Back to GetFilings.com



Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended November 30, 2004

Commission File Number 1-11758

 

Morgan Stanley

(Exact name of Registrant as specified in its charter)

Delaware   36-3145972
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

1585 Broadway

New York, NY 10036

(Address of principal executive offices, including zip code)

 

(212) 761-4000

(Registrant’s telephone number, including area code)

 

Title of each class


 

Name of exchange on

which registered


Securities registered pursuant to Section 12(b) of the Act:

   

Common Stock, $.01 par value

  New York Stock Exchange
Pacific Exchange

Rights to Purchase Series A Junior Participating Preferred Stock

  New York Stock Exchange
Pacific Exchange

8.03% Capital Units

  New York Stock Exchange

7 ¼% Capital Securities of Morgan Stanley Capital Trust II (and Registrant’s guaranty with respect thereto)

  New York Stock Exchange

6 ¼% Capital Securities of Morgan Stanley Capital Trust III (and Registrant’s guaranty with respect thereto)

  New York Stock Exchange

6 ¼% Capital Securities of Morgan Stanley Capital Trust IV (and Registrant’s guaranty with respect thereto)

  New York Stock Exchange

5 ¾% Capital Securities of Morgan Stanley Capital Trust V (and Registrant’s guaranty with respect thereto)

  New York Stock Exchange

SPARQS® due March 1, 2005; due April 1, 2005 (2 issuances); SPARQS due May 15, 2005 (2 issuances); SPARQS due June 15, 2005; SPARQS due July 15, 2005; (2 issuances); SPARQS due August 15, 2005; SPARQS due September 15, 2005; SPARQS due November 1, 2005 (4 issuances); SPARQS due December 1, 2005 (2 issuances); SPARQS due January 15, 2006 (2 issuances); SPARQS due January 30, 2006 (2 issuances)

  American Stock Exchange

Exchangeable Notes due June 5, 2006

  New York Stock Exchange

Exchangeable Notes due December 30, 2008; Exchangeable Notes due December 30, 2010; Exchangeable Notes due January 30, 2011; Exchangeable Notes due April 1, 2009; Exchangeable Notes due April 30, 2011; Exchangeable Notes due June 30, 2011; Exchangeable Notes due December 30, 2011

  American Stock Exchange

Callable Index-Linked Notes due December 30, 2008

  American Stock Exchange

Redeemable BRIDGESSM due May 30, 2005

  New York Stock Exchange

BRIDGESSM due August 30, 2008; BRIDGES due December 30, 2008 (2 issuances); BRIDGES due February 28, 2009; BRIDGES due March 30, 2009; BRIDGES due June 30, 2009; BRIDGES due July 30, 2009; BRIDGES due August 30, 2009; BRIDGES due October 30, 2009; BRIDGES due December 30, 2009; BRIDGES due June 15, 2010

  American Stock Exchange

7.25% Notes due June 17, 2029

  New York Stock Exchange

Capital Protected Notes due June 30, 2008; Capital Protected Notes due January 30, 2011; Capital Protected Notes due March 30, 2011 (2 issuances) Capital Protected Notes due October 30, 2011; Capital Protected Notes due December 30, 2011; Capital Protected Notes due September 30, 2012

  American Stock Exchange

MPSSM due December 30, 2008; MPS due December 30, 2009; MPS due February 1, 2010; MPS due June 15, 2010; MPS due December 30, 2010 (2 issuances); MPS due March 30, 2012

  American Stock Exchange

Stock Participation Notes due September 15, 2010; Stock Participation Notes due December 30, 2010

  American Stock Exchange

PLUSSM due April 30, 2005; PLUS due January 30, 2006 (2 issuances); PLUS due July 15, 2006; PLUS due July 30, 2006; PLUS due June 30, 2009

  American Stock Exchange

PROPELSSM due December 30, 2011 (3 issuances)

  American Stock Exchange

Strategic Total Return Securities due December 17, 2009

  American Stock Exchange

BOXES® due October 30, 2031; BOXES due January 30, 2032

  American Stock Exchange
Philadelphia Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

   

PLUS due January 30, 2006; PLUS due March 30, 2006 (2 issuances); PLUS due September 30, 2009

  Nasdaq National Market

MPS due March 30, 2009

  Nasdaq National Market

 

Indicate by check mark whether Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES x NO ¨

 

As of May 31, 2004, the aggregate market value of the common stock of Registrant held by non-affiliates of Registrant was approximately $58,156,889,114. This calculation does not reflect a determination that persons are affiliates for any other purposes.

 

As of December 31, 2004, there were 1,087,465,976 shares of Registrant’s common stock, $.01 par value, outstanding.

 

Documents Incorporated By Reference: Portions of Registrant’s definitive proxy statement for its annual stockholders’ meeting to be held on March 15, 2005 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

 



Table of Contents

LOGO

Annual Report on Form 10-K

for the fiscal year ended November 30, 2004

 

Table of Contents

 

          Page

     Part I     

Item 1.

  

Business

   1
    

Overview

   1
    

Available Information

   2
    

Institutional Securities

   3
    

Individual Investor Group

   5
    

Investment Management

   6
    

Credit Services

   7
    

Competition

   8
    

Regulation

   9
    

Executive Officers of Morgan Stanley

   13

Item 2.

  

Properties

   14

Item 3.

  

Legal Proceedings

   15

Item 4.

  

Submission of Matters to a Vote of Security Holders

   24
     Part II     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   25

Item 6.

  

Selected Financial Data

   27

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   29

Item 7A.

  

Quantitative and Qualitative Disclosures about Market Risk

   82

Item 8.

  

Financial Statements and Supplementary Data

   99

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   157

Item 9A.

  

Controls and Procedures

   157

Item 9B.

  

Other Information

   160
     Part III     

Item 10.

  

Directors and Executive Officers of the Registrant

   161

Item 11.

  

Executive Compensation

   161

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   162

Item 13.

  

Certain Relationships and Related Transactions

   163

Item 14.

  

Principal Accountant Fees and Services

   163
     Part IV     

Item 15.

  

Exhibits and Financial Statement Schedules

   164

Signatures

   165

Index to Financial Statements and Financial Statement Schedules

   S-1

Exhibit Index

   E-1

 

          LOGO


Table of Contents

Forward-Looking Statements

 

We have included or incorporated by reference into this report, and from time to time may make in our public filings, press releases or other public statements, certain statements, including (without limitation) those under “Legal Proceedings” in Part I, Item 3, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 (“MD&A”), and “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 7A, that may constitute forward-looking statements. In addition, our management may make forward-looking statements to analysts, investors, representatives of the media and others. These forward-looking statements are not historical facts and represent only Morgan Stanley’s beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control.

 

The nature of Morgan Stanley’s business makes predicting the future trends of our revenues, expenses and net income difficult. The risks and uncertainties involved in our businesses could affect the matters referred to in such statements and it is possible that our actual results may differ, possibly materially, from the anticipated results indicated in these forward looking statements. Important factors that could cause actual results to differ from those in the forward-looking statements include (without limitation):

 

    the effect of political, economic and market conditions and geopolitical events,

 

    the availability and cost of capital,

 

    the level and volatility of equity prices, commodity prices and interest rates, currency values and other market indices,

 

    the actions and initiatives of current and potential competitors,

 

    the impact of current, pending and future legislation, regulation and regulatory and legal actions in the U.S. and worldwide,

 

    our reputation,

 

    investor sentiment, and

 

    the potential effects of technological changes and other risks and uncertainties detailed under “Certain Factors Affecting Results of Operations” in Part II, Item 7, “Competition” and “Regulation” in Part I, Item 1 and throughout this report.

 

Accordingly, you are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which they are made. Morgan Stanley undertakes no obligation to update publicly or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the dates they are made, whether as a result of new information, future events or otherwise. You should, however, consult further disclosures Morgan Stanley may make in future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments thereto.

 

LOGO        


Table of Contents

Part I

 

Item 1. Business.

 

Overview.

 

Morgan Stanley is a global financial services firm that, through its subsidiaries and affiliates, provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. Morgan Stanley was originally incorporated under the laws of the State of Delaware in 1981, and its predecessor companies date back to 1924. Morgan Stanley conducts its business from its headquarters in and around New York City, its regional offices and branches throughout the U.S. and its principal offices in London, Tokyo, Hong Kong and other world financial centers. At November 30, 2004, Morgan Stanley had 53,284 employees worldwide. Unless the context otherwise requires, the terms “Morgan Stanley,” the “Company,” “we” and “our” mean Morgan Stanley and its consolidated subsidiaries.

 

Morgan Stanley maintains leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services.

 

Morgan Stanley’s institutional securities business segment (“Institutional Securities”) includes:

 

    Investment banking, including securities underwriting and distribution and financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance.

 

    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.

 

    Other activities such as principal investing and real estate investment management, aircraft financing, benchmark indices and risk management analytics, and research.

 

Morgan Stanley’s individual investor group business segment (“Individual Investor Group”) includes:

 

    Comprehensive brokerage, investment and financial services designed to accommodate individual investment goals and risk profiles.

 

Morgan Stanley’s investment management business segment (“Investment Management”) includes:

 

    Global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of Morgan Stanley’s representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and Morgan Stanley’s institutional channel.

 

Morgan Stanley’s credit services business segment (“Credit Services”) includes:

 

    Discover Financial Services (“DFS”), which includes Discover®-branded cards and other consumer finance products and services, including residential mortgage loans.

 

    Discover Network, a network of merchant and cash access locations primarily in the U.S.

 

    PULSE EFT Association, Inc. (“PULSE®”), an automated teller machine (“ATM”)/debit network.

 

    Consumer Banking Group International, which includes Morgan Stanley-branded cards and personal loan products in the U.K.

 

Financial information concerning Morgan Stanley, our business segments and geographic regions for each of the fiscal years ended November 30, 2004, November 30, 2003 and November 30, 2002 is included in the consolidated financial statements and the notes thereto in “Financial Statements and Supplementary Data” in Part II, Item 8. See also “Results of Operations-Executive Summary” in Part II, Item 7 for an overview of Morgan Stanley’s fiscal 2004 performance.

 

LOGO


Table of Contents

Available Information.

 

Morgan Stanley files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 450 Fifth Street, NW, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Morgan Stanley) file electronically with the SEC. The SEC’s internet site is www.sec.gov.

