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Morgan Stanley (MS - Analyst Report) has been charged by a Singapore-based firm, Hong Leong Finance Ltd., of selling structured notes that were deliberately designed to fail. About six years ago, Hong Leong had entered into a deal with the company to sell Pinnacle notes (issued from August 2006 to December 2007) valued at approximately $72.4 million (S$89.8 million) to the customers.

Hong Leong alleged that though Morgan Stanley had sold the Pinnacle notes as secure investments, the company had manipulated these in such a way that Morgan Stanley would benefit from its failure. The notes eventually failed and Hong Leong had to pay nearly $32 million as compensation to the investors. The company had sold these notes through a special purpose vehicle, Pinnacle Performance Ltd.

Hong Leong has accused Morgan Stanley of fraud, breach of contract and omission of correct information. The firm further alleged that while entering into the distribution agreement for selling Pinnacle notes, Morgan Stanley had described the underlying assets as synthetic collateralized debt obligations (CDOs) tied to the performance of major global firms and sovereign nations with high credit ratings.

However, Morgan Stanley had actually based the notes on risky investments primarily in real estate-related firms and distressed Icelandic banks. Also, the company was to gain from the failure of the notes as it had entered into a swap deal with the holders of Pinnacle notes through its affiliate, Morgan Stanley Capital Services Inc.

Last year, a U.S. District court had dismissed an appeal by Morgan Stanley seeking permission for preventing investors from suing it from outside the country related to the losses incurred due to the failure of Pinnacle notes.

Morgan Stanley is not the only bank that had to face the wrath of the investors for the soaring of similar offerings. Over the last couple of years, a few of the major banks including The Goldman Sachs Group Inc. (GS - Analyst Report), Citigroup Inc. (C - Analyst Report) and JPMorgan Chase & Co. (JPM - Analyst Report) agreed to pay about $1 billion in total to settle Securities & Exchange Commission (SEC) litigations related to such offerings.

We believe that these litigations will adversely impact Morgan Stanley’s financial credibility. This would also deter the company from repeating such acts again. However, the investors who were duped of their hard earned money will get some respite.

Morgan Stanley currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain our long-term Neutral recommendation on the stock.

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