as of the
current measurement date. Instead, much as Defendants did in the Second and Third Quarter
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2007 with respect to the ABX Index and value of the Long Position, Morgan discounted or
ignored then-current market conditions, took “a longer view of the market,” and valued the
bonds based on Morgan’s subjective opinion instead of prices quoted by external pricing sources.
By overvaluing those bonds, the SEC concluded that “Morgan Stanley’s financial results for the
fourth quarter of fiscal year 2000, as reported on filings made with the Commission, were
misstated and not in conformity with GAAP.”
337. In this same order, the SEC also found that the Company overvalued certain
aircraft leasing assets during a slump period in that industry brought about by the September 11,
2001 terrorist attacks. Morgan used a contrived valuation method not in compliance with GAAP
to determine the value of certain impaired aircraft in its portfolio. As with the high-yield bonds,
Morgan failed to consider the current market conditions to calculate fair value. As a result of
overvaluing the aircraft assets, the SEC concluded that “Morgan Stanley’s financial results for
the fourth quarter of fiscal year 2001, third quarter of fiscal 2002 and the first quarter of fiscal
2003, as reported on filings made with the Commission, were misstated and not in conformity
with GAAP.”
A. John J. Mack
338. Defendant Mack participated in the issuance of, signed, and certified as accurate
and complete as required by Sarbanes-Oxley, the Company’s materially false and misleading
SEC filings issued during the Class Period, specifically the Company’s Second and Third
Quarter Form 10-Qs. Throughout the Class Period, Defendant Mack also made a number of
materially false and misleading statements as stated herein regarding the Company’s subprime
exposure and earnings. In light of the foregoing, Mack had a duty to know, and knew or
recklessly disregarded, but concealed, the true loses on the Long Position, and that the Long
Position constituted a significant concentration of credit risk.
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339. Morgan’s acquisition and aggressive trading of risky subprime assets, including
the Long Position, was fostered by Mack who implemented a business strategy that steered the
Company to assume higher levels of risk.
340. Mack’s knowledge of the Company’s subprime exposure and fraudulent
valuation of the Long Position is evidenced by the fact that Mack actively changed the risk
reporting structure within the Company so that one of his direct reports would receive all
material information regarding Morgan’s risk exposures. Specifically, in October 2005, Mack
altered Defendant Daula’s reporting line so that he reported directly to Mack’s hand-picked
Company Co-President, head of trading, and direct report, Zoe Cruz, notwithstanding that Cruz’s
colleagues had panned her as recklessly assuming or disregarding risk. See, supra, 2008 Cruz
Article (“‘I’d be more than happy for Zoe [Cruz] to take more risk,’' [Vikram] Pandit told a
friend, ‘if I felt comfortable that she understood the risk she’d be taking.’').
341. In an April 21, 2007 Shareholder Meeting, Mack singled out Cruz (and Daula) as
being responsible for managing Morgan’s risk exposure and reassured investors that Cruz and
Daula’s management of the Company’s risk exposure boded well for the Company and investors.
Thus, while Mack was encouraging Morgan to increase its risk appetite – while assuring
investors that Morgan’s risk assessment tools were effective – he deliberately altered the
reporting structure to place a manager with debilitating conflicts of interest (as Cruz’s
compensation was based on the performance of ISG) in charge of ensuring that the Company
complied with its stated risk exposure policies. Cruz – who reported directly to Mack –
effectively held sole authority for managing risks of trades that she was approving.
342. Defendant Mack’s willingness to recklessly amass risk initially paid dividends as
ISG reported record results throughout fiscal 2006, and through the first two quarters of fiscal
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2007. The Company’s positive statements about its ability to manage risk continued into the first
and second quarters of 2007 which led to, inter alia, credit upgrades from S&P, which were
based on Morgan’s purported ability to distinguish itself from its Wall Street peers as problems
continually erupted from the ongoing collapse of the subprime market.
343. However, while Mack and Morgan were touting the Company’s disciplined
growth, by at least May 2007 before the Class Period even began, by her own admission, Mack’s
direct report and the head of the trading unit, Zoe Cruz, became personally aware of the potential
catastrophic exposure Morgan faced by a collapse of the housing/credit markets. When (by July
2007) the results of Cruz’s requested stress test results demonstrated that the Company could
lose $3.5 billion from its subprime related exposure, such that she ordered the Long Position cut,
disclosure of this potential subprime-related loss could have cost the Company a ratings
downgrade from rating agencies thereby forcing the Company to raise hundreds of millions of
dollars in additional capital. As Cruz was a direct report of Mack, it is more than reasonable to
infer that Mack knew of and/or recklessly disregarded the foregoing facts.
344. There is little doubt that Mack was aware of and purposely and/or recklessly
concealed Morgan’s exposure to the Long Position during the Class Period, as credit markets
were tightening and panic was ensuing as Wall Street titans like Citigroup and Merrill Lynch
reported declines in profits and huge multi-billion-dollar losses from bad bets on securities
underpinned by subprime mortgages. Throughout most of fiscal 2007, until November 7, 2007,
Defendant Mack and the other Defendants deliberately and/or recklessly stated and implied that
Morgan had largely skirted subprime mortgage losses that plagued the Company’s rivals. By
distinguishing Morgan from its Peers, Mack had a duty to know about Morgan’s exposure to the
deteriorating subprime market in order to have a reasonable basis for making such statements.
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Furthermore, Mack was incented to separate Morgan from its peers as he knew that cash was
critical as capital suddenly was hard to come by – even for Wall Street stalwarts like Morgan --
and earnings volatility and ratings downgrades that would have occurred with the disclosure of
the $13.2 billion Long Position would have materially impaired Morgan’s ability to obtain cash
infusions.
345. As disclosed by the Company in its Form 10-Q for Third Quarter, a one-notch
downgrade by the Rating Agencies would have materially disrupted the Company’s operations
and would have required the Company to post an additional $588 million in collateral to
counterparties. By deliberately failing to mark to market and record losses on its risky Long
Position and deliberately and recklessly avoiding disclosure of Morgan’s multi-billion dollar
subprime exposure, Mack was quietly able to negotiate a $5 billion capital infusion from a
Chinese sovereign wealth fund that prevented a capital void that would have severely disrupted
the Company’s ability to operate in the already roiling credit markets. As noted above, the
concealment of the Long Position also enabled Mack to effectuate the $1 billion note issuance.
346. Cruz’s stress test, which was ordered in May of 2007 and completed by the first
week of July, and which demonstrated the potential debilitating effect of the Long Position (that
she approved) on Morgan’s financial condition, was not the only piece of information that Mack
had access to regarding the Company’s ensuing financial crisis during the Class Period. In a
letter dated August 20, 2007, the SEC informed Defendants that Morgan’s subprime-related
disclosures were insufficient. As CEO it is highly unlikely that Mack would not have been
aware of the SEC letter and their request for additional information and disclosures by Morgan.
Moreover, by August 2007, Daula – who was touted by Mack as being “one of the best overall
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risk managers” – admitted that he was “vocally” warning Defendants that the pricing models
used by Morgan to value assets were flawed and were not producing accurate results.
347. Mack, along with the other Defendants, managed the day-to-day affairs of the
Company through his CEO responsibilities and participation on Morgan’s management
committee. As reported in The Wall Street Journal, Mack also had been attending weekly risk-
assessment meetings at least by October 2007 regarding “rumblings” of the Company’s
“$7.8 billion fourth-quarter write-down tied to bad CDO bets.” (Randall Smith & Kate Kelly,
“Once Again the Risk Protection Fails,” The Wall Street Journal, Jan. 25, 2008.) As such, Mack
undoubtedly knew that the Company had already concealed the $300 million and the $1.9 billion
write-down of the Long Position in order to conceal the very existence of the Long Position in
the first place and that his certifications of these previously filed financial statements were false
and misleading.
348. Mack was aware or recklessly disregarded that credit rating downgrades for
RMBS and ABS CDOs signaled that mezzanine ABS CDO tranches were also going to be
subject to downgrades and write-downs. Mack also knew about, or had at his disposal but
recklessly disregarded, Morgan’s own analysts’ reports, which by mid July predicted that
mezzanine-grade RMBSs were likely to suffer significant losses imminently. As a former fixed-
income trader, and the creator of the PTG, Mack understood or recklessly disregarded that such
losses would have a disastrous effect on the Long Position.
349. Given Mack’s position in the company, his interest in the PTG, and the reporting
structure in place, Mack knew about the Deutsche Bank collateral call, as Hubler and his
immediate bosses were Mack’s direct reports, and a collateral call for $1.2 billion was a
significant financial event for Morgan, given that net revenue for Second Quarter 2007 for the
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entire ISG – which had a record quarter – was roughly $7.4 billion and income from continuing
operations was roughly $3.0 billion.
350. Despite all of the following: 1) receipt of the SEC’s letter demanding additional
subprime-related disclosures; 2) critical deterioration in the credit markets; 3) enormous reported
subprime-related losses from Morgan’s Wall Street peers; 4) participation in weekly credit
assessment meetings regarding the multi-billion dollar Fourth Quarter 2007 write-down; 5)
Daula’s warnings and the reports of losses as demonstrated by Cruz’s stress test; and 6)
knowledge or reckless disregard of growing illiquidity from tightening credit markets; Mack
publicly concealed the extent of the Company’s massive subprime exposure until
unavoidable billions in write-downs could no longer be concealed because of leaks in the market
regarding the Long Position and the continuing demise of the subprime and credit markets, and
most importantly, the continuing substantial decline in the ABX Index.
351. Defendant Mack certified both the Second Quarter 2007 Form 10-Q, which failed
to disclose and properly value the Long Position, and the Form 10-Q for Third Quarter, which
failed to disclose and properly value of the Long Position, and knowingly and recklessly stated
that each of the 10-Qs “fairly presents, in all material respects, the financial condition and results
of operations of the Company.”
352. Further, Morgan’s attempt to paint its November 7, 2007, write-down as the result
of a sudden realization that its U.S. subprime liabilities suddenly materialized is completely
undermined by the actions of Cruz, Mack’s direct report, who beginning in May and continuing
through the summer of 2007, ordered the unwinding other subprime positions and required a
stress test on the Long Position and demanded that the position be cut.
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353. Throughout the Class Period, Mack knew and/or recklessly disregarded that the
overall impression created by Morgan’s financial statements and earnings reports were not
consistent with the business realities of the Company’s financial condition and prospects.
Moreover, for each of the Form 10-Qs for Second and Third Quarter 2007, Mack had a duty to
assess the accuracy of the statements therein as he signed a “Rule 13A-14(A) Certification of
Chief Executive Officer,” which was filed with the each Form 10-Q.
354. Mack had strong personal incentives – both economic and reputational -- to
manipulate Morgan’s true financial condition, as the majority of his compensation was through a
bonus that was directly tied to the Company’s performance. Mack’s annual salary was
$800,000, but over 98 percent of his compensation was received in year-end bonuses (restricted
stock units and stock options) that depended upon Mack’s performance and the Company’s
performance and progress towards its strategic goals. Mack held the distinction in years past as
having received “the largest bonus awarded to a Wall Street CEO,” as reported in USA Today,
December 15, 2006.
355. Mack had publicly announced in 2005 the goal of doubling Morgan’s pre-tax
profits in five years and committed to substantially growing income and earnings by balancing a
deliberate increased risk appetite for aggressive proprietary trading with increased risk controls.
Mack knew or recklessly disregarded the extent of Morgan’s subprime exposure, the liabilities
resulting from multi-billion-dollar, high-risk Long Position, and the fact that the exposures
deliberately were not properly valued in accordance with GAAP so that the Company could meet
analyst expectations during the Class Period. Defendant Mack and the other defendants
recklessly hoped – against clear moribund signals – that the subprime and CDO markets would
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rebound and that they could unwind Morgan’s Long Position, or buy time to find an investor to
shore up the Company’s capital needs.
B. David Sidwell
356. As Morgan’s CFO for the majority of the Class Period, Defendant Sidwell
participated in the issuance of, signed and certified the Company’s materially false and
misleading SEC filings as accurate and complete, as required by Sarbanes-Oxley. During the
Class Period, Sidwell signed and certified the Company’s Form 10-Qs for Second and Third
Quarter filed with the SEC, and until he resigned on October 31, 2007, Sidwell conducted
quarterly earnings conference calls with shareholders and investors and made a number of
materially false and misleading statements regarding the Company’s subprime exposure as well
as its risk-monitoring infrastructure. As Morgan’s CFO, Sidwell had a duty to know of the
significant concentration of credit risk and the correct value of the Long Position and that such
was properly reported to investors consistent with FAS 107, FAS 157, and Regulation S-K.
357. As the Company’s CFO, Sidwell was in a position to and did in fact know and/or
recklessly disregard the above false statements and omissions as he was in charge of monitoring
the Company’s internal controls and reporting Morgan’s risks, including the undisclosed and
undervalued $13.2 billion-dollar Long Position during the Class Period. Sidwell assumed his
CFO role at Morgan in March 2004, and therefore, he was keenly aware of Morgan’s agreement
to enter in the Cease and Desist Order with the SEC in November 2004, in which the Company
agreed to not violate the Exchange Act again and to maintain adequate controls to ensure that
Morgan valued its positions in accordance with GAAP and accurately stated its positions in the
Company’s books and records. In an investment bank, it is the CFO’s job to know the
company’s proprietary trading positions because the CFO is responsible for obtaining the
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financing to purchase those securities. Therefore, Sidwell could not have been ignorant about
the existence, size, nature and improper valuation of the Proprietary Trade.
358. Having singled out and publicly discussed during the September 19, 2007
conference call the transfer of CDS valuations from Level 2 to Level 3 inputs, Sidwell either
knew or was reckless in not knowing that the fair value category of the Long Position was being
changed because the proper fair value of these CDSs was based on the ABX Index. Thus,
Sidwell either knew or was reckless in not knowing that the Long Position was not being
recorded at fair value.
359. In addition to his years of experience as Morgan’s CFO, Sidwell had 20 years of
extensive experience as the former CFO of the investment bank division of JPMorgan Chase and
as Controller of its predecessor, JPMorgan. Prior to his experience at JPMorgan Chase, Sidwell
spent nine years with the public accounting firm, PricewaterhouseCoopers, and he had served as
a trustee of the International Accounting Standards Committee Foundation and was a member
and Chair of the SEC Committee on Corporate Reporting of Financial Executives International.
He also had in the past been a committee member of an advisory council of Emerging Issues
Task Force of FASB. Sidwell also was tapped in October 2007 to be a member of the SEC
Advisory Committee on Improvements to Financial Reporting.
360. Defendant Sidwell drew upon his numerous years of expertise in GAAP and
financial reporting to guide Morgan through its adoption of FAS 157 in December 2006.
Therefore, he was acutely aware of the FAS 157s fair value reporting requirements and had
purportedly implemented them at the Company. During the Class Period, Sidwell knowingly
and recklessly caused Morgan to issue and file financial statements and reports with the SEC that
stated that the Company had implemented FAS 157 and had prepared its financial statements in
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accordance with FAS 157, when he knew or recklessly disregarded that Defendants had not
complied with FAS 157 for the Company’s risky multi-billion-dollar bet on subprime-related
securities.
361. Sidwell also served on Morgan’s Management Committee through which he and
other high-level executives, including Defendants Mack, Cruz and Daula, oversaw and
controlled the Company’s day-to-day activities and had ultimate responsibility for the control
function over trading activities.
362. Additionally, Sidwell knew about the Long Position, and knew he was concealing
it from investors because he refused point blank to disclose information regarding how Morgan
was positioned when he was asked for that information. During the First Quarter 2007 earnings
conference call an analyst stated that he gleaned from Sidwell’s comments that Morgan had been
“short subprime very successfully” during First Quarter. Sidwell responded, “I actually don’t
really want to address specifically how we were positioned . . .”
363. Even prior to the Class Period, Sidwell assured investors that Defendants kept a
close watch over and thus knew the extent of the Company’s risk, touting that Morgan increased
its risk taking endeavors in a “disciplined and balanced way.” Likewise, in reporting earnings
for the First Quarter 2007, Sidwell assured investors that subprime had been a key focus in the
market during early March 2007, and, as a result, the Company purportedly had managed its risk
through a variety of hedging strategies and proprietary risk positions that had significantly
contributed to Morgan’s record trading results and income. By virtue of Sidwell having made
these representations in his capacity as the Company’s CFO, it is reasonable to infer that he
knew of and purposely concealed the risk exposure from and value of the Long Position.
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364. Sidwell further assured investors that the Company had decreased Morgan’s risk
exposure in early 2007 to balance Morgan’s level of risk with Defendants’ view of potential
market changes. This was all part of the total mix of information regarding Morgan leading into
the Class Period. However, once the Class Period began, Sidwell knew and/or deliberately and
recklessly disregarded that the PTG’s Long Position had exposed the Company to billions of
dollars in losses because he participated on the Company’s Management Committee along with
Defendant Daula, the Company’s CRO. As confirmed by CW 5, Morgan’s controllers created
daily summaries of trading positions and marks from Morgan’s traders that passed up the line of
authority at Morgan to Sidwell and other managers.
365. Sidwell knowingly and/or recklessly made material misrepresentations
concerning the Company’s ability to weather the subprime meltdown during the Class Period.
Indeed, at the beginning of the Class Period, during a June 20, 2007 Second Quarter earnings call
with analysts, Sidwell served as the spokesperson for the Company assured the market that the
Company “certainly did not lose money in [the subprime] business” during Second Quarter 2007
notwithstanding, inter alia, that the Company wrote down the Long Position by $300 million by
June 30, 2007 (the end of the second quarter). Sidwell’s comments were made after Cruz
(starting in May 2007) began cutting, and selectively advising Morgan customers to eliminate,
subprime-related positions and had ordered Daula to conduct a stress test on Morgan’s positions.
Sidwell admittedly was familiar with the Company’s stress testing, commenting on the Second
Quarter 2007 earnings call that stress testing scenarios helped him and others “manage less liquid
risk” as the Company had increased risk exposure during the latter half of Second Quarter to
“balance the level of risk with our view of market opportunities....”
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366. Thus, while Sidwell was assuring analysts and the market that the Company had
not suffered from any marks in the mortgage area from “betting the wrong way” and “did not
lose money in [the subprime] business,” and that concerns regarding the spread of the subprime
meltdown “dissipated” during the Second Quarter, (1) Morgan executives who worked closely
with Sidwell (Cruz, in particular) simultaneously were advocating unwinding the Company’s
exposure to subprime losses and had ordered stress tests on the Long Position; and (2) Sidwell
knew by this time that the Proprietary Trade had been written down by at least $300 million.
Sidwell made no mention on the Second Quarter 2007 earnings conference call of these facts,
nor of the Company’s multi-billion-dollar exposure to a significant concentration of credit risk
from the Long Position.
367. Further, the SEC’s August 30, 2007 letter was addressed to Sidwell and put him
and the Company on further notice that the SEC considered Morgan’s disclosures about its
subprime exposure inadequate. Moreover, an article appearing in The Financial Times disclosed
that “[b]y August [2007], Mr. Daula was very vocal in saying that there were no proper pricing
models for [subprime related] . . . trades, that positions were not being properly measured, and
that the history traders used in their models was not a reliable guide.” (Henry Sender, “Morgan
Stanley reviews risk role,” The Financial Times, Dec. 21, 2007 (“Sender Article”).) Despite the
SEC’s direct request to Sidwell for more transparency and Daula’s “vocal” warnings, Morgan’s
Third Quarter 10-Q (filed 40 days after the SEC’s letter was issued) – which was signed by
Sidwell – failed to provide investors with any detail concerning: i) Morgan’s exposure to
potentially unavoidable multi-billion-dollar losses from the Long Position; ii) Cruz’s frantic
divestment of subprime-related exposure beginning in May; iii) the results of Cruz’s stress test;
iv) Daula’s warnings; or v) Deutsche Bank’s collateral call in early July.
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368. Flouting the SEC’s request, Sidwell knew or recklessly disregarded that the
Company was attempting to conceal Morgan’s exposure to and fair value of the Long Position
by using Level 3 inputs to generate a more favorable valuation when the Level 2 inputs, which
had been used all along, yielded an unacceptable result. The use of those Level 3 inputs over
Level 2 inputs – which violated GAAP – was motivated not only by Sidwell’s desire to conceal
losses from the Long Position, but also by his desire to ensure that Morgan met earnings
expectations. The Company reported earnings per share of $1.3 8, which exactly met the low end
of Wall Street’s expectations solely by using Level 3 inputs to value the Long Position and
ignoring inputs from the ABX Index. Without the manipulation of fair value and deliberate
disassociation of the Long Position from the ABX Index, Morgan would have been forced to
record $4.4 billion of losses on the Long Position, and would have reported a quarterly loss for
the first time in the Company’s history.
369. Defendants failed to respond timely to the SEC’s request for additional subprime
disclosures, until November 27, 2007 (after Sidwell had retired) and well after the Company had
been forced to confirm the existence of an aggressive multi-billion-dollar subprime bet that had
exposed the Company and its investors to billions in losses.
370. Given Sidwell’s position in the company, his involvement in the PTG, and the
reporting structure in place, Sidwell knew about the Deutsche Bank collateral call, as a collateral
call for $1.2 billion was a significant financial event for Morgan. By way of comparison,
Morgan’s net revenue for Second Quarter 2007 for the entire ISG – which had a record quarter –
was roughly $7.4 billion and income from continuing operations was roughly $3.0 billion.
371. Sidwell’s fraudulent concealment of the significant concentration of credit risk
inherent in, and the improper valuation of, the Long Position is also amply evident in his
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comments on the Third Quarter 2007 Conference Call. During the Third Quarter 2007
Conference Call, Sidwell acknowledged that the credit markets had deteriorated considerably
during the course of the Company’s Third Quarter and that “increased volatility, significant
spread widening, lower levels of liquidity, and reduced price transparency at all parts of the
capital structure” had affected lending markets, the effectiveness of hedging strategies, subprime
mortgage markets, including the CDS market, and other structured credit products. He further
stated that the “credit environment” had significantly impacted Morgan’s results in lending and
credit sales and trading. Sidwell provided granular detail of how markdowns to loans and
commitments had led to approximately $940 million in mark-to-market losses during the quarter
and that EPS from such losses was approximately $0.33 per share. He also gave details
regarding $480 million in other losses, but neglected to mention that Defendants had secretly
written down the Long Position by $1.9 billion during Third Quarter. This astonishing failure to
mention a $1.9 billion write-down was deliberate and/or omitted with recklessness disregard.
372. On the Third Quarter 2007 earnings conference call, Sidwell also knowingly
and/or recklessly omitted any reference to: i) reclassification of subprime-related CDS liabilities
from Level 2 to Level 3; ii) the subprime-related exposure to billions of dollars in losses; or iii)
the devastating results of Cruz’s stress test. He further deliberately and/or recklessly omitted to
reference the true motivation behind the improper reclassification of assets and liabilities, which
was to meet earnings projections and allow the Company to quietly obtain a capital infusion
before shareholders and investors were able to discover that the Long Position had saddled the
Company with billions in losses that had not been reported.
373. Sidwell deliberately and/or recklessly stated that the Company’s “assets and
liabilities that is are recorded at fair value.” Sidwell also publicly claimed that Defendants used
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observable market data to value its assets and liabilities, which, as CFO, he knew was materially
false and misleading as he and other Defendants knowingly and/or recklessly failed to record the
$13.2 billion Long Position at fair value as dictated by the decline in the benchmark ABX
indices, which was the most significant observable input to value the Long Position in Third
Quarter 2007.
374. Moreover, for each of the Form 10-Qs for the Second and Third Quarters 2007,
Sidwell signed a Rule 13A-14(A) Certification of Chief Financial Officer. Defendant Sidwell
also certified both the Form 10-Qs for Second and Third Quarter 2007, as required by Sarbanes-
Oxley, and knowingly and/or recklessly confirmed that each of the 10-Qs “fairly presents, in all
material respects, the financial condition and results of operations of the Company.” Sidwell
knew or recklessly disregarded that these statements and certifications were materially false and
misleading when made.
375. Sidwell directly benefited from misrepresenting Morgan’s true financial
condition. His compensation was tied to the Company’s performance, and although Sidwell had
announced his intention to resign effective at fiscal 2007 year end, he relinquished his CFO
position on October 11, 2007, which was the day after the Form 10-Q for Third Quarter was filed
with the SEC. Sidwell retired from employment with Morgan on October 31, 2007, according to
Morgan’s 2008 Proxy (filed with the SEC on February 27, 2008). Therefore, Morgan’s
compensation committee considered only his and the Company’s performance for the first three
quarters of the fiscal year 2007 in deciding Sidwell’s bonus. Based on Sidwell’s “helping
develop the Company’s strategic growth plan and communicating it to the investment
community” during the first three quarters of fiscal 2007, Morgan’s compensation committee
awarded Sidwell a bonus of $13 million. Because Sidwell retired before the grant date of fiscal
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year-end incentive compensation, Sidwell was able to obtain his entire fiscal 2007 bonus in cash,
instead of an equity award.
C. Zoe Cruz
376. While investors were being assured that Morgan’s risk from subprime exposure
was contained, according to the Cruz 2008 Article, Cruz claimed that she had personally become
concerned about the Company’s exposure to the entire mortgage business and subprime losses
and began ordering the unwinding Morgan’s mortgage-related exposure by May of 2007. Cruz
also claims to have informed some of Morgan’s clients – but not Morgan’s shareholders – of an
impending collapse of the mortgage and housing markets and urged the Company’s clients to
exit positions to limit their exposure to mortgage related positions.
377. Cruz further acknowledged that her concerns led her to order Daula to run stress
tests on the PTG’s positions in May 2007. Cruz purportedly received the results of the stress test
on July 4, 2007, according to her own account of the timing. At that time, Defendant Daula
informed Cruz that the stress analysis suggested that Morgan could lose $3.5 billion on the
PTG’s Long Position.
378. Despite having specific knowledge of Morgan’s multi-billion dollar exposure to
subprime losses and concerns regarding that exposure, Cruz kept quiet and allowed the Company
to pre-announce earnings on June 20, 2007 and to file its Second Quarter 2007 Form 10-Q with
the SEC on July 10, 2007, without any disclosures regarding the Long Position or likely
subprime-related multi-billion-dollar losses. With respect to the actual filing of the Form 10-Q
for Second Quarter 2007, by that point in time, Cruz was in possession of the stress test results
and had already ordered Daula to cut the position. No disclosure of these material events was set
forth in connection with the filing, however.
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379. Given her position in the company, her involvement in the PTG, and the reporting
structure in place, Cruz knew about the Deutsche Bank collateral call, as Hubler and his
immediate bosses were her direct reports and a collateral call for $1.2 billion was a significant
financial event for Morgan. By way of comparison, Morgan’s net revenue for Second Quarter
2007 for the entire ISG – which had a record quarter – was roughly $7.4 billion and income from
continuing operations was roughly $3.0 billion.
380. Moreover, less than one month after Cruz ordered the Long Position to be cut,
Morgan continued to conceal the existence of the Long Position during the Second Quarter 2007
conference call held on June 20. During the call, Sidwell, as the spokesperson for the Company,
failed to mention the massive loss uncovered by the stress test ordered by Cruz weeks earlier.
Cruz had actual knowledge that these statements were materially false and misleading when
made.
381. On the Third Quarter 2007 conference call held on September 19, Defendant
Kelleher reported that an additional $2 billion in capital had been allocated to the ISG, which
was under Cruz’s control. Thus, while Cruz was ordering the Company to cut its exposure to
subprime losses and had concerns with how the exposure would affect the Company, Cruz knew
that Morgan’s investors were being led to believe that all was well within the Company. Cruz
also knowingly and recklessly stood idly by as Morgan’s Third Quarter 2007 earnings release
and Form 10-Q for Third Quarter said nothing of the Company’s $1.9 billion write-down of the
Long Position – caused by the PTG of the ISG division that she managed and controlled – or the
existence of the Company’s Long Position.
382. Throughout the summer of 2007, Cruz “underplayed the extent of the losses [at
Morgan]” to Morgan investors, although according to ISG clients, she was very bearish on
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subprime and very concerned. See, supra, 2008 Cruz Article (“‘She was clearly a bear and
clearly extremely concerned, and she called me every couple of weeks,’ says one of her former
clients, Stanley Druckenmiller, a veteran hedge-fund manager.”).
383. Throughout the Class Period, Cruz received weekly updates from Daula on the
Company’s risk positions, and Hubler directly reported to Cruz. Further, Cruz’s job
responsibilities required her personally to be aware of material transactions and exposures within
her department, such as the Long Position. In addition, unbeknownst to investors, Defendant
Daula, the Company’s CRO, reported directly to Cruz. As a result, Cruz had unfettered access to
this material adverse information regarding Morgan’s risk exposures at any time she wanted it.
Cruz’s knowledge that the Long Position amounted to a significant concentration of credit risk is
evidenced not only by her own account of events (including the results of the stress test and
Daula’s reports), but also by external markets factors about which she was doubtlessly aware,
such as the eroding ABX Index, subprime losses by Morgan’s peers, increasing subprime default
rates, and a the deteriorating subprime housing market.
384. Also in July 2007, Cruz and the rest of the Defendants were aware or recklessly
disregarded that credit rating downgrades for subprime-backed RMBS and ABS CDOs signaled
that mezzanine ABS CDO tranches were also going to be subject to downgrades and write-
downs. Morgan’s own analysts publicly projected in a July 16, 2007 research report that write-
downs could “bleed into parts of the A stack”, signaling that the Long Position was at risk.
Morgan’s own analyst reports detailed the across-the-board RMBS ratings downgrades, the
increasing delinquency and default rates, and the disastrous effects these forces were likely to
have on subprime RMBS-backed CDO like those underlying the Long Position. Thus, Cruz
knew about, or had at her disposal and recklessly disregarded, key information during the Class
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Period that the Long Position would suffer massive losses in the near term. By no later than July
4, 2007, Cruz knew that Daula’s stress test revealed that the Long Position could lose
$3.5 billion under the assumptions of the test. Given all this knowledge, a strong inference is
established that Cruz knowingly and/or recklessly caused Morgan to disclose materially false and
misleading reports regarding the financial results of the ISG and the management of increased
high-risk trading to shareholders and investors.
385. Mack’s firing of Cruz provided further indicia of her scienter. See “The colossus
brought to its knees,” The Daily Mail, Sept. 19, 2008 (“Then came the credit crunch. Morgan's
lost $10 billion on the mortgage markets and critics called for him [Mack] to be sacked. Instead,
ever ruthless, Mack blamed his chief henchman, Zoe Cruz ‘Missile,’ and removed her instead.”).
386. In addition to her actual knowledge of the fraudulent misstatements, Cruz was
motivated to boost the Company’s reported performance because the majority of her multi-
million compensation was received in the form of year-end incentive compensation. Cruz also
was motivated to misrepresent Morgan’s true financial condition to avoid being fired, which is
exactly what happened to her when the truth was revealed.
D. Thomas V. Daula
387. As Morgan’s CRO, Defendant Daula was responsible for all risk-related
disclosures issued by the Company, including risk-related disclosures concerning Morgan’s PTG
and the Company’s proprietary trades. As such, Daula was responsible for knowing and
assessing the risk associated with and accurate value of the Long Position. Daula also was one
of the chief spokespersons for assuring investors that Morgan’s risk monitoring exposure was
adequate. For example, in a power point presentation by Daula to investors (dated February 14,
2006), titled “Risk Management at Morgan Stanley An Overview,” Daula outlined the
procedures Morgan supposedly had in place to monitor trading risks. Daula’s presentation was
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intended to, and did assure investors that Defendants were monitoring and timely disclosing the
risk that faced Morgan in the rapidly deteriorating subprime market.
388. Moreover, in an April 21, 2007 Shareholder Meeting, Mack singled out Daula
(and Cruz) as being responsible for managing Morgan’s risk exposure and reassured investors
that Cruz and Daula’s management of the Company’s risk exposure boded well for the Company
and investors. Thus, Daula’s job responsibilities required him to understand and quantify
Morgan’s risk exposures, and ensure that Defendants and investors were aware of those risks.
389. Notwithstanding Daula’s responsibilities as Morgan’s CRO, at the very outset of
the Class Period and months before Defendants disclosed Morgan’s massive subprime-related
exposure and losses, Daula was personally aware of the Long Position, the risk exposure
therefrom and that the Long Position potentially exposed the Company to $3.5 billion in losses,
as he himself had performed a stress test that Cruz had directed him to run in May 2007.
Defendant Daula also provided weekly updates to Cruz on the Company’s risk exposure, at least
each week from July 4, 2007 until the end of the Class Period, and Daula had actual knowledge
that Morgan’s undisclosed subprime exposure had grown to $10.4 billion as of August 31, 2007.
390. Given Daula’s position in the company and the reporting structure in place, Daula
knew about the Deutsche Bank collateral call, as a collateral call for $1.2 billion was a
significant financial event for Morgan. By way of comparison, Morgan’s net revenue for Second
Quarter 2007 for the entire ISG – which had a record quarter – was roughly $7.4 billion, and
income from continuing operations was roughly $3.0 billion. The collateral call, and the dispute
over the proper valuation of the Long Position, would have called into question Morgan’s risk
monitoring systems, which doubtlessly would have been brought to Daula’s attention as the
CRO.
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391. Moreover, Daula knew the gravity of his findings and that Defendants had no
reasonable basis for making statements surrounding the valuation of the Company’s subprime
assets as evidenced by the fact that beginning in August 2007, “Daula was very vocal in saying
that there were no proper pricing models for [subprime related] . . . trades, that positions were
not being properly measured, and that the history traders used in their models was not a reliable
guide.” (See, supra, Sender Article.) Daula’s concerns and the true dire state of the Company’s
pricing models were not disclosed to investors during the Class Period as the Company falsely
reported that it had no material subprime exposure and that it was valuing its assets fairly. Daula
served on the Company’s management committee and had a duty to ensure that the Company
accurately reported its financial results, condition and prospects, which Daula knew or recklessly
disregarded, was not being done during the Class Period.
E. Thomas Colm Kelleher
392. Defendant Kelleher assumed the role as Morgan’s CFO on October 11, 2007,
although he was not slated to take over the position until the beginning of fiscal 2008 (December
1, 2007), when Defendant Sidwell was supposed to retire. As Sidwell stated on the Third
Quarter earnings conference call, Kelleher had been shadowing Sidwell as CFO for five months
prior to Kelleher assuming the CFO helm. Thus, Kelleher was well-informed about the issues
and responsibilities of the position even before assuming the job officially. Sidwell relinquished
the CFO position to Kelleher on October 11, 2007, which was the day after Morgan filed its
materially false and misleading Form 10-Q for Third Quarter with the SEC.
393. Kelleher also was a member of Morgan’s management committee during the
Class Period and participated in decisions and risk management at the highest levels of the
Company. According to the Deutsche Bank analysts, Kelleher’s background included fixed
income sales and structuring and an early career with the accounting firm, Arthur Andersen. The
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analysts stressed that Kelleher, in expressing his philosophy of risk management, had stressed
“that there cannot be valuation issues if there is going to be efficient risk management.” He also
stated that one of his first moves was to “find alternative means to prove valuations.” Thus,
Kelleher also had the background that enabled him personally to understand that the Long
Position at the end of Third Quarter 2007 was improperly valued in order to manage earnings
and avoid reporting a loss.
394. Kelleher held meetings with analysts in October 2007, after which analysts at
Deutsche Bank reported that they had taken away “comfort that the 3Q07 shortfall stemmed
from bad execution vs. bad systems and that, with more normal markets, performance should
mostly recover.” They further reported that the Company’s problems “were attributed less to
risk control than to poor trading, a good portion of which should recover with better markets.”
Kelleher also apparently reported to the Deutsche Bank analysts that he had “shadowed the
outgoing CFO for the past five months.” Therefore, Defendant Kelleher acknowledged that he
was privy to the information reviewed by Defendant Sidwell during the entire Class Period,
including the accounting manipulations through which the Long Position improperly was valued
after being reclassified to Level 3 from Level 2 to manage earnings and buy time for the
Company to find a capital infusion.
395. Given Kelleher’s “shadow” position in the company, and the reporting structure
in place, Kelleher knew about the Deutsche Bank collateral call, as a collateral call for
$1.2 billion was a significant financial event for Morgan. By way of comparison, Morgan’s net
revenue for Second Quarter 2007 for the entire ISG – which had a record quarter – was roughly
$7.4 billion and income from continuing operations was roughly $3.0 billion.
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396. In addition, Kelleher participated in the Company’s Third Quarter 2007 earnings
conference call and made a number of statements, the falsity of which he must have known.
Defendants Kelleher and Sidwell volleyed coverage of the Company’s financial performance
back and forth during the call, and Kelleher falsely stated that Sidwell had “covered the primary
drivers of the decrease” in revenue from fixed income sales and trading during Third Quarter,
when in fact, Sidwell and Kelleher each knew and both failed to disclose the $1.9 billion write-
down to the Long Position during Third Quarter 2007 (later disclosed to investors on November
7, 2007). On the call, Kelleher and Sidwell provided granular detail regarding losses generated
from mark-to-market loan commitments and related $940 million in losses and a $726 million
write-down, which demonstrates that the concealment of the far larger $1.9 billion write-down
from the Long Position was deliberate and reckless.
397. On November 7, 2007, after Morgan announced a $3.7 billion decline in its
subprime related assets. For the reasons set forth herein, this statement confirmed a write-down
that was predicted by analysts and actually forced Morgan to accelerate its reporting of the loss.
However, the statement was also knowingly and/or recklessly false and misleading as Kelleher
and other Morgan senior executives (including the Individual Defendants) knew and/or
recklessly disregarded throughout the Class Period that Morgan was exposed to and had
suffered billions of dollars in subprime related losses. Kelleher also had participated in the Third
Quarter 2007 earnings conference call and therefore was also aware that the Company had
secretly written off $1.9 billion from the Long Position, and he was further aware that the
liabilities from the Long Position were deliberately understated to manage earnings and that the
valuation of the Long Position had ignored the observable input represented by the decline in the
benchmark ABX Index during the same time period.
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398. Kelleher directly benefited from misrepresenting Morgan’s true financial
condition because his compensation was directly tied to the Company’s performance. In
explaining the compensation awarded to Kelleher in 2007, the 2008 Proxy (filed with the SEC on
February 27, 2008) stated that the compensation Committee considered Mr. Kelleher’s
“accomplishments as Head of Global Capital Markets and his transition into the CFO role,
including helping the Company to address issues relating to the disruption in the mortgage
securities market during the second half of the year” and awarded Kelleher over $11.36 million
in cash and other incentive compensation for 2007.
X. LOSS CAUSATION
A. The Market Learns Of Morgan’s Subprime Exposure And Writedowns
399. Over the course of a week, from November 1 through November 7, 2007, the
market learned that Morgan had taken a large proprietary CDO position that had suffered billions
of dollars in impairment. This new information about Morgan’s CDO exposure and related
necessary write-downs caused investors to drive down the price of Morgan’s common stock as
investors reassessed Morgan’s true financial condition. By the time Defendants officially
confirmed the existence of the Long Position after the market closed on November 7, 2007, the
corrective information had already been incorporated into the price of Morgan’s stock. Yet
Defendants continued to mislead investors by understating the fair value declines of the Long
Position, thereby reinflating Morgan’s stock price after November 7.
400. The market began learning about the true extent of Morgan’s CDO exposures on
Thursday, November 1, when Deutsche Bank’s Mike Mayo issued an analyst report predicting
that various securities firms, including Morgan, would collectively write down more than
$10 billion “due to CDOs/mortgage/etc.” This was the first time that an analyst had predicted
that Morgan would record a significant writedown due to CDO exposure. In reaction to Mayo’s
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report, on November 1, Morgan’s stock price dropped $4.84 per share (7.2 percent), from $67.26
to $62.42.
401. The following day, November 2, 2007, Morgan fired Howard Hubler, the
Managing Director of PTG, the group that had established the Long Position. On that day,
Morgan’s stock price dropped $3.52 per share (5.6 percent), from $62.42 to $58.90.
402. On Monday, November 5, 2007, a CNBC editor predicted on the air that Morgan
would record a write-down of $3 billion, citing unidentified sources. A Bloomberg News article
picked up CNBC’s prediction, stating that “Morgan Stanley will have a $3 billion writedown tied
to securities, CNBC reported, citing unidentified ‘sources.’” The article further stated: “The
company is ‘eyeballing’ that amount right now, CNBC on-air editor Charles Gasparino
reported.” By the end of the trading day, another Bloomberg News article stated: “Morgan
Stanley fell . . . after CNBC reported that the firm might write down $3 billion of securities,
citing unidentified sources.” That day, Morgan’s stock price dropped $3.31 per share (5.6
percent), from $58.90 to $55.59.
403. By Tuesday, November 6, 2007, analysts were predicting Morgan would take a
write-down as big as $6 billion. In this respect, analyst David Trone of Fox-Pitt Kelton issued a
report that day downgrading Morgan “[g]iven the likelihood that it will take significant write
downs on ABS-CDOs and other mortgage exposures.” Trone stated, “[W]e believe forthcoming
write-downs could be around $4 billion,” but “[w]e wouldn’t be surprised to see $6 billion in
total write-downs.” Further, Trone questioned whether Morgan’s disclosures were accurate,
stating that the Company’s “[e]stimated ‘maximum exposures’ as listed in the 10Q may be
outdated or flawed.” For these reasons, Trone suggested “outright avoidance [of Morgan’s
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stock] until either mgmt discloses more specific exposure data and it proves smaller than we
thought, or they actually take write-downs big enough to get beyond this.”
404. Picking up on Trone’s projection, on November 6, Bloomberg issued an article
titled “Morgan Stanley Writedowns May Reach 6 Billion, Fox-Pitt Says.” Meanwhile, Deutsche
Bank’s Mike Mayo increased his prior estimate of the writedown, now suggesting that it could
be as large as $3 billion and $4 billion. On that day, Morgan’s stock price declined another
$1.08 per share (1.9 percent) from $55.59 to $54.51.
405. In articles issued before U.S. trading started on Wednesday, November 7, 2007,
both The New York Times and The Wall Street Journal highlighted Fox-Pitt Kelton’s $6 billion
projected write-down. The New York Times article, titled “Write-Down Expected for Morgan
Stanley,” stated that the projection had come “amid intense speculation that the Company might
announce a write-down next month of $2 billion to $4 billion.” The Wall Street Journal article,
titled “Storm May Hit Morgan Stanley After Its Calm – Write-Downs Projected By Two
Analysts; More Firms Face Risks,” reported that analysts had projected a writedown for Morgan
of between $3 billion and $6 billion. The Wall Street Journal attributed Morgan’s recent stock
price drops to the Deutsche Bank and Fox-Pitt Kelton analysts’ projections, which had caused
investors to be “increasingly nervous.”
406. Citing market participants, the November 7 Wall Street Journal article stated that
Morgan’s subprime exposure was the result of a proprietary trading position. The market was
led to believe that Morgan’s subprime exposure was limited largely because the Company
ranked low among its peers in underwriting subprime ABS and CDO issuances; investors had no
idea that Morgan was creating massive subprime exposure by establishing proprietary trading
positions in such securities. As the Wall Street Journal article explained: “Of all the blue-chip
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Wall Street securities firms, Morgan Stanley seemed one of the least likely to get thumped by the
subprime-mortgage crisis.” Accurately assessing what had, in fact, happened, the article stated:
“While the firm may not have underwritten as many CDOs, . . . Morgan Stanley may have been
involved in transactions with other firms that left it with exposure to CDO risks, market
participants say.”
407. The November 7 New York Times article further explained the market’s surprise
about the write-down, stating: “While Morgan Stanley joined the Wall Street rush into
underwriting pools of securities tied to subprime mortgages, or collateralized debt obligations, in
2006 and 2007, it ranked far behind market leaders Merrill Lynch and Citigroup. Accordingly,
the view has been that Morgan Stanley would not experience as big a loss.” The New York
Times further reported: “The loss came as a surprise to analysts who were led to believe that the
firm’s low rank as an underwriter of C.D.O.’s would not lead to a major write-down.” As this
article makes clear, the market had not given any credit to Defendant Kelleher’s statement that
the Company had “risk exposure through . . . CDOs, ” given the strongly negative reaction to the
true extent of the exposure and the fact that it was a proprietary trading position, rather than
underwriting of CDOs, that had caused massive write-downs.
408. By the close of trading on November 7, 2007, Morgan’s stock price had dropped
another $3.32 per share (6.1 percent), from $54.51 to $51.19. As these corrective disclosures
emerged between November 1 and November 7, the new information was incorporated into the
price of Morgan’s stock. As reported by Bloomberg on November 7, “[c]oncerns about potential
writedowns at Morgan Stanley [had] pushed the stock lower” that week. All told, between the
market close on October 31 and the market close on November 7, the Company’s stock declined
$16.07 per share (23.9 percent), from $67.26 to $51.19 as a result of these corrective disclosures.
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409. In sum, by the time the market closed on November 7, the market finally
understood that Morgan had a large proprietary trading position with substantial exposure to the
dramatically deteriorating subprime-backed ABS markets, and that Morgan likely was going to
have to record a multi-billion-dollar write-down relating to that position. These revelations
corrected Defendants’ fraudulent, material misstatements and omissions regarding Morgan’s
subprime and CDO exposure as of that date. However, while confirming the existence of the
Long Position, Defendants continued to misrepresent the true fair value of the Long Position.
B. Defendants’ November 7, 2007 Disclosures Were Fraudulent
410. The corrective disclosures and resulting price drops between November 1 and 7,
along with increasing market concerns and uncertainty going forward, forced Defendants to
make an announcement regarding its interim Fourth Quarter 2007 financial results. After the
close of trading on November 7, Morgan issued a long-overdue press release entitled “Morgan
Stanley Provides Information Regarding Subprime Exposure.”
411. Defendants’ November 7 press release stated that the fair value of the Long
Position declined $0.3 billion prior to the start of Third Quarter 2007, $1.9 billion in Third
Quarter 2007, and $3.4 billion in the two months ended October 31, 2007. Thus, according to
Morgan, as of October 31, 2007, the total impairment of the Long Position was $5.6 billion.
This chart, for the first time, informed investors that Morgan had massive subprime exposure and
already had secretly taken subprime-related write-downs in previous quarters, including on the
Long Position.
412. Although Defendants finally confirmed Morgan’s CDO exposure, they made
additional materially false and misleading statements regarding the timing and amount of the
impairment of the Long Position. In deliberate or reckless disregard for the truth, Defendants
misrepresented to investors that: (1) the Long Position had declined in value by only $1.9 billion
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dollars in Third Quarter 2007; and (2) the write-downs taken on the Long Position were
sufficient to reflect its fair value.
413. Defendants misstated the cumulative and period losses on the Long Position as of
August 31 and October 31, 2007. As explained in detail in Section VII.C, GAAP required
Defendants to record a $4.4 billion impairment on the Long Position in Third Quarter 2007 and
an additional $3.4 billion impairment for the two months ending October 31, 2007. However, in
the November 7, 2007 press release, while Defendants disclosed a $3.4 billion impairment for
the two months ending October 31, they disclosed only a $1.9 billion impairment for Third
Quarter 2007. In doing so, Defendants deceptively concealed $2.5 billion in losses on the Long
Position. And rather than inaccurately reporting cumulative year-to-date losses on the Long
Position of $5.6 billion as of October 31, Defendants should have reported a fair value write-
down of $5.9 billion for the Fourth Quarter to date to correct the false marks from the Third
Quarter, and cumulative losses of $8.1 billion year to date.
414. In their November 7 disclosures, Defendants failed to disclose that Morgan should
have recognized an additional $2.5 billion in losses for Third Quarter 2007, which would later
require additional mark-to-market losses to catch up for those unrecognized losses. Because
Defendants knew and deliberately or recklessly disregarded this materially adverse fact, their
statements regarding the true extent of the write-down and the valuation of the Long Position
were materially false and misleading when made.
C. Market Reaction To November 7, 2007 Disclosures
415. Defendants’ partially misleading November 7 disclosures achieved the objective
of containing the damage resulting from the November 1-7 corrective disclosures from analyst
publications and reinflating Morgan’s stock price. Following Defendants’ material
misrepresentations on November 7, 2007, the immediate consensus among securities analysts
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and the market was that Morgan’s $3.7 billion write-down that fell within estimated ranges was
“manageable.” In an analyst report issued on the evening of November 7, Deutsche Bank’s
Mike Mayo stated that the $3.7 billion write-down was “in line with our estimate of $3-4B.” He
added that “[w]hile this is bad news, we believe it will be manageable for Morgan Stanley.”
That same evening, Credit Suisse analyst Susan Roth Katzke stated in a report that the write-
down was “Not Good, But Manageable.” As reported by Bloomberg, “[i]nvestors sent [the
Company’s] shares higher in after-hours trading on comfort that Morgan Stanley identified the
total losses it might suffer – the first Wall Street investment bank to do so.”
416. On the first trading day after Morgan issued its subprime-related valuations and
disclosures, November 8, 2007, Citigroup analyst Prashant Bhatia wrote, as reported by
Bloomberg, “We now have a much better understanding of maximum loss exposure, which in
our view is very manageable.” That day, Wachovia analyst Douglas Sipkin stated “MS Comes
Clean” and reiterated his “Market Perform” rating.
417. The market’s positive reaction to Defendants’ November 7, 2007 valuation and
disclosures was due to the fact that: (1) from November 1-7, 2007, the market had already
punished Morgan’s stock price upon the revelation of the exposure to billions in subprime losses
and in anticipation of Morgan’s write-down; and (2) Defendants partially reversed the stock’s
decline by issuing additional material misstatements and omissions on November 7, which
understated the impairment of the Long Position by $2.5 billion in Third Quarter 2007. By
fraudulently reporting an impairment of only $1.9 billion for Third Quarter 2007, instead of $4.4
billion, which would have resulted in a sizeable quarterly loss, Defendants accomplished two
things: (1) they left intact Morgan’s EPS from continuing operations for that quarter, which
exactly matched the lower bound of analysts’ earnings estimates; and (2) they were able to
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announce a net write-down on subprime-related exposures that was less than $6 billion, the
worst-case scenario projected by analysts.
418. On November 8, 2007, Morgan’s common stock price rose 4.9 percent from
$51.19 to $53.68.
D. The Market Learns Of Morgan’s Additional Write-Down
419. On November 7, 2007, Defendants disclosed that its remaining net exposure on
the Long Position was $8.3 billion. The market did not know, however, that Defendants had
already fraudulently concealed $2.5 billion in unrecognized losses on the Long Position in Third
Quarter 2007. To catch up with these unrecognized losses, Defendants would have to report a
much larger write-down than that indicated by the decline of the ABX Index in November 2007.
On December 19, 2007, Morgan announced a write-down for November that doubled the rate of
decline of the ABX Index.
420. On the last day of the Class Period, November 19, 2007, the market was informed
that a much larger Morgan write-down indeed was coming. On that day, in an article titled
“New bank fears hit shares,” MarketWatch reported that Goldman Sachs expected a write-down
of $8 billion at Morgan, shared over the final quarter of 2007 and 2008. The same news was
reported in a Financial Times article titled, “Credit squeeze could last until next Christmas.”
421. As reported, on November 19, 2007, Goldman Sachs issued a report estimating
that Morgan would record CDO write-downs of $8 billion ($5 billion in Fourth Quarter 2007 and
$3 billion in fiscal year 2008). By projecting the write-downs on Morgan’s CDO-related
exposure, Goldman Sachs informed investors to expect more than double the write-down in
Fourth Quarter 2007 than was indicated by the decline in the ABX Index. This larger write-
down was a materialization of the risk created by Defendants’ concealment of the unrecognized
losses on the Long Position in Third Quarter 2007.
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422. On November 19, 2007, the price of Morgan’s stock dropped $1.77 per share (3.3
percent), from $52.90 to $51.13, reflecting investors’ expectation of a further multi-billion-dollar
write-down of Morgan’s Long Position far in excess of the drop in the ABX Index. This
outcome already had been priced into the market by the time Defendants confirmed the write-
down on December 19, 2007.
423. On November 30, 2007, analyst Richard Bove of Punk Ziegel issued a report
confirming Goldman Sachs’s November 19 analysis. Bove concluded that the actual Third
Quarter 2007 write-downs at Morgan were higher than those disclosed by Defendants.
Specifically, in stark contrast to Morgan’s contention that it took a $1.9 billion write-down for
Third Quarter 2007, Bove stated: “I estimate that in the third fiscal quarter the company had
write-downs and write-offs of $3.6 billion on a gross basis.” In part for this reason, Bove rated
Morgan a “sell.”
E. Defendants Confirm Additional Write-Down AndThe Market Is Relieved That CDO-Related Losses Have Reached Bottom
424. On December 19, 2007, a month after Goldman Sachs had informed the market to
expect an additional, multi-billion-dollar write-down that exceeded the decline in the ABX
Index, Defendants confirmed the market’s expectations when they released Morgan’s financial
results for the fiscal year ended November 30, 2007. In Morgan’s earnings release, Defendants
disclosed an additional write-down of $3.7 billion on the Long Position. This brought year-to-
date losses on the Long Position to $9.3 billion.
425. For Fourth Quarter 2007, Defendants reported a pre-tax loss of $6.5 billion for the
ISG, down from $2.2 billion of pre-tax income in Fourth Quarter 2006. For fiscal year 2007, the
ISG reported pre-tax income of $817 million, an 89 percent decrease from 2006. Company-
wide, “[n]et revenues decreased 24 percent to $16.1 billion” and “[f]ixed income sales and
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trading revenues were $0.7 billion, down 93 percent from 2006 reflecting significant losses in
credit products resulting from the mortgage related writedowns.”
426. On December 19, 2007, Mack and Kelleher held an earnings conference call with
analysts. During this call, Kelleher responded to questions from analysts regarding the
Company’s Level 3 assets and liabilities, though he avoided describing what the biggest
“component” was of Level 3. Kelleher would state only that, “obviously there was one very big
mark that ran through Level 3, which we’ve just announced.”
427. As Fourth Quarter 2007 ended, facing $6.8 billion in net losses from subprime-
exposure, Morgan sought and obtained a financial life-line from overseas. On December 19,
along with confirming the expected write-down, Defendants also unexpectedly announced that
they had secured a $5 billion cash infusion from the China Investment Corporation (“CIC”),
which gave the CIC a 10 percent share in Morgan. Analysts were encouraged by the CIC
investment, as it provided Morgan additional capital cushion and financial stability.
428. Analysts were also heartened by Morgan’s December 19 disclosures regarding
subprime losses because they correctly believed that the Company’s once-hidden mezzanine
ABS CDO problems were now fully disclosed, enabling a balance sheet catharsis and a
collective look to the future. For example, on December 19, Meredith Whitney of CIBC World
Markets wrote that “MS’s 4Q marks on its exposures were severe, thus it is not likely in our
opinion that anything similarly disruptive could occur again given its current exposure levels.”
Whitney also indicated that Morgan’s stock had “bottomed out.” Similarly, on the same day,
Mike Mayo of Deutsche Bank stated: “We maintain our Buy, given our view that the worst
subprime is behind [Morgan].” And a Bloomberg News article reported: “The ‘significant capital
raise’ and writedowns suggest to investors that Morgan Stanley has put the worst of its subprime
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losses behind it, Jeffrey Harte, an analyst at Sandler O’Neill & Partners LP, wrote in a note
today.”
429. As supported by contemporaneous news accounts, the additional subprime write-
downs already had been impounded into the price of Morgan’s stock. For example, on
December 19, a Bloomberg News article quoted the president of South Beach Capital Markets:
“‘The stock was sold down and all the bad news has been out. Today was just a verification of
the numbers – bigger than anyone thought, but most people already knew. The cash coming in –
significant 10 percent ownership in Morgan Stanley . . . heartened the investors.’” Thus, major
investors had been expecting the additional write-down announced on December 19, and they
were now relieved that the CDO losses had bottomed out.
430. Accordingly, after Morgan announced its annual financial results and the CIC
cash infusion on December 19, Morgan’s stock price rose from a close of $48.07 on the prior day
to a close of $50.58 per share.
XI. APPLICABILITY OF PRESUMPTION OF RELIANCE:THE FRAUD ON THE MARKET DOCTRINE
431. The market for Morgan’s common stock was open and efficient at all relevant
times for the following reasons (among others):
• The Company’s common stock met the requirements forlisting, and were listed and actively traded on the NYSE;
• As a regulated issuer, Morgan filed periodic public reportswith the SEC;
• Morgan regularly communicated with public investors viaestablished market communication mechanisms, includingthrough regular disseminations of press releases on thenational circuits of major newswire services and throughother wide-ranging public disclosures, such ascommunications with the financial press and other similarreporting services;
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• The market reacted to public information disseminated byMorgan;
• Morgan was followed by numerous securities analystsemployed by major brokerage firms who wrote reportswhich were distributed to the sales force and certaincustomers of their respective brokerage firms. Each ofthese reports was publicly available and entered the publicmarket place;
• The material misrepresentations and omissions allegedherein would tend to induce a reasonable investor tomisjudge the value of Morgan’s common stock; and
• Without knowledge of the misrepresented or omittedmaterial facts, Plaintiffs and the other members of the Classpurchased or otherwise acquired Morgan’s common stockbetween the time Defendants made the materialmisrepresentations and omissions and the time thefraudulent scheme was being disclosed, during which timethe price of Morgan’s common stock was inflated byDefendants’ misrepresentations and omissions.
432. As a result of the foregoing, the market for Morgan’s common stock promptly
digested current information regarding Morgan from all publicly available sources and reflected
such information in Morgan’s common stock prices. Under these circumstances, all purchasers
and acquirers of Morgan’s common stock during the Class Period suffered similar injury through
their purchase or acquisition of Morgan’s common stock at artificially inflated prices. For all
these reasons, a presumption of reliance applies in this action.
XII. INAPPLICABILITY OF SAFE HARBOR
433. As alleged herein, the Defendants acted with scienter because at the time that they
issued public documents and other statements in Morgan’s name, they knew and/or with extreme
recklessness disregarded the fact that such statements were materially false and misleading or
omitted material facts. Moreover, the Defendants knew such documents and statements would
be issued or disseminated to the investing public, knew that persons were likely to rely upon
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those misrepresentations and omissions, and knowingly and/or recklessly participated in the
issuance and dissemination of such statements and documents as primary violators of the federal
securities laws.
434. As set forth in detail throughout this Complaint, the Defendants, by virtue of their
control over, and/or receipt of Morgan’s materially misleading statements and their positions
with the Company that made them privy to confidential proprietary information, used such
information to artificially inflate Morgan’s financial results. The Defendants created, were
informed of, participated in, and knew of the scheme alleged herein to distort and suppress
material information pertaining to Morgan’s financial condition, profitability and present and
future prospects of the Company. With respect to non-forward looking statements and
omissions, the Defendants knew and/or recklessly disregarded the falsity and misleading nature
of that information, which they caused to be disseminated to the investing public.
435. The statutory safe harbor provided for forward-looking statements under certain
circumstances does not apply to any of the false statements pleaded in this Complaint. None of
the statements pleaded herein are “forward-looking” statements and no such statement was
identified as a “forward-looking statement” when made. Rather, the statements alleged herein to
be materially false and misleading by affirmative misstatement and/or omissions of material fact
all relate to facts and conditions existing at the time the statements were made. Moreover,
cautionary statements, if any, did not identify important factors that could cause actual results to
differ materially from those in any putative forward-looking statements.
436. In the alternative, to the extent that the statutory safe harbor does apply to any
statement pleaded herein which is deemed to be forward-looking, the Defendants are liable for
such false forward-looking statements because at the time each such statement was made, the
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speaker actually knew the fact that forward-looking statements were materially false or
misleading and/or omitted facts necessary to make statements previously made not materially
false and misleading, and/or that each such statement was authorized and/or approved by a
director and/or executive officer of Morgan who actually knew that each such statement was
false and/or misleading when made. None of the historic or present tense statements made by
the Defendants was an assumption underlying or relating to any plan, projection, or statement of
future economic performance, as they were not stated to be such an assumption underlying or
relating to any projection or statement of future economic performance when made nor were any
of the projections or forecasts made by the Defendants expressly related to or stated to be
dependent on those historic or present tense statements when made.
XIII. CLASS ACTION ALLEGATIONS
437. Plaintiffs bring this action as a class action pursuant to Rule 23(a) and (b)(3) of
the Federal Rules of Civil Procedure on behalf of all persons and entities who purchased Morgan
common stock during the Class Period (from June 20, 2007 through and including November 19,
2007, inclusive) and who suffered damages as a result of their purchases (the “Class”). Excluded
from the Class are: (1) the Company and the Individual Defendants; (2) members of the
immediate family of each of the Individual Defendants; (3) the subsidiaries or affiliates of the
Company or any of the Defendants; (4) any person or entity who is, or was during the Class
Period, a partner, officer, director, employee, or controlling person of the Company or any of the
Defendants; (5) any entity in which any of the Defendants has a controlling interest; and (6) the
legal representatives, heirs, successors, or assigns of any of the excluded persons or entities
specified in this paragraph.
438. The members of the Class are so numerous that joinder of all members is
impracticable. As of the date of this Complaint, there were approximately 1.1 billion shares of
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Morgan’s common stock outstanding. While Plaintiffs do not know the exact number of Class
members, Plaintiffs believe that there are, at minimum, thousands of members of the Class who
purchased Morgan’s common stock during the Class Period.
439. A class action is superior to other available methods for the fair and efficient
adjudication of this controversy.
440. Common questions of law and fact exist as to all members of the Class, and
predominate over any questions affecting solely individual members of the Class. Among the
questions of law and fact common to the Class are:
• Whether the federal securities laws were violated by theDefendants’ acts as alleged herein;
• Whether the SEC filings and other public statementspublished and disseminated by the Defendants to theinvesting public and purchasers of Morgan’s common stockduring the Class Period omitted and/or misrepresentedmaterial facts about Morgan’s financial condition,subprime mortgage exposure, profitability, risks ofinvesting in the Company, or present and/or futureprospects of the Company;
• Whether the Defendants omitted to state and/ormisrepresented material facts about the financial condition,subprime mortgage exposure, profitability, risks ofinvesting in the Company, and/or future prospects of theCompany;
• Whether the Defendants acted intentionally or recklessly inomitting to state and/or misrepresenting material factsabout the Company’s financial condition, profitability,subprime mortgage exposure, risks of investing in theCompany, or present and/or future prospects of theCompany;
• Whether the market price of Morgan’s common stockduring the Class Period was artificially inflated due to thematerial non-disclosures and/or misrepresentationscomplained of herein; and
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• Whether the members of the Class have sustained damages,and, if so, what is the proper measure thereof.
441. Plaintiffs’ claims are typical of the claims of the members of the Class. Plaintiffs
will fairly and adequately protect the interests of the members of the Class, and have retained
counsel competent and experienced in class and securities litigation. Plaintiffs have no interests
that are adverse or antagonistic to the Class.
442. A class action is superior to other available methods for fair and efficient
adjudication of the controversy since joinder of all members of the Class is impracticable.
Furthermore, because damages suffered by the individual Class members may be relatively
small, the expense and burden of individual litigation make it impossible for the Class members
individually to redress the Defendants’ wrongful conduct. Furthermore, there will be no
difficulty in the management of this litigation as a class action.
XIV. COUNTS
COUNT I
For Violation of Section 10(b) of the Exchange Act andRule 10b-5 Promulgated Thereunder
443. Plaintiffs repeat and reallege each and every allegations in the foregoing
paragraphs of this Complaint as if fully set forth herein. This claim is asserted against all
Defendants.
444. During the Class Period, Defendants: (a) knowingly and recklessly deceived the
investing public, including Plaintiffs, as alleged herein; (b) artificially inflated the market price
of Morgan’s common stock; and (c) caused Plaintiffs and the Class to purchase or otherwise
acquire Morgan common stock at artificially-inflated prices.
445. Each of Defendants, in violation of Section 10(b) of the Exchange Act and Rule
10b-5(b), made untrue statements of material facts and/or omitted to state material facts
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necessary to make the statements made by Defendants not misleading, and/or substantially
participated in the creation of the alleged misrepresentation, which operated as a fraud and deceit
upon Plaintiffs and the Class, in an effort to artificially inflate and/or maintain the artificially-
inflated price of Morgan’s common stock during the Class Period. Defendants’ false and
misleading statements (and omissions of material facts) are set forth in Section VIII, supra.
446. As a result of their making and/or substantially participating in the creation of
affirmative statements to the investing public, Defendants had a duty to promptly disseminate
truthful information that would be material to investors in compliance with applicable laws and
regulations.
447. Defendants, individually and in concert, directly and indirectly, by the use, means
or instrumentalities of interstate commerce and/or of the mails, made or substantially participated
in the creation/dissemination of, untrue statements of material fact as set forth herein, or with
extreme recklessness failed to ascertain and disclose truthful facts, even though such facts were
available to them.
448. The facts alleged herein give rise to a strong inference that each of Defendants
acted with scienter. Each of the Defendants knew and/or with extreme recklessness disregarded
that the Class Period statements set forth in Section VIII, supra, were materially false and
misleading for the reasons set forth herein.
449. Defendants carried out a deliberate scheme to misrepresent the value of Morgan’s
assets, liabilities, income, earnings, revenue, and the risks to which the Company’s investors
were being exposed.
450. As a result of the dissemination of the materially false and misleading information
and failure to disclose material facts, as set forth above, the market price of Morgan’s common
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stock was artificially inflated throughout the Class Period. Unaware that the market price of
Morgan’s common stock was artificially inflated, and relying directly or indirectly on the false
and misleading statements made by Defendants, or upon the integrity of the markets in which
Morgan’s common stock traded, and the truth of any representations made to appropriate
agencies and to the investing public, at the times at which any statements were made, and/or in
the absence of material adverse information that was known, or with deliberate recklessness
disregarded, by Defendants but not disclosed in their public statements, Plaintiffs purchased or
otherwise acquired Morgan’s common stock at artificially-inflated prices. As a direct and
proximate result of Defendants’ wrongful conduct, Plaintiffs and the other members of the Class
suffered damages in connection with their transactions in Morgan’s common stock during the
Class Period, when the inflation in the price of Morgan’s common stock was gradually removed
as the truth regarding Defendants’ conduct was revealed causing the price of Morgan’s common
stock to decline and thereby resulting in economic losses to Plaintiffs and the Class.
451. By reason of the foregoing, Defendants violated Section 10(b) of the Exchange
Act and Rule 10b-5(b) promulgated thereunder, and are liable to Plaintiffs and the Class for
damages suffered in connection with their transactions in Morgan’s common stock during the
Class Period.
COUNT II
For Violation of Section 20(a) of the Exchange Act(Against the Individual Defendants)
452. Plaintiffs repeat and reallege each and every allegations in the foregoing
paragraphs of this Complaint as if fully set forth herein. This claim is asserted against all of the
Individual Defendants.
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453. Morgan is primary violator of Section 10(b) and Rule 10b-5, promulgated
thereunder.
454. The Individual Defendants acted as controlling persons of Morgan within the
meaning of Section 20(a) of the Exchange Act, as alleged herein. By reason of their positions as
officers and/or directors of Morgan, their ability to approve the issuance of statements, their
ownership of Morgan’s securities and/or by contract. As such, the Individual Defendants had the
power and authority to direct and control, and did direct and control, directly or indirectly, the
decision-making of the Company as set forth herein. The Individual Defendants were provided
with or had unrestricted access to copies of the Company’s reports, press releases, public filings
and other statements alleged by Plaintiffs to be misleading prior to and/or shortly after these
statements were issued and had the ability to prevent the issuance of the statements or cause the
statements to be corrected. Each of the Individual Defendants had direct and supervisory
involvement in the day-to-day operations of the Company and, therefore, is presumed to have
had the power to control or influence, and during the Class Period did exercise their power to
control and influence, the conduct giving rise to the violations of the federal securities laws
alleged herein. The Individual Defendants prepared, or were responsible for preparing, the
Company’s press releases and SEC filings and made statements to the market in SEC filings,
annual reports, press releases, news articles and conference calls. The Individual Defendants
controlled Morgan Stanley and each of its employees.
455. By virtue of their positions as controlling persons of Morgan, and by reason of the
conduct described in this Count, the Individual Defendants are liable pursuant to Section 20(a) of
the Exchange Act for controlling primary a violator of the federal securities laws.
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456. As a direct and proximate result of the Individual Defendants’ wrongful conduct,
Plaintiffs and other members of the Class suffered damages in connection with their purchases of
the Company’s common stock during the Class Period.
XV. PRAYER FOR RELIEF
WHEREFORE, Plaintiffs pray for relief and judgment, including preliminary and
permanent injunctive relief, as follows:
A. Determining that this action is a proper class action, and certifying Plaintiffs as
class representatives under Rule 23 of the Federal Rules of Civil Procedure;
B. Awarding preliminary and permanent injunctive relief in favor of Plaintiffs and
the Class against all defendants and their counsel, agents and all persons acting under, in concert
with or for them;
C. Restitution of investors’ monies of which they were defrauded;
D. Awarding compensatory damages in favor of Plaintiffs and the other Class
members against all defendants, jointly and severally, for all damages sustained as a result of
Defendants’ conduct set forth herein, in an amount to be proven at trial, including interest
thereon;
E. Awarding Plaintiffs and the Class their reasonable costs and expenses incurred in
this action, including counsel fees and expert fees; and
F. Such other and further relief as the Court may deem just and proper.
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XVI. JURY DEMAND
Plaintiffs demand a trial by jury.
Dated: New York, New YorkJune 9, 2011
Cn
LAB: TON SUCHAROW LLPJo, -than M. Plasse (JP-7515)Joseph A. Fonti (JF-3201)Javier Bleichmar (JB-0435)Joshua Crowell (JC-0914)Kevin Oberdorfer (KO-2376)140 BroadwayNew York, New York 10005Telephone: (212) 907-0700Facsimile: (212) [email protected]@[email protected]@[email protected]
Counsel for Lead Plaintiff State-Boston RetirementSystem and Co-Lead Counsel for the Class
KESSLER TOPAZ MELTZER & CHECK, LLPDavid KesslerAndrew L. Zivitz (pro hac vice)Sharan NirmulLauren Wagner PedersonRichard A. Russo, Jr. (pro hac vice)280 King of Prussia RoadRadnor, Pennsylvania 19087Telephone: (610) 667-7706Facsimile: (610) [email protected]@[email protected]@[email protected]
Counsel for Fjdrde AP-Fonden and Co-LeadCounsel for the Class
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Case 1:09-cv-02017-DAB Document 30 Filed 06/09/11 Page 170 of 170
CERTIFICATE OF SERVICE
I, Joseph A. Fonti, hereby certify that on June 9, 2011, 1 electronically served a copy of
the foregoing Second Amended Class Action Complaint on Defendants' counsel Robert F. Wise,
Jr., at [email protected] and via U.S. Mail at Davis Polk & Wardell LLP, 450
Lexington Avenue, New York, New York 10017.
Josep A. Fonti'LAB TON SUCHARO W LLP
5 BroadwayNew York, New York 10005Telephone: (212) 9070700Facsimile: (212) 818-0477