 

Morgan Stanley’s internet site is www.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage through our internet site, www.morganstanley.com, by clicking on the “About Morgan Stanley” link to the heading “Investor Relations.” You can also access our Investor Relations webpage directly at www.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through our Investor Relations webpage, its proxy statements, annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Morgan Stanley also makes available, through our Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of Morgan Stanley’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

 

Morgan Stanley also has a Corporate Governance webpage. You can access Morgan Stanley’s Corporate Governance webpage through our internet site, www.morganstanley.com, by clicking on the “About Morgan Stanley” link to the heading “Inside the Company.” You can also access our Corporate Governance webpage directly at www.morganstanley.com/about/inside/governance. Morgan Stanley posts the following on its Corporate Governance webpage:

 

    Composite Certificate of Incorporation,

 

    Bylaws,

 

    Charters for our Audit Committee, Compensation Committee and Nominating and Governance Committee,

 

    Corporate Governance Policies,

 

    Policy Regarding Shareholder Communication with the Board of Directors,

 

    Policy Regarding Director Candidates Recommended by Shareholders,

 

    Policy Regarding Corporate Political Contributions,

 

    Policy Regarding Shareholder Rights Plan, and

 

    Code of Ethics and Business Conduct.

 

Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including our chief executive officer, our chief financial officer, our controller and our principal accounting officer. We will post any amendments to the Code of Ethics and Business Conduct, and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange, Inc. (“NYSE”), on our internet site. The information on Morgan Stanley’s internet site is not incorporated by reference into this report.

 

You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations at 1585 Broadway, New York, NY 10036 (212-761-4000).

 

LOGO   2    


Table of Contents

Institutional Securities.

 

Morgan Stanley provides worldwide financial advisory and capital-raising services to a diverse group of corporate and other institutional clients globally, primarily through wholly-owned subsidiaries that include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley & Co. International Limited, Morgan Stanley Japan Limited and Morgan Stanley Dean Witter Asia Limited. These subsidiaries also conduct sales and trading activities worldwide, as principal and agent, and provide related financing services on behalf of institutional investors and on a proprietary basis.

 

Investment Banking.

 

Underwriting.    Morgan Stanley manages and participates in public offerings and private placements of debt, equity and other securities worldwide. Morgan Stanley is a leading underwriter of common stock, preferred stock and other equity-related securities, including convertible securities and American Depositary Receipts (“ADRs”). Morgan Stanley is a leading underwriter of fixed income securities, including investment grade debt, non-investment grade instruments, mortgage-related and other asset-backed securities, tax-exempt securities and commercial paper and other short-term securities.

 

Financial Advisory Services.    Morgan Stanley provides corporate and other institutional clients globally with advisory services on key strategic matters, such as mergers and acquisitions, divestitures, corporate defense strategies, joint ventures, privatizations, spin-offs, restructurings, proxy and consent solicitations, tender offers, exchange offers and leveraged buyouts. Morgan Stanley provides advice concerning recapitalizations, rights offerings, dividend policy, valuations, foreign exchange exposure, financial risk management strategies and financial planning. Morgan Stanley furnishes advice and services regarding project financings and provides advisory services in connection with the purchase, sale, leasing and financing of real estate.

 

Corporate Lending.    Morgan Stanley provides to selected corporate clients through subsidiaries (including Morgan Stanley Bank) loans or lending commitments, including bridge financing. The borrowers may be rated investment grade or non-investment grade (as determined by Morgan Stanley’s Institutional Credit Department using methodologies generally consistent with those employed by external rating agencies). These loans and commitments have varying terms, may be senior or subordinated, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by Morgan Stanley.*

 

Sales, Trading, Financing and Market-Making Activities.**

 

Morgan Stanley conducts sales, trading, financing and market-making activities on securities and futures exchanges and in over-the-counter (“OTC”) markets around the world.

 

Equity Securities and Related Products.    Morgan Stanley’s equity sales, trading and market-making activities cover equity and equity-related products globally, including common stock, ADRs, restricted/control stock, convertible securities, preferred securities and exchange-traded funds and warrants, equity index products, equity swaps, futures and options overlying individual securities, indices and baskets of securities and other equity-related products.

 

Morgan Stanley issues equity-linked products to institutional and individual investors, including principal-protected securities, Stock Participation Accreting Redemption Quarterly-pay Securities® (SPARQS®), Performance Leveraged Upside SecuritiesSM (PLUSSM) and Strategic Total Return Securities. Morgan Stanley advises clients and executes transactions globally in connection with, among other things, block trades and program trading, equity repurchase strategies, hedging and monetization strategies and other trading strategies. Morgan Stanley engages in proprietary trading and arbitrage activities in equity securities and equity-related products.

 


* Revenues and expenses associated with the trading of syndicated loans are included in “Sales, Trading, Financing and Market-Making Activities.”
** See also “Risk Management” in Part II, Item 7A for a description of Morgan Stanley’s trading risk management structure, policies and procedures.

 

     3    LOGO


Table of Contents

Morgan Stanley provides equity financing services, including prime brokerage, which offers, among other services, consolidated clearance and settlement of securities trades, custody, financing and portfolio reporting services. Morgan Stanley also acts as principal and agent in stock borrowing and stock lending transactions in support of its global trading and brokerage, investment management and clearing activities and as an intermediary between broker-dealers.

 

Fixed Income Securities and Related Products.    Morgan Stanley trades and makes markets in fixed income securities and related products globally, including investment grade corporate debt, non-investment grade instruments, bank loans, U.S. and non-U.S. government securities, municipal securities, emerging market securities, preferred stock and commercial paper, money market and other short-term securities. Morgan Stanley trades and makes markets in, and acts as principal with respect to, mortgage-related and other asset-backed securities and real estate loan products. Morgan Stanley is a primary dealer of U.S. government securities and a member of the selling groups that distribute various U.S. agency and other debt securities. Morgan Stanley is a primary dealer or market-maker of government securities in numerous European, Asian and Emerging Market countries. Morgan Stanley is a dealer in interest rate and currency swaps and other fixed income and credit derivative products (including credit default swaps), OTC options on U.S. and non-U.S. government bonds and mortgage-backed forward agreements, options and swaps. Morgan Stanley also trades fixed income futures. Through its triple-A rated subsidiary, Morgan Stanley Derivative Products Inc., Morgan Stanley enters into swaps and related derivative transactions with counterparties seeking a triple-A rated counterparty. Morgan Stanley engages in proprietary trading in various fixed income products.

 

Morgan Stanley advises clients globally on investment and liability strategies and assists corporations in their debt repurchases and tax planning. Morgan Stanley structures debt securities and derivatives with risk/return factors designed to suit client objectives, including using repackaged asset vehicles through which clients can restructure asset portfolios to provide liquidity or recharacterize risk profiles. Through the use of repurchase and reverse repurchase agreements, Morgan Stanley acts as an intermediary between borrowers and lenders of short-term funds and provides funding for various inventory positions. Morgan Stanley also provides financing to customers for commercial and residential real estate loan products.

 

Morgan Stanley is a market-maker in foreign currencies. Most of Morgan Stanley’s foreign exchange business relates to major foreign currencies such as Yen, Euro, Sterling, Swiss francs and Canadian dollars. Morgan Stanley trades on a principal basis in the spot, forward, option and futures markets and takes proprietary positions in such currencies.

 

Morgan Stanley trades as principal and maintains proprietary trading positions in the spot, forward and futures markets in several commodities, including precious metals, base metals, crude oil, oil products, natural gas, electric power, emission credits and related energy products. Morgan Stanley is a market-maker in exchange-traded and OTC options and swaps on commodities, such as metals, crude oil, oil products, natural gas and electricity, and offers clients hedging programs relating to production, consumption, reserve/inventory management and energy-contract securitizations. Morgan Stanley trades many of these products through the IntercontinentalExchange, Inc., an electronic trading system in which Morgan Stanley maintains an ownership interest. Morgan Stanley is an electricity power marketer in the U.S. and is the sole or majority shareholder of three exempt wholesale generators (as defined in the Public Utility Holding Company Act of 1935) from which Morgan Stanley is the exclusive purchaser of electric power.

 

Other Activities.

 

Principal Investing and Real Estate Investment Management.    Morgan Stanley invests for its own account and for the account of clients seeking exposure to private equity, real estate-related and other alternative investments. These investments may be made in connection with the investments made by private equity funds, real estate funds and separate accounts for which Morgan Stanley acts as general partner or investment advisor or in connection with Morgan Stanley’s investment banking and sales and trading activities (including foreign

 

LOGO   4    


Table of Contents

currencies and commodities), and in other contexts. Such investments may include purchases of equity or debt securities of companies that may have strategic value for Morgan Stanley, such as alternative trading systems, information technology and other strategic businesses and technologies. See also “Investment Management—Private Equity Activities.”

 

Aircraft Financing.    Morgan Stanley engages in aircraft leasing through AWAS Aviation Holdings LLC (also referred to as Ansett Worldwide Aviation Services), one of the world’s leading aircraft leasing groups, leasing commercial jet aircraft to airlines around the world.

 

Benchmark Indices and Risk Management Analytics.    Morgan Stanley’s majority-owned subsidiary, Morgan Stanley Capital International Inc. (“MSCI®”), calculates and distributes over 25,000 international and U.S. equity benchmark indices (including the MSCI World and EAFE® Indices) covering 50 countries, and has a 35-year historical database that includes fundamental and valuation data on thousands of equity securities in developed and emerging market countries. MSCI also calculates and distributes over 7,500 fixed income and 190 hedge fund indices. MSCI’s subsidiary, Barra, Inc., is a global leader in providing risk analytic tools and services to managers of portfolio and firm-wide investment risk.

 

Research.    Morgan Stanley’s global research departments (“Research”), comprised of economists, strategists, and industry analysts, engage in equity and fixed income research activities and produce reports and studies on the U.S. and global economy, financial markets, portfolio strategy, technical market analyses, individual companies and industry developments. Research examines worldwide trends covering numerous industries and approximately 2,200 individual companies, approximately half of which are located outside of the U.S. Research provides analysis and forecasts relating to economic and monetary developments that affect matters such as interest rates, foreign currencies, securities, derivatives and economic trends. Research provides analytical support and publishes reports on asset-backed securities and the markets in which such securities are traded. Research reports and data are disseminated to investors through third-party distributors, proprietary internet sites such as Client Link, and Morgan Stanley’s sales forces.

 

Operations.

 

Morgan Stanley’s Institutional Infrastructure and Information Technology departments provide the process and technology platform that supports Institutional Securities sales and trading activity, including the post-execution trade processing and related internal controls over activity from trade entry through settlement and custody including asset servicing. This is done for proprietary and customer transactions in listed and over-the-counter transactions in commodities, equity and fixed income securities, including both primary and secondary trading, as well as listed, over-the-counter and structured derivatives in markets around the world. This activity is undertaken through its own facilities as well as through membership in various clearing and settlement organizations globally.

 

Individual Investor Group.

 

Morgan Stanley, through its Individual Investor Group, provides comprehensive brokerage, investment and financial services worldwide to individual investors, families and the companies they control. Through its representatives, Morgan Stanley is committed to delivering professional brokerage, investment and financial services to its affluent, high net worth and ultra high net worth clients. Morgan Stanley had $602 billion in client assets at November 30, 2004.

 

Client Coverage.    Morgan Stanley’s global network of 10,962 representatives provides clients with comprehensive brokerage, investment and financial services through a flexible platform designed to accommodate individual financial needs, objectives and risk profiles.

 

In the U.S., representatives in 525 retail locations cover multiple client segments from affluent to ultra high net worth, primarily through Morgan Stanley’s wholly-owned subsidiary Morgan Stanley DW Inc. (“MSDWI”). Certain representatives specialize in serving the U.S. ultra high net worth segment with sophisticated customized financial solutions, primarily through MS&Co.

 

     5    LOGO


Table of Contents

Morgan Stanley also offers financial advisory services to high net worth and ultra high net worth clients in Europe, Asia and Latin America. Morgan Stanley’s international operations also include two regional businesses: Quilter & Co. Limited, a U.K.-based investment management business, which provides asset management and advisory services to affluent private clients, charities, trusts and pension funds and Morgan Stanley S.V., S.A. (Spain), which provides investment advice and execution to individual investors in Spain.

 

Client Solutions.    Morgan Stanley’s network of representatives provides clients with comprehensive brokerage, investment and financial services that are tailored to their individual investment objectives, risk tolerance and liquidity needs. These products include mutual funds, equities, fixed income products, alternative investments and separately managed accounts. Morgan Stanley also offers mortgage products, such as residential mortgage home loans originated through DFS, and acts as an agent for leading insurance carriers to meet the insurance and annuity requirements of individual clients. In addition, Morgan Stanley provides trust and fiduciary services to individual and corporate clients. Morgan Stanley also offers financial solutions to small businesses in the U.S. through BusinesScapeSM, a program that offers cash management and commercial credit solutions to qualified business clients. Defined contribution plans, 401(k) plans and stock plan administration complement the services Morgan Stanley offers to businesses of all sizes.

 

Morgan Stanley provides various account options for individual clients. The Active Assets Account® offers clients brokerage and banking services in one account. With this account, clients’ uninvested cash is consolidated into various money market options or an account insured by the Federal Deposit Insurance Corporation (“FDIC”). For clients who prefer fee-based pricing, there is the Morgan Stanley ChoiceSM account, which charges a percentage of assets rather than a per-transaction fee. Clients can also choose to have a fee-based separately managed account managed by professional asset managers.

 

Client Services.    Morgan Stanley’s infrastructure and technology platform supports Client Coverage and Client Solutions. Morgan Stanley executes and clears its transactions (delivery of securities sold, receipt of securities purchased and transfer of related funds) through its own facilities and memberships in various clearing corporations. Systems at computer centers operated by an unaffiliated services provider also support the Individual Investor Group’s operations.

 

Investment Management.

 

Morgan Stanley, through Morgan Stanley Investment Management, is one of the largest global asset management organizations of any full-service securities firm, with $424 billion of assets under management or supervision as of November 30, 2004. Morgan Stanley’s investment management activities are principally conducted under the Morgan Stanley and Van Kampen brands. Portfolio managers located in the U.S., Europe, Japan, Singapore, and India manage investment products, ranging from money market funds to equity, taxable and tax-exempt fixed income funds and alternative investment products in developed and emerging markets. Morgan Stanley offers clients various investment styles, such as value, growth, core, fixed income and asset allocation; global investments; active and passive management; and diversified and concentrated portfolios.

 

Individual Investors.    Morgan Stanley offers proprietary open- and closed-end funds and separately managed accounts to individual investors through affiliated and unaffiliated broker-dealers, banks, insurance companies and financial planners. A small number of unaffiliated broker-dealers account for a substantial portion of Van Kampen fund sales. Morgan Stanley also sells Van Kampen funds directly and through numerous retirement plan platforms. Internationally, Morgan Stanley distributes investment products to individuals outside the U.S. through international non-proprietary distributors.

 

Institutional Investors.    Morgan Stanley provides investment management products and services to institutional investors worldwide, including pension plans, corporations, private funds, non-profit organizations, foundations, endowments, governmental agencies, insurance companies and banks. Products and services are available to institutional investors primarily through separate accounts, U.S. and non-U.S. mutual funds and other

 

LOGO   6    


Table of Contents

pooled vehicles. Morgan Stanley Investment Management sub-advises funds for various unaffiliated financial institutions and intermediaries. A global sales force and a team dedicated to covering the investment consultant industry serve institutional investors. Morgan Stanley offers clients alternative investment products primarily through Alternative Investment Partners, a joint venture that utilizes a fund-of-funds strategy to invest in hedge funds and private equity funds.

 

Private Equity Activities.    Morgan Stanley’s private equity funds generally invest in companies in a range of industries worldwide. Morgan Stanley typically acts as general partner and advisor of its private equity funds and typically commits to invest a minority of the capital of such funds, with subscribing limited partners contributing the remainder. An independent private equity firm manages the Morgan Stanley Capital Partners funds in a sub-advisory capacity.

 

Operations.    Morgan Stanley Investment Management performs a variety of functions required to support its business either through its operations group or through agreements with unaffiliated third parties. These functions include transfer agency, mutual fund accounting and administration, transaction processing, custodial, trustee and other fiduciary services, on behalf of institutional, retail and intermediary clients.

 

Credit Services.*

 

Based on its approximately 46.2 million general purpose credit card accounts at November 30, 2004, Morgan Stanley, through its Credit Services business, is one of the largest single issuers of general purpose credit cards in the U.S. Morgan Stanley’s Credit Services business includes DFS, which offers Discover-branded credit cards issued by Discover Bank and other consumer products and services; Discover Network, which operates Morgan Stanley’s merchant and cash access network; PULSE, an ATM/debit network; and its Consumer Banking Group International in the U.K.

 

Credit Cards and Services.    DFS offers several general purpose credit cards that are designed to appeal to different market segments of consumers and that are used on the Discover Network, including the Discover Classic Card, the Discover Platinum Card, the Discover Gold Card, the Discover Titanium Card, the Miles Card from Discover as well as affinity cards and Discover gift cards. DFS offers other consumer finance products and services, including home loans that are offered to Individual Investor Group and DFS customers, and credit protection products. DFS offers cardmembers certificates of deposit and money market accounts and the ability to transfer balances from other accounts or credit sources. In the U.K., Consumer Banking Group International offers the Morgan Stanley Card, the Leeds and Holbeck Card and the Morgan Stanley buy and fly! MasterCard on the MasterCard® network, and personal loan products.

 

DFS offers cardmembers other customer services. Pursuant to the Cashback Bonus® award program, DFS provides certain cardmembers awards based upon their level and type of purchases. Cardmembers may register their account online at discovercard.com, which offers a menu of free e-mail notifications to inform cardmembers about the status of their accounts, including reminders that cardmembers are approaching their credit limit or that a minimum payment is due. Cardmembers may view detailed account information and receive exclusive discounts and special Cashback Bonus awards by shopping at the internet ShopCenterSM. In addition, the Discover Deskshop® virtual credit card enables cardmembers to use a single-use credit card number (a unique credit card number used for purchases at a single web site) for online purchases so that cardmembers never have to reveal their actual card number. As of November 30, 2004, DFS had over 13 million Discover cardmembers registered at discovercard.com.

 

Network.    Only merchants that are participants in the Discover Network accept DFS’s general purpose credit cards. Established in 1986, Discover Network is the largest proprietary credit card network in the U.S. In January 2005, DFS announced that GE Consumer Finance will issue a new card, Wal-Mart Discover, on the Discover Network.

 


* See also “Risk Management” in Part II, Item 7A for a description of Morgan Stanley’s interest rate and credit risk management structure, policies and procedures.

 

     7    LOGO


Table of Contents

Discover Network operates the network and acquiring businesses primarily in the U.S., provides customized programs to its merchants in such areas as processing, and otherwise tailors program terms to meet merchant needs. Discover Network utilizes its own national sales and support force, independent sales agents and telemarketing force to maintain and increase its merchant base.

 

With its acquisition in January 2005 of PULSE, an ATM/debit network that links an estimated 90 million cardholders with more than 250,000 ATMS and 3.3 million POS terminals at retail locations nationwide, Credit Services offers financial institutions of various sizes a full-service debit platform and a complete product set, including credit, signature debit, PIN debit, gift card, stored value card and ATM services.

 

Operations.    Credit Services performs the functions required to service and operate card accounts either by itself or through agreements with unaffiliated third parties. These functions include new account solicitation, application processing, new account fulfillment, transaction authorization and processing, cardmember billing, payment processing, fraud prevention and investigation, cardmember services and collection of delinquent accounts. Credit Services maintains several operations centers throughout the U.S. and one in Scotland. Systems at computer centers operated by an unaffiliated services provider also support the operations of Credit Services.

 

Competition.

 

All aspects of Morgan Stanley’s businesses are highly competitive and Morgan Stanley expects them to remain so. Morgan Stanley competes in the U.S. and globally for clients, market share and human talent in all aspects of its business segments.

 

Institutional Securities and Individual Investor Group.    Morgan Stanley competes directly in the U.S. and globally with other securities and financial services firms, brokers and dealers. Morgan Stanley competes with commercial banks, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the internet. Morgan Stanley competes with some of its competitors globally and with others on a regional or product basis.

 

Morgan Stanley’s competitive position depends on its reputation, the quality of its personnel, its products, services and advice, ability to make capital commitments, execution capability, relative pricing and innovation. Morgan Stanley’s ability to sustain or improve its competitive position also depends substantially on its ability to continue to attract and retain qualified employees while managing compensation costs.

 

Morgan Stanley’s ability to access capital at competitive rates (which is generally dependent on Morgan Stanley’s credit ratings) and to commit capital efficiently, particularly in its capital-intensive underwriting and sales, trading, financing and market-making activities, also affects its competitive position. Corporate clients continue to request that Morgan Stanley provide loans or lending commitments in connection with certain investment banking activities and Morgan Stanley expects this activity to continue in the future.

 

Certain sectors of the financial services industry have become considerably more concentrated, as financial institutions involved in a broad range of financial services industries have been acquired by or merged into other firms. Such convergence could result in Morgan Stanley’s competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. It is possible that competition may become even more intense as Morgan Stanley continues to compete with financial institutions that may be larger, or better capitalized, or may have a stronger local presence in certain areas. The complementary trends in the financial services industry of consolidation and globalization present, among other things, technological, risk management, regulatory and other infrastructure challenges that require effective resource allocation in order for Morgan Stanley to remain competitive.

 

Morgan Stanley has experienced intense price competition in some of its businesses in recent years. In particular, the ability to execute trades electronically through the internet and other alternative trading systems has increased

 

LOGO   8    


Table of Contents

the pressure on trading commissions. The trend toward the use of alternative trading systems will likely continue. In addition, decimalization has led to a reduction in revenues and the implementation of a fee-based pricing structure in our Nasdaq trading business. It is possible that Morgan Stanley will experience competitive pressures in these and other areas in the future as some of its competitors may seek to obtain market share by reducing prices.

 

Investment Management.    Competition in the asset management industry is affected by several factors, including performance of investment products relative to peers and an appropriate benchmark index, advertising and sales promotion efforts, fee levels, the effectiveness of and access to distribution channels, and the types and quality of products offered. Morgan Stanley’s products compete with the funds and separately managed account products of other asset management firms and other investment alternatives, including hedge funds.

 

Credit Services.    DFS competes directly with other bank-issued credit cards (the vast majority of which bear the MasterCard or Visa servicemark), charge cards, credit cards that travel and financial advisory companies issue and debit cards. Credit cards that may be issued on the Discover Network by other financial institutions may also compete with credit cards offered by DFS through Discover Bank. Competition centers on merchant acceptance of credit cards, account acquisition and customer utilization. Merchant acceptance is based on competitive transaction pricing and the volume and usage of cards in circulation. Account acquisition and customer utilization are driven by competitive and appealing credit card features, such as no annual fees, low introductory interest rates and other customized features targeting specific consumer groups. Credit card industry participants have increasingly used advertising, targeted marketing, account acquisitions and pricing competition in interest rates, annual fees, reward programs and low-priced balance transfer programs to compete and grow.

 

On October 4, 2004, the U.S. Supreme Court rejected an appeal by Visa and MasterCard in U.S. v. Visa/MasterCard. The trial and appellate courts found that Visa and MasterCard rules and policies that prevented virtually all U.S. financial institutions from doing business with competing networks violated the antitrust laws. Following this decision, Credit Services filed a lawsuit in federal court in New York seeking damages for harm caused by the anti-competitive rules. Now that these rules have been struck down as illegal, financial institutions (in addition to Discover Bank) will be able to issue credit and debit cards on the Discover Network. For example, GE Consumer Finance will issue a new card, Wal-Mart Discover, on the Discover Network and DFS’s acquisition of PULSE will enable Credit Services to offer financial institutions a full service debit platform and associated products.

 

Regulation.

 

Most aspects of Morgan Stanley’s business are subject to stringent regulation by U.S. Federal and state regulatory agencies and securities exchanges and by non-U.S. government agencies or regulatory bodies and securities exchanges. Aspects of Morgan Stanley’s public disclosure, corporate governance principles, internal control environment and the roles of auditors and counsel are subject to the Sarbanes-Oxley Act of 2002 and related regulations and rules of the SEC and the NYSE.

 

New laws or regulations or changes to existing laws and regulations (including changes in the interpretation or enforcement thereof) could materially adversely affect the financial condition or results of operations of Morgan Stanley. As a global financial institution, to the extent that different regulatory regimes impose inconsistent or iterative requirements on the conduct of its business, Morgan Stanley faces complexity and additional costs in its compliance efforts.

 

Consolidated Supervision and Revised Capital Standards.    In April 2004, the SEC approved the Consolidated Supervised Entities rule (the “CSE Rule”) that establishes a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies by the SEC. The framework is designed to minimize the duplicative regulatory requirements on U.S. securities firms resulting from the European Union (“EU”) Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. The CSE Rule also would allow MS&Co., one of Morgan Stanley’s U.S. broker-dealers, to use an alternative method, based on mathematical models, to calculate net capital charges

 

     9    LOGO


Table of Contents

for market and derivatives-related credit risk. Under the CSE Rule, the SEC will regulate the holding company and any unregulated affiliate of a registered broker-dealer, including subjecting the holding company to capital requirements generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). In December 2004, Morgan Stanley applied to the SEC for permission to operate under the CSE Rule and expects to be approved in fiscal 2005.

 

Morgan Stanley continues to work with its regulators to understand and assess the impact of the CSE Rule and Basel II capital standards. Morgan Stanley cannot fully predict the impact that these changes will have on its businesses; however, compliance with consolidated supervision and the imposition of revised capital standards are likely to impose additional costs and may affect capital raising and allocation decisions.

 

Anti-Money Laundering.    Morgan Stanley’s Anti-Money Laundering (“AML”) Program is coordinated and implemented on an enterprise-wide basis. In the U.S., for example, the USA PATRIOT Act of 2001 (the “PATRIOT Act”) imposes significant new obligations to detect and deter money laundering and terrorist financing activity, including requiring banks, broker-dealers and mutual funds to identify and verify customers that maintain accounts. The PATRIOT Act also mandates that certain types of financial institutions report suspicious activity to appropriate law enforcement or regulatory authorities. An institution subject to the PATRIOT Act also must provide employees with AML training, designate an AML compliance officer and undergo an annual, independent audit to assess the effectiveness of its AML Program. Outside the U.S., applicable laws and regulations subject designated types of financial institutions to similar AML requirements. Morgan Stanley has established appropriate policies, procedures and internal controls that are designed to comply with these AML requirements

 

Protection of Client Information.    Many aspects of Morgan Stanley’s business are subject to increasingly comprehensive legal requirements concerning the use and protection of certain client information including those adopted pursuant to the Gramm-Leach-Bliley Act of 1999 and the Fair and Accurate Credit Transactions Act of 2003 in the U.S. and the European Union Data Protection Directive in the EU. Morgan Stanley has adopted policies and procedures in response to such requirements.

 

Institutional Securities and Individual Investor Group.

 

Broker-Dealer Regulation.    MS&Co. and MSDWI are registered as broker-dealers with the SEC and in all 50 states, the District of Columbia and Puerto Rico, and are members of self-regulatory organizations, including the National Association of Securities Dealers, Inc. (the “NASD”) and securities exchanges, including the NYSE. Broker-dealers are subject to laws and regulations covering all aspects of the securities business, including sales and trading practices, public offerings, publication of research reports, use of customers’ funds and securities, capital structure, record-keeping and retention, and the conduct of their directors, officers, employees and other associated persons. Broker-dealers are also regulated by securities administrators in those states where they do business. Violations of the laws and regulations governing a broker-dealer’s actions could result in censures, fines, the issuance of cease-and-desist orders, revocation of licenses or registrations, the suspension or expulsion from the securities industry of such broker-dealer or its officers or employees, or other similar consequences by both federal and state securities administrators.

 

Margin lending by broker-dealer subsidiaries is regulated by the Federal Reserve Board’s restrictions on lending in connection with customer and proprietary purchases and short sales of securities, as well as securities borrowing and lending activities. Such subsidiaries are also required by NASD and NYSE rules to impose maintenance requirements on the value of securities contained in margin accounts. In many cases, Morgan Stanley’s margin policies are more stringent than these rules.

 

Morgan Stanley conducts some of its government securities activities through Morgan Stanley Market Products Inc., a NASD member registered as a government securities broker-dealer with the SEC and in certain states. The Department of Treasury has promulgated regulations concerning, among other things, capital adequacy, custody

 

LOGO   10    


Table of Contents

and use of government securities and transfers and control of government securities subject to repurchase transactions. The rules of the Municipal Securities Rulemaking Board, which are enforced by the NASD, govern the municipal securities activities of Morgan Stanley.

 

As registered broker-dealers, certain subsidiaries of Morgan Stanley, including MS&Co. and MSDWI, are subject to the SEC’s net capital rule and the net capital requirements of various securities exchanges. Many non-U.S. securities exchanges and regulatory authorities either have imposed or are proposing rules relating to capital requirements applicable to Morgan Stanley’s broker-dealer subsidiaries. These rules, which specify minimum capital requirements, are generally designed to measure general financial integrity and liquidity and require that at least a minimum amount of net assets be kept in relatively liquid form. See also Note 13 in “Notes to Financial Statements” in Part II, Item 8. NASD rules also impose limitations on the transfer of a broker-dealer’s assets.

 

Compliance with the capital requirements may limit Morgan Stanley’s operations requiring the intensive use of capital. Such requirements restrict Morgan Stanley’s ability to withdraw capital from its broker-dealer subsidiaries, which in turn may limit its ability to pay dividends, repay debt or redeem or purchase shares of its own outstanding stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect Morgan Stanley’s ability to pay dividends or to expand or maintain present business levels. In addition, such rules may require Morgan Stanley to make substantial capital infusions into one or more of its broker-dealer subsidiaries in order for such subsidiaries to comply with such rules, either in the form of cash or subordinated loans made in accordance with the requirements of the SEC’s net capital rule.

 

Additional Regulation of U.S. Entities.    As registered futures commission merchants, MS&Co. and MSDWI are subject to the net capital requirements of, and their activities are regulated by, the Commodity Futures Trading Commission (the “CFTC”) and various commodity exchanges. Certain subsidiaries of Morgan Stanley are registered with the CFTC as commodity trading advisors and/or commodity pool operators. Morgan Stanley’s futures and options-on-futures businesses are also regulated by the National Futures Association (the “NFA”), a registered futures association, of which MS&Co. and MSDWI and certain of their affiliates are members. Violations of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration restrictions or terminations, trading prohibitions or revocations of commodity exchange memberships.

 

Morgan Stanley Capital Group Inc., through which Morgan Stanley conducts certain power generation and trading activities, is subject to extensive and evolving energy, environmental and other governmental laws and regulations. In the past several years, intensified scrutiny of the energy markets by federal, state and local authorities and the public has resulted in increased regulatory and legal enforcement and remedial proceedings involving energy companies, including those engaged in power generation and trading.

 

Morgan Stanley Bank, through which Morgan Stanley conducts certain financing and lending activities, is an industrial bank chartered under the laws of the State of Utah. It has deposits insured by the FDIC and is subject to comprehensive regulation and periodic examination by the Utah Department of Financial Institutions and the FDIC. Morgan Stanley Bank is not considered a “bank” under the Bank Holding Company Act of 1956, as amended (the “BHCA”). See also “Credit Services” below.

 

Morgan Stanley Trust National Association, a wholly-owned subsidiary, is a federally chartered national bank whose activities are limited to fiduciary activities, primarily personal trust services. It is subject to comprehensive regulation and periodic examination by the Office of the Comptroller of the Currency. Morgan Stanley Trust, National Association is not FDIC-insured and is not considered a “bank” for purposes of the BHCA.

 

Non-U.S. Regulation.    Morgan Stanley’s securities and futures businesses are also regulated extensively by non-U.S. governments, securities exchanges, commodity exchanges, self-regulatory organizations, central banks and regulatory bodies, especially in those jurisdictions in which Morgan Stanley maintains an office. For

 

     11    LOGO


Table of Contents

instance, the Financial Services Authority, the London Stock Exchange and Euronext.liffe regulate its activities in the U.K.; the Deutsche Borse AG and the Bundesanstalt für Finanzdienstleistungsaufsicht (the Federal Financial Supervisory Authority) regulate its activities in the Federal Republic of Germany; The Swiss Federal Banking Commission regulates its activities in Switzerland; the Comisión Nacional del Mercado del Valores (C.N.M.V.) regulates its activities in Spain; the Financial Services Agency, the Bank of Japan, the Japanese Securities Dealers Association and several Japanese securities and futures exchanges, including the Tokyo Stock Exchange, the Osaka Securities Exchange and the Tokyo International Financial Futures Exchange, regulate its activities in Japan; the Hong Kong Securities and Futures Commission, the Stock Exchange of Hong Kong Limited and the Hong Kong Futures Exchange Limited regulate its operations in Hong Kong; and the Monetary Authority of Singapore and the Singapore Exchange Securities Trading Limited regulate its business in Singapore.

 

Research.    Both U.S. and non-U.S. regulators continue to focus on research conflicts of interest. Research-related regulations have been implemented in many jurisdictions and are proposed or under consideration in other jurisdictions. New and revised requirements resulting from these regulations and the global research settlement with U.S. Federal and state regulators (to which Morgan Stanley is a party) have necessitated the development of corresponding policies and procedures.

 

Investment Management.    The majority of subsidiaries related to Morgan Stanley’s investment management activities and others, including MS&Co. and MSDWI, are registered as investment advisers with the SEC, and, in certain states, some employees or representatives of subsidiaries are registered as investment adviser representatives. Many aspects of Morgan Stanley’s investment management activities are subject to federal and state laws and regulations primarily intended to benefit the investor or client. These laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict Morgan Stanley from carrying on its investment management activities in the event that it fails to comply with such laws and regulations. Sanctions that may be imposed for such failure include the suspension of individual employees, limitations on Morgan Stanley engaging in various investment management activities for specified periods of time, the revocation of registrations, other censures and fines. The SEC has also adopted numerous rules and new requirements relating to the operation of the investment management business.

 

Morgan Stanley’s Investment Management business is also regulated outside the U.S. For example, the Financial Services Authority regulates Morgan Stanley’s business in the U.K.; the Financial Services Agency regulates Morgan Stanley’s business in Japan; the Securities and Exchange Board of India regulates Morgan Stanley’s business in India; and the Monetary Authority of Singapore regulates Morgan Stanley’s business in Singapore.

 

Morgan Stanley Trust, a wholly-owned subsidiary, is a federally chartered savings bank subject to comprehensive regulation and periodic examination by the federal Office of Thrift Supervision (“OTS”). As a result of its ownership of Morgan Stanley Trust, Morgan Stanley is registered with the OTS as a unitary savings and loan holding company (“SLHC”) and subject to regulation and examination by the OTS as a SLHC. Subsidiaries of Morgan Stanley, including Morgan Stanley Trust, are registered transfer agents subject to regulation and examination by the SEC.

 

Credit Services.    Morgan Stanley conducts substantial portions of its Credit Services business in the U.S. through its wholly-owned indirect subsidiary, Discover Bank, a state bank chartered under the laws of the State of Delaware. Discover Bank’s deposits are insured by the FDIC and it is subject to comprehensive regulation and periodic examination by the Office of the Delaware Bank Commissioner and by the FDIC.

 

Generally, a company that controls a “bank,” as defined in the BHCA, is required to register as a bank holding company and is regulated as a bank holding company by the Board of Governors of the Federal Reserve System. Discover Bank is considered a “bank” under the BHCA; however, under the BHCA, Morgan Stanley’s control of Discover Bank is grandfathered and Morgan Stanley is generally not treated as a bank holding company for purposes of the BHCA as long as Discover Bank either refrains from engaging in commercial lending or taking demand deposits.

 

LOGO   12    


Table of Contents

Federal and state consumer protection laws and regulations regulate extensively the relationships among cardholders and credit card issuers. Under federal law, Discover Bank may charge interest at the rate allowed by Delaware law, the state in which it is located, and export such interest rate to all other states. Delaware law does not limit the amount of interest that may be charged on loans of the type offered by Discover Bank. Federal and state bankruptcy and debtor relief laws may have a financial impact on Credit Services to the extent such laws result in any loans being charged off as uncollectible.

 

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the federal bank regulatory agencies are required to take “prompt corrective action” in respect of banks that do not meet minimum capital requirements, and certain restrictions are imposed upon banks that meet certain capital requirements but are not “well capitalized” for purposes of FDICIA. A bank that is not well capitalized, as defined for purposes of FDICIA, is, among other consequences, generally prohibited from accepting brokered deposits and offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited). Discover Bank currently uses brokered deposits as a funding source and, if it were not able to do so, its funding costs could be impacted.

 

Morgan Stanley conducts its U.K. credit card and personal loan business through Morgan Stanley Bank International Limited, Morgan Stanley’s chartered bank in the U.K., which is subject to regulation related to capital adequacy, consumer protection and deposit protection. The bank is governed primarily by the U.K.’s Financial Services and Markets Act 2000 and its activities are supervised by the Financial Services Authority and by the Office of Fair Trading in relation to its consumer credit activities.

 

Executive Officers of Morgan Stanley.

 

The executive officers of Morgan Stanley (all of whom are members of Morgan Stanley’s Management Committee) and their ages and titles as of February 10, 2005 are set forth below. Business experience for the past five years is provided in accordance with SEC rules.

 

Philip J. Purcell (61).    Chairman of the Board of Directors and Chief Executive Officer (since May 1997). Director of AMR Corporation.

 

Stephan F. Newhouse (57).    President (since December 2003). Co-President and Chief Operating Officer of Institutional Securities (September 2000 to December 2003). Deputy head of Institutional Securities (December 1997 to September 2000) and Chairman of Morgan Stanley & Co. International Limited (December 2000 to November 2003).

 

Tarek F. Abdel-Meguid (48).    Head of Investment Banking Division (since September 2000). Deputy Head of Investment Banking Division (May 1997 to September 2000).

 

Stephen S. Crawford (40).    Executive Vice President and Chief Administrative and Risk Officer (since March 2004). Executive Vice President and Chief Financial Officer (March 2001 to March 2004). Executive Vice President and Chief Strategic and Administrative Officer (June 2000 to March 2001). Managing Director of MS&Co. (since 1998).

 

Zoe Cruz (50).    Head of Fixed Income Division (since September 2000). Co-Head of Foreign Exchange Department (August 1993 to September 2000).

 

John P. Havens (48).    Head of Institutional Equity Division (since September 2000). Managing Director of MS&Co. (since 1990). Director of Nasdaq Stock Market, Inc.

 

Roger C. Hochschild (40).    President and Chief Operating Officer of DFS (since January 2004). Executive Vice President and Chief Strategic and Administrative Officer (March 2001 to January 2004). Executive Vice President of DFS (November 1998 to February 2001).

 

     13    LOGO


Table of Contents

Donald G. Kempf, Jr. (67).    Executive Vice President, Chief Legal Officer and Secretary (since December 1999). Partner at the law firm of Kirkland & Ellis (1971 to January 2000) and a member of its management committee (1981 to 1998).

 

Mitchell M. Merin (51).    President and Chief Operating Officer of Investment Management (since December 1998). Director or trustee of approximately 55 registered investment companies for which Morgan Stanley Investment Management serves as investment manager or investment advisor.

 

David W. Nelms (43).    Chairman and Chief Executive Officer of DFS (since January 2004). President and Chief Operating Officer of DFS (September 1998 to January 2004).

 

Vikram S. Pandit (48).    President and Chief Operating Officer of Institutional Securities (since December 2003, Co-President September 2000 to December 2003). Head of Institutional Equity Division (May 1997 to September 2000).

 

Joseph R. Perella (63).    Chairman of Institutional Securities (since September 2000). Head of Investment Banking Division (January 1997 to September 2000).

 

John H. Schaefer (52).    President and Chief Operating Officer of Individual Investor Group (since June 2000). Executive Vice President and Chief Strategic and Administrative Officer (June 1998 to June 2000).

 

David H. Sidwell (51).    Executive Vice President and Chief Financial Officer (since March 2004). Chief Financial Officer of the investment bank of J.P. Morgan Chase & Co. (December 2000 to March 2004). Controller of J.P. Morgan & Co. Incorporated (April 1994 to January 2001).

 

Item 2.    Properties.*

 

Morgan Stanley owns its executive offices, located at 1585 Broadway, New York, New York, where it occupies approximately 925,000 square feet as its New York headquarters. Morgan Stanley owns a 748,000 square foot office building on 107 acres in Westchester County, New York. Morgan Stanley also owns 83 acres in Riverwoods, Illinois where DFS’s executive offices occupy 1,200,000 square feet.

 

Morgan Stanley occupies approximately 1,800,000 square feet at various locations in Manhattan under leases expiring between 2005 and 2013. Morgan Stanley also leases approximately 420,000 square feet in Brooklyn, New York under a lease expiring in 2013 and approximately 440,000 square feet in Jersey City, New Jersey under leases expiring between 2005 and 2013. In December 2004, Morgan Stanley reached an agreement to lease, beginning in January 2005, approximately 445,000 square feet at One New York Plaza in New York, New York under a lease expiring in 2014.

 

Morgan Stanley’s London headquarters are located at 25 Cabot Square, Canary Wharf where it occupies approximately 450,000 square feet and owns the freehold interest in the land and the building. Morgan Stanley also leases approximately 1,170,000 square feet at locations in Canary Wharf under lease arrangements expiring or with break options occurring between 2005 and 2028.

 

Morgan Stanley’s Tokyo headquarters are located in Sapporo’s Yebisu Garden Place, Ebisu, Shibuya-ku, where it occupies approximately 280,000 square feet under a lease with an option to cancel in 2006, or at any time thereafter.

 

Morgan Stanley has offices, operations and processing centers and warehouse facilities located throughout the U.S., and certain subsidiaries maintain offices and other facilities in international locations. Morgan Stanley’s properties that are not owned are leased on terms and for durations that are reflective of commercial standards in

 


* The indicated total aggregate square footage leased is at November 30, 2004 and does not include space occupied by Morgan Stanley securities branch offices.

 

LOGO   14    


Table of Contents

the communities where these properties are located. Morgan Stanley believes the facilities it owns or occupies are adequate for the purposes for which they are currently used and are well maintained.

 

Item 3. Legal Proceedings.

 

(a) Morgan Stanley is involved in the following legal proceedings:

 

IPO Fee Litigation.

 

In November and December 1998, purported class actions, later consolidated into In re Public Offering Fee Antitrust Litigation, were initiated in the U.S. District Court for the Southern District of New York (the “SDNY”) against Morgan Stanley and 24 other underwriters. The consolidated amended complaint, filed on behalf of purchasers of certain shares in initial public offerings (“IPOs”), alleges that defendants conspired to fix the underwriters’ spread in IPOs of U.S. companies at 7%, particularly in issuances of $20 to $80 million, in violation of Section 1 of the Sherman Act. The consolidated amended complaint seeks treble damages and injunctive relief. During 2001, the Court dismissed this action with prejudice and denied plaintiffs’ motion to amend the complaint to include an issuer plaintiff, but stated that any class actions brought on behalf of issuer plaintiffs were not affected by this decision. On December 13, 2002, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) reversed the district court’s dismissal and remanded the purchaser case to the trial court. On June 24, 2003, defendants filed a supplemental brief in support of their motion to dismiss on the ground of standing. On February 24, 2004, the Court dismissed plaintiffs’ claims for damages on standing grounds, but did not dismiss the claim for injunctive relief.

 

Other purported class actions were filed in the SDNY by issuer plaintiffs making similar antitrust allegations with respect to the 7% underwriters’ spread, and on May 23, 2001, the Court consolidated these actions under the caption In re Issuer Plaintiff Initial Public Offering Fee Antitrust Litigation. During 2002, the Court denied defendants’ motion to dismiss the issuer plaintiffs’ complaint. On June 26, 2003, the Court denied defendants’ motion to dismiss both the purchaser and issuer class actions on grounds of implied immunity. On March 9, 2004, the Court supplemented its 2002 order denying defendants’ motion to dismiss the issuer plaintiffs’ claims after considering all of defendants’ arguments on statute of limitations grounds.

 

On September 16, 2004, plaintiffs filed motions for class certification in both the purchaser and issuer class actions.

 

IPO Allocation Matters.

 

In March 2001, a purported class action, now captioned In re Initial Public Offering Antitrust Litigation, was initiated in the SDNY against Morgan Stanley and numerous other underwriters of various IPOs. The consolidated amended complaint alleged that defendants required customers who wanted allocations of “hot” IPO securities to pay undisclosed and excessive underwriters’ compensation in the form of increased brokerage commissions and to buy shares of securities offered in the IPOs after the IPOs were completed (“tie-in purchases”) at escalating price levels higher than the IPO price (a practice plaintiffs refer to as “laddering”). The complaint alleged violations of federal and/or state antitrust laws, including Section 1 of the Sherman Act. On November 3, 2003, the Court dismissed all of the federal and state antitrust claims. On April 14, 2004, the Court denied plaintiffs’ motion for reconsideration of the dismissal. On June 23, 2004, plaintiffs submitted their appeal to the Second Circuit.

 

Also beginning in March 2001, numerous purported class actions, now captioned In re Initial Public Offering Securities Litigation, were filed in the SDNY against certain issuers of IPO securities, certain individual officers of those issuers, Morgan Stanley and other underwriters of those IPOs, purportedly on behalf of purchasers of stock in the IPOs or the aftermarket. These complaints make factual allegations similar to the complaint in the antitrust action described above, but claim violations of the federal securities laws, including Sections 11 and 12(a)(2) of the Securities Act of 1933 (the “Securities Act”) and Section 10(b) of the Exchange Act. Some of the complaints also allege that continuous “buy” recommendations by the defendants’ research analysts improperly

 

     15    LOGO


Table of Contents

increased or sustained the prices at which the securities traded after the IPOs. On February 19, 2003, the underwriter defendants’ joint motion to dismiss was denied, except as to certain specified offerings. On June 10, 2004, plaintiffs and issuer defendants entered into a definitive settlement agreement under which insurers of the issuers would guarantee recovery of at least $1 billion by class members. As part of the settlement, the settling issuer defendants would assign to the class members certain claims they may have against the underwriters. On June 14, 2004, those parties jointly moved for approval of the proposed settlement. On October 13, 2004, the Court granted in large part plaintiffs’ motions for class certification in six focus cases selected for class certification briefing. In November and December 2004, purported assignees of certain issuers filed suit against several members of the underwriting syndicate, including Morgan Stanley, on the ground that underwriters breached the underwriting agreement and related duties by allocating shares in each company’s IPO to customers who allegedly paid the underwriters “excess compensation.” The assignment was conferred in the issuers’ settlement, and plaintiffs have moved to stay this action pending approval of the issuers’ settlement.

 

On or about April 2, 2002, a purported class action complaint, captioned Breakaway Solutions, Inc. v. Morgan Stanley & Co. Incorporated, et al., was filed in the Delaware Court of Chancery against Morgan Stanley and two other underwriters. The complaint was brought on behalf of a class of issuers that issued IPO securities from January 1, 1998 to October 31, 2000 pursuant to underwriting agreements with defendants and whose securities increased in value by 15 percent or more within 30 days following the IPO. The complaint alleges that defendants allocated underpriced stock to certain of defendants’ favored clients and, directly or indirectly, shared in portions of the profits of such favored clients pursuant to side agreements or understandings, with the alleged effect of depriving issuers of millions of dollars in IPO proceeds. The complaint seeks unspecified damages for allegedly underpricing the IPOs, as well as indemnification and contribution for the costs of defending securities class action lawsuits brought by shareholders relating to issuers’ IPOs. On August 27, 2004, the Court granted in part and denied in part defendants’ motion to dismiss, dismissing a breach of contract claim and the claims for indemnification and/or contribution.

 

On or about May 18, 2004, Morgan Stanley entered into a settlement with the NASD to resolve a matter relating to IPO allocation practices and the receipt of higher than usual commission rates. Morgan Stanley submitted a Letter of Acceptance, Waiver and Consent for the purpose of settling alleged violations of NASD Rule 2110 requiring member firms to observe high standards of commercial honor and adhere to just and equitable principles of trade. Morgan Stanley consented, without admitting or denying the allegations, to the imposition of a censure, a fine of $490,000 and a payment of $4.9 million in disgorgement for receiving high commissions from approximately 25 customers without inquiry and within one day of allocating shares of “hot” IPOs to those customers.

 

On January 25, 2005, the SEC announced a settlement with MS&Co. and Goldman Sachs & Co. resolving the SEC’s investigation relating to IPO allocation practices. The SEC filed a settled civil injunction action in the United States District Court for the District of Columbia against MS&Co. relating to the allocation of stock to institutional customers in IPOs underwritten during 1999 and 2000. Under the terms of the settlement, Morgan Stanley agreed, without admitting or denying the allegations, to the entry of a judgment enjoining it from violating Rule 101 of Regulation M and the payment of a $40 million civil penalty. The court approved the settlement on February 4, 2005. The complaint alleges that MS&Co. violated Rule 101 of Regulation M by attempting to induce certain customers who received allocations of IPOs to place purchase orders for additional shares in the aftermarket. No allegation of fraud or impact on the market was made.

 

Research Matters.

 

On April 28, 2003, Morgan Stanley, along with nine other financial services firms operating in the U.S., reached a settlement with the SEC, the New York State Attorney General’s Office, the NYSE, the NASD, and the North American Securities Administrators Association (on behalf of state securities regulators) to resolve their investigations relating to alleged research conflicts of interest. Without admitting or denying allegations with respect to violations of certain rules of the NYSE and NASD relating to investment research activities (there were no allegations of fraud or federal securities law violations made against Morgan Stanley), Morgan Stanley

 

LOGO   16    


Table of Contents

entered into consents and other documentation pursuant to which Morgan Stanley agreed, among other things, to (1) pay $25 million as a penalty, (2) pay $25 million as disgorgement of commissions and other monies, (3) provide $75 million over five years to make available independent third-party research to clients, (4) adopt internal practices and procedures that will further enhance steps it has taken to ensure research analyst integrity and promote investor confidence and (5) be permanently restrained and enjoined from violating certain rules of the NYSE and NASD relating to investment research activities. In connection with the final settlement, Morgan Stanley also voluntarily agreed to adopt restrictions on the allocation of shares in initial public offerings to certain corporate executives and directors. The settlement has been approved by the SEC, the NYSE, the NASD, the SDNY and almost all states, and was entered as a court-ordered injunction in the SDNY on October 31, 2003.

 

On May 30, 2003, the SEC issued a subpoena to Morgan Stanley requesting documents and information in connection with its continuing investigation of research analysts’ conflicts of interests, focusing on supervision by the heads of equity research and investment banking. The SEC issued similar subpoenas to all of the firms that settled the investigations regarding research independence matters. Morgan Stanley continues to receive, and respond to, subpoenas and requests for documents, information and witness testimony.

 

Starting in 2001 and continuing through 2004, Morgan Stanley has been named as a defendant in a number of civil actions, including class, shareholder and derivative actions, alleging various claims relating to research analysts’ conflicts of interest.

 

On May 21, 2004, in Fogarazzo v. Lehman Bros., et al., a case filed in the SDNY against Morgan Stanley and two other underwriters alleging that underwriters failed to disclose that they were issuing positive research on RSL Communications, Inc. to obtain investment banking business, the Court denied defendants’ motion to dismiss.

 

On June 30, 2004, the Supreme Court of the State of New York dismissed Striffler v. Purcell, et al., a shareholder derivative action against certain current or former members of the Board of Directors and certain other officers alleging breach of fiduciary duty in connection with research practices. On July 30, 2004, plaintiff filed a notice of appeal.

 

On July 23, 2004, in State of West Virginia ex rel. Darrell v. Bear Stearns & Co., Inc., et al., a case filed in the Circuit Court of Marshall County, West Virginia against Morgan Stanley and nine other firms that settled regulatory actions in connection with research independence matters seeking to impose civil fines for alleged violations of the West Virginia Consumer Credit and Protection Act based on alleged conflicts of interest between defendants’ investment bankers and research analysts, the Court denied defendants’ motion to dismiss and certified a question for the Supreme Court of Appeals of West Virginia. On September 21, 2004, defendants filed a Petition for Review of Certified Question with the Supreme Court of Appeals of West Virginia. On January 24, 2005, the Supreme Court of Appeals accepted review of the certified question.

 

On September 29, 2004, the SDNY dismissed Shah v. Morgan Stanley & Co. Inc., et al., a shareholder class action alleging that Morgan Stanley’s stock price declined upon disclosure of the 2003 global research settlement and alleged banking-research conflicts. On November 10, 2004, plaintiffs filed a notice of appeal.

 

Mutual Fund Matters.

 

Sales Practices.    On July 14, 2003, the Massachusetts Securities Division (the “Division”) filed an administrative complaint alleging that Morgan Stanley filed false information in response to an inquiry from the Division pertaining to mutual fund sales practices. On August 11, 2003, the Division filed an administrative complaint, alleging that Morgan Stanley failed to make disclosures of incentive compensation for proprietary and partnered mutual fund transactions. On November 25, 2003, the Division filed an administrative complaint, alleging that a former branch manager engaged in securities fraud and dishonest conduct in promoting the sales of proprietary mutual funds. On May 24, 2004, the presiding hearing officer granted Morgan Stanley’s motion to dismiss all claims relating to Morgan Stanley’s differential compensation practices and its receipt of

 

     17    LOGO


Table of Contents

remuneration from third-party fund families, holding that these practices did not violate any state law or regulation. Regarding the Division’s complaint filed on July 14, 2003, Morgan Stanley waived its right to a hearing and agreed to pay an administrative fine of $25,000 on September 27, 2004. Regarding the Division’s complaints filed on August 11, 2003 and November 25, 2003, hearings were concluded on December 20, 2004, and the parties are awaiting a decision from the independent hearing officer.

 

From October 2003 to December 2003, nine purported class actions now captioned In re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation, were initiated in the SDNY against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen mutual funds, and certain officers of Morgan Stanley and its affiliates and certain trustees of the named Morgan Stanley funds. The consolidated amended complaint was filed on behalf of all persons or entities, other than defendants, who purchased or held shares of certain Morgan Stanley or Van Kampen mutual funds from October 1, 1999 to November 17, 2003 against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen funds. Plaintiffs allege that defendants gave their sales force economic incentives to promote the sale of proprietary mutual funds and that they improperly failed to disclose these economic incentives. The complaint also alleges that defendants improperly used Rule 12b-1 fees and that the named funds paid excessive commissions to MSDWI in connection with the sale of proprietary funds. The complaint alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act, Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 20(a) of the Exchange Act, Section 206 of the Investment Advisors Act of 1940, Sections 34(b), 36(b) and 48(a) of the Investment Company Act of 1940, and of common law fiduciary duties. The consolidated amended complaint seeks, among other things, compensatory damages, rescissionary damages, fees and costs. On July 2, 2004, defendants filed a motion to dismiss the consolidated amended complaint.

 

On November 17, 2003, MSDWI consented, without admitting or denying the findings, to the entry of an order (the “Order”) by the SEC that resolved the SEC’s and NASD’s investigations into certain practices relating to MSDWI’s offer and sale of certain mutual funds from January 1, 2000 to the date of the Order. Pursuant to the Order, MSDWI will: (a) distribute for the benefit of certain customers who purchased shares of mutual funds through MSDWI pursuant to the marketing arrangements between MSDWI and certain mutual fund complexes the amount of $50 million; (b) place on its website disclosures relating to certain marketing programs pursuant to which it offered and sold certain mutual funds; (c) prepare a Mutual Fund Bill of Rights that discloses, among other things, the differences in fees and expenses associated with the purchase of different classes of proprietary mutual fund shares; (d) prepare a plan by which certain customers’ proprietary Class B shares can be converted to Class A shares; (e) retain an independent consultant to review, among other things, the adequacy of MSDWI’s disclosures with respect to such marketing programs and other matters in connection with MSDWI’s offer and sale of shares of mutual funds and compliance with the Order; and (f) adopt the recommendations of the independent consultant.

 

On June 17, 2004, the New Hampshire Bureau of Securities Regulation filed a petition for relief against MSDWI alleging, among other things, that a former representative solicited certain customers to purchase certain unregistered, non-exempt securities, that certain managers promoted the sale of proprietary mutual funds and other products by the use of certain “sales contests” and that MSDWI failed to disclose the allegedly material fact of such contests. The petition for relief seeks, among other things, an administrative fine of $500,000 and an order to show cause why MSDWI’s broker-dealer license should not be suspended or revoked.

 

Late Trading and Market Timing.    Starting in July 2003, Morgan Stanley received subpoenas and requests for information from various regulatory and governmental agencies, including the Attorney General of the State of New York, the SEC, NASD, the Massachusetts Securities Division, the U.S. Attorney’s Office of Massachusetts and the Office of the State Auditor and the Attorney General of West Virginia in connection with industry-wide investigations of broker-dealers and mutual fund complexes relating to possible late trading and market timing of mutual funds. Morgan Stanley is cooperating with these and other regulatory investigations and continues to receive, and respond to, subpoenas and requests for documents and information from the SEC, NASD and other regulators.

 

LOGO   18    


Table of Contents

On December 18, 2003, a purported class action, captioned Jackson v. Van Kampen Series Fund, Inc. and Van Kampen Investment Advisory Corp., was filed in the Circuit Court of Madison County, Illinois, alleging that defendants failed to make daily adjustments for fluctuations between the U.S. and foreign markets in calculating net asset values in the Van Kampen International Magnum Fund, thereby exposing long-term shareholders to the effects of market-timing trades. Defendants removed the case to federal court, but, on April 1, 2004, the case was remanded to state court. The complaint seeks, among other things, compensatory and punitive damages. On April 30, 2004, defendants appealed to the U.S. Court of Appeals for the Seventh Circuit seeking review of the decision to remand the case from federal to state court. On August 10, 2004, the state court denied defendants’ motion to dismiss.

 

On February 20, 2004, a derivative action, captioned Starr v. Van Kampen Investments Inc., et al., was filed in the U.S. District Court for the Northern District of Illinois on behalf of various Van Kampen mutual funds against Van Kampen Investments Inc., Van Kampen Asset Management Inc., Morgan Stanley, MSDWI, Morgan Stanley Investment Advisors Inc. and individual trustees of the funds. The original complaint alleges violations of the Investment Company Act of 1940, the Investment Advisers Act of 1940, and common law breach of fiduciary duty with respect to Van Kampen’s participation in certain mutual fund marketing programs operated by MSDWI. Plaintiff seeks, among other things, to remove current trustees, to rescind the management contracts for the Van Kampen Funds and to replace the manager, disgorgement, monetary damages, including punitive damages and interest, and fees and expenses. On April 26, 2004, the Court ordered the action transferred to the SDNY for coordination with In re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation. On December 8, 2004, defendants filed a motion to dismiss the First Amended Derivative Complaint. On December 23, 2004, plaintiff filed a Motion for Leave to File a Second Amended Derivative Complaint adding a new allegation that defendants permitted or recklessly disregarded market timing or late trading in Van Kampen funds. On December 23, 2004, plaintiff also filed a Notice of Tag-Along Action with the Judicial Panel on Multidistrict Litigation, requesting that the case be transferred to the United States District Court for the District of Maryland (the “Maryland District Court”). On January 28, 2005, the Judicial Panel on Multidistrict Litigation issued a Conditional Transfer Order. On February 3, 2005, the parties agreed that plaintiff’s proposed Second Amended Derivative Complaint would be withdrawn and that the allegations regarding market-timing and late trading asserted therein would be filed in a separate complaint in the Maryland District Court in coordination with In re Mutual Funds Investment Litigation. The parties also stipulated that the Starr case in the SDNY would be stayed and placed on the Court’s suspense calendar until the later of a decision on the pending motions to dismiss in In re Morgan Stanley and Van Kampen Mutual Fund Securities Litigation or a decision by the Maryland District Court of any motion to dismiss the Maryland litigation.

 

On September 29, 2004, MSDWI was added as a defendant in two of the actions that are part of the multi-district market-timing litigation captioned In re Mutual Funds Investment Litigation in the United States District Court for the District of Maryland. The complaints, Lepera v. Invesco Funds Group, Inc., et al., and Riggs v. Massachusetts Financial Services Company, et al., assert claims against MSDWI for unjust enrichment, aiding and abetting, breach of fiduciary duty, and violation of Section 10(b) of the Exchange Act and seek, among other things, compensatory and punitive damages. These claims are based on allegations that MSDWI was among a group of broker-dealers that facilitated market-timing transactions in various mutual funds controlled by third parties.

 

Other.    On September 28, 2001, a purported class action, Abrams v. Van Kampen Funds Inc., et al., was commenced in the U.S. District Court for the Northern District of Illinois against Van Kampen Funds Inc., Van Kampen Investment Advisory Corp., Van Kampen Prime Rate Income Trust and certain of the Trust’s officers and trustees. The complaint alleges that, from September 30, 1998 to March 26, 2001, defendants violated certain

provisions of the Securities Act and common law fiduciary duties by misstating the Trust’s net asset value in its prospectus, registration statement and financial reports. The complaint seeks rescissionary damages, unspecified damages, interest, fees and costs. In 2002, the Court granted in part and denied in part defendants’ motion to dismiss and granted the lead plaintiff’s motion for class certification. On June 24, 2004, the Court denied plaintiff’s motion for summary judgment and granted in part and denied in part defendants’ motion for summary

 

     19    LOGO


Table of Contents

judgment. On December 8, 2004, the Court dismissed with prejudice plaintiffs’ claims under Section 12(a)(2) of the Securities Act and plaintiffs’ common law fiduciary duty claims.

 

On November 14, 2001, a purported class action, Hicks v. Morgan Stanley & Co., et al., was filed in the SDNY against Morgan Stanley & Co., Morgan Stanley Dean Witter Services Company Inc., Morgan Stanley Investment Advisors Inc., Morgan Stanley Dean Witter Prime Income Trust, and certain of the Trust’s officers and trustees. The complaint alleges that, between November 1, 1998 and April 26, 2001, defendants violated certain provisions of the Securities Act and common law fiduciary duties by misstating the Trust’s net asset value in its prospectus, registration statement and financial reports. The complaint seeks rescissionary damages, unspecified damages, interest, fees and costs. In 2002, the Court dismissed the state law claims. On July 16, 2003, the Court granted plaintiffs’ motion for class certification. The parties reached an agreement-in-principle to settle the matter. On December 9, 2004, the Court entered an Order Preliminarily Approving the Proposed Settlement, Directing Issuance of Notice to the Class, and Setting a Fairness Hearing.

 

In 2002, several purported class action complaints were filed in the SDNY against Morgan Stanley, the Morgan Stanley Technology Fund, the Morgan Stanley Information Fund, Morgan Stanley Investment Management, Inc., and certain other subsidiaries of Morgan Stanley, alleging securities fraud violations in connection with the underwriting and management of the Technology Fund and the Information Fund and seeking unspecified damages for losses on investments in these funds. Plaintiffs allege that Morgan Stanley analysts issued overly optimistic stock recommendations to obtain investment banking business and that investment banking considerations influenced investment decisions made by the fund managers. On August 29, 2003, the SDNY entered an Order approving the parties’ stipulation to stay the actions pending the decision of the Second Circuit in an appeal from the dismissal of a similar case brought against another party by the same plaintiffs’ law firm.

 

On February 24, 2003, a putative class action captioned Edward Benzon, et al., v. Morgan Stanley Distributors Inc., et al., was commenced in the U.S. District Court for the Middle District of Tennessee against Morgan Stanley Distributors Inc., Morgan Stanley Investment Advisors Inc., Morgan Stanley Investment Management Inc., Morgan Stanley Investments L.P., MSDWI, and Morgan Stanley. The complaint alleges that defendants failed to disclose certain benefits of Class A and Class C shares relative to Class B shares in the prospectuses of certain Morgan Stanley mutual funds and the alleged financial conflicts of Morgan Stanley representatives in selling Class B shares. In addition to individual claims asserted on behalf of the named plaintiffs, the complaint alleges, on behalf of a purported class of investors who purchased Class B shares from February 25, 1998 to the present, violations of Sections 11 and 12 of the Securities Act and Section 10(b) of the Exchange Act. The complaint seeks unspecified rescissionary damages, unspecified damages, interest, fees and costs. On January 8, 2004, the Court granted defendants’ motions to dismiss. On February 5, 2004, plaintiffs’ motion to alter or amend judgment and for leave to file an amended complaint was denied. On February 17, 2004, plaintiffs filed a notice of appeal, which appeal is now pending before the U.S. Court of Appeals for the Sixth Circuit.

 

On May 21, 2004, a putative class action captioned The Robert N. Clemens Trust, et al., v. Morgan Stanley DW Inc. was filed in the U.S. District Court for the Western District of Tennessee. The complaint alleges that the defendant’s representatives inappropriately recommended Class B shares of Morgan Stanley mutual funds. In addition to individual claims asserted on behalf of the named plaintiffs, the complaint alleges on behalf of a purported class of certain purchasers of Morgan Stanley mutual funds’ Class B shares from February 25, 1998 to the present, violations of Section 10(b) of the Exchange Act and Rules 10b-5(a), (b) and (c). The complaint seeks, among other things, disgorgement and restitution of unspecified fees and charges, and unspecified compensatory and punitive damages, interest, fees and costs.

 

Mutual fund industry practices continue to be the subject of intense regulatory, governmental and public scrutiny. Morgan Stanley has received various regulatory inquiries, relating to, among other things, fees and revenue sharing, and is cooperating with all inquiries, including an SEC investigation regarding the amount of fees charged by certain Morgan Stanley index funds, as well as the process by which those fees were determined.

 

LOGO   20    


Table of Contents

Electricity Trading Matters.

 

Morgan Stanley is involved in certain ongoing proceedings arising out of its activities as a wholesale power marketer in the Western energy markets during and after the summer of 2000. These proceedings include a number of purported class actions on behalf of electricity consumers in California and Washington against several power marketers and generators, including Morgan Stanley. These complaints assert violations of state unfair competition statutes based on allegations that, during the summer of 2000, defendants fixed the prices for electricity. In those actions, plaintiffs seek reimbursement of alleged overcharges and punitive damages. An additional class action, Millar v. Allegheny Energy, seeks to rescind various long-term power contracts entered into between California and defendants, including Morgan Stanley. All of the California actions except Millar have been remanded to California Superior Court, and an appeal of the remand decision is pending before the U.S. Court of Appeals for the Ninth Circuit. Millar was removed to the U.S. District Court for the Southern District of California. The Washington class action, City of Tacoma v. American Electric Power Service Corp., is pending in the U.S. District Court for the Western District of Washington.

 

Morgan Stanley also was named in four proceedings filed with the Federal Energy Regulatory Commission (“FERC”) by counterparties seeking to rescind or modify long-term power contracts entered into during and after the summer of 2000 as allegedly unjust and unreasonable. FERC denied the relief sought in all of these cases, and appeals from FERC’s rulings are pending in the U.S. Court of Appeals for the Ninth Circuit. Morgan Stanley has settled the long-term contract cases brought by the State of California and PacificCorp.

 

AOL Time Warner Litigation.

 

Beginning on April 11, 2003, Morgan Stanley has been named as a defendant in one purported class action in the SDNY and a number of individual state court actions involving AOL Time Warner, including cases in New Jersey, Ohio, West Virginia, Pennsylvania, Alaska, and four cases in California that have been coordinated in the Superior Court of the State of California, County of Los Angeles. All these cases also name as defendants AOL Time Warner, numerous individual defendants, AOL Time Warner’s auditors, and other underwriter defendants. The complaints allege that AOL Time Warner issued false and misleading financial statements by inflating advertising revenues, among other things. These complaints also name Morgan Stanley in its capacity as financial advisor to Time Warner in the merger of America Online and Time Warner, and/or as underwriter of bond offerings completed in 2001 and 2002. The complaints allege violations of Section 11 of the Securities Act and Section 14(a) of the Exchange Act (and Rule 14a-9 thereunder) in connection with the merger registration statement, as well as various state laws, and violations of Section 11 and 12(a)(2) of the Securities Act in connection with the bond registration statements.

 

In 2003, defendants filed motions to dismiss the actions in the SDNY and in the New Jersey and Ohio state courts. In January 2004, the parties agreed to stay the New Jersey action. On May 5, 2004, the Court granted Morgan Stanley’s motion to dismiss in the SDNY action. On May 19, and August 13, 2004, respectively, defendants filed motions to dismiss the West Virginia and Alaska actions. On July 20, 2004, plaintiffs and bank defendants entered into a tolling agreement and stipulation of discontinuance and dismissal in the Pennsylvania action. On September 10, 2004, defendants filed demurrers seeking dismissal of the California coordinated actions. On October 8, 2004, in the Ohio state individual action, the Ohio Court of Common Pleas denied Morgan Stanley’s motion to dismiss the state securities law claims, but dismissed the common law claims.

 

Coleman Litigation.

 

On May 8, 2003, a complaint captioned Coleman (Parent) Holdings Inc. v. Morgan Stanley & Co., Inc., was filed in the Circuit Court of the Fifteenth Judicial Circuit in and for Palm Beach County, Florida (the “Fifteenth Circuit”) relating to Coleman (Parent) Holdings Inc.’s (“CPH”) receipt of 14.1 million shares of Sunbeam Corporation common stock when it sold its 82% interest in The Coleman Company (“Coleman”) to Sunbeam on March 30, 1998. The complaint alleges that Morgan Stanley misrepresented Sunbeam’s financial condition,

 

     21    LOGO


Table of Contents

inducing CPH to enter into the transaction, and makes claims for fraudulent misrepresentation, aiding and abetting fraud, conspiracy and negligent misrepresentation. On December 15, 2003, the Court denied Morgan Stanley’s motion to dismiss the CPH complaint. In November 2004, the court allowed CPH to amend its complaint to add a claim for punitive damages. On February 1, 2005, Morgan Stanley’s motion for summary judgment was denied. Trial is scheduled to begin in February 2005.

 

On March 1, 2004, Morgan Stanley, MS&Co. and Morgan Stanley Senior Funding, Inc. filed an action in the Fifteenth Circuit against Arthur Andersen LLP and certain of its affiliates and former partners. The complaint asserts fraudulent misrepresentation, fraudulent inducement, and aiding and abetting fraud, and seeks to recover damages incurred by Morgan Stanley and its affiliates as a result of their reliance on Arthur Andersen’s certification of Sunbeam’s financial statements. Morgan Stanley filed a First Amended Complaint in August 2004. Between August and September 2004, all defendants filed various motions to dismiss the complaint.

 

LVMH Litigation.

 

On October 30, 2002, the French company LVMH Moet Hennessey Louis Vuitton (“LVMH”) initiated proceedings in the Paris Commercial Court against Morgan Stanley & Co. International Limited and Morgan Stanley alleging that, between 1999 and 2002, in research reports and newspaper interviews concerning the luxury goods sector, Morgan Stanley failed in its duties of independence and impartiality and denigrated LVMH to the benefit of Gucci, a Morgan Stanley client.

 

In a judgment dated January 12, 2004, the Paris Commercial Court awarded LVMH €30 million for damage to its image and appointed an expert to assist it in assessing whether LVMH is entitled to additional damages, and, if so, in what amount. On October 18, 2004, LVMH filed submissions before the expert claiming €182.9 million in additional damages.

 

On February 12, 2004, Morgan Stanley filed a notice of appeal against the judgment. The parties are in the process of filing appeal submissions.

 

Carlos Soto Matter.

 

In fiscal 2004, Morgan Stanley discovered irregularities in the accounts of certain clients of Carlos Soto, a former registered representative in its San Juan, Puerto Rico branch. Mr. Soto stated that, with respect to certain clients, he had raised some funds by making misrepresentations, issuing false account statements and diverting some funds to accounts he controlled. Morgan Stanley promptly notified regulators and law enforcement. On February 11 and 13, 2004, respectively, the U.S. District Court for District of Puerto Rico granted the SEC’s and Morgan Stanley’s requests for temporary restraining orders freezing Mr. Soto’s assets. On February 19, 2004, Mr. Soto was arrested by federal authorities. On February 20, 2004, in the SEC matter, the Court granted a preliminary injunction freezing Mr. Soto’s assets, and on November 8, 2004, the SEC barred Mr. Soto from any association with any broker or dealer. On December 3, 2004, Morgan Stanley reached a final settlement with the NYSE to resolve this matter (see also “New York Stock Exchange Matter” below). Morgan Stanley is continuing to assist other regulators in their investigations of Mr. Soto’s activities and to resolve customer claims concerning those activities. On November 29, 2004, the U.S. District Court for the District of Puerto Rico presiding in Mr. Soto’s criminal proceeding issued a preliminary order of forfeiture with respect to Mr. Soto’s assets. Morgan Stanley and others have filed petitions in that proceeding with respect to such assets. On January 25, 2005, the United States Attorney’s Office moved to dismiss the third-party petitions.

 

Parmalat Matter.

 

From 2001 through 2003, Morgan Stanley entered into interest rate and currency derivative transactions with Parmalat, an Italian publicly-listed company. In 2002 and 2003, Morgan Stanley also was involved in two public and one private bond offerings for Parmalat outside the U.S.

 

In fiscal 2004, Morgan Stanley and several other financial institutions were requested to provide documents and other information to Italian and U.K. authorities conducting criminal and regulatory investigations relating to

 

LOGO   22    


Table of Contents

Parmalat, which was declared insolvent on December 27, 2003. Morgan Stanley and several other financial institutions, together with employees of those institutions involved in Parmalat-related matters, are under investigation in Italy. Morgan Stanley is cooperating with these various investigations.

 

On April 8, 2004, Morgan Stanley voluntarily provided the SEC information concerning its dealings with Parmalat.

 

On December 17, 2004, the Parma, Italy bankruptcy court ruled to admit the full amount of Morgan Stanley’s €35 million claim in the administration of Parmalat. This claim resulted from amounts due to Morgan Stanley on the closing out of various derivative transactions with Parmalat at the time of its declaration of insolvency.

 

The administrator of Parmalat is also reviewing past Parmalat transactions and has filed various suits seeking restitution of monies paid by Parmalat to various banks and auditors. On January 27, 2005, the administrator of Parmalat filed an insolvency clawback claim against Morgan Stanley & Co. International Ltd. and Morgan Stanley Bank International Ltd. in the civil court of Parma, Italy seeking repayment of approximately €136 million. The basis of this claim is that Morgan Stanley allegedly knew that Parmalat was insolvent at the time the monies were paid by Parmalat.

 

Indonesian Litigation.

 

In November 2003, two proceedings were initiated in the Indonesian District Courts by two members of the Asia Pulp & Paper Group (PT Indah Kiat Pulp & Paper Tbk and PT Lontar Papyrus Pulp & Paper Industry, respectively) against Morgan Stanley and thirteen other defendants, with respect to two bond issues in 1994 and 1995, guaranteed by plaintiffs, in which Morgan Stanley acted as underwriter. The claims allege that the bond issues were invalid and contrary to Indonesian law, and allege damages in the amount of all principal and interest paid under the bonds as well as other amounts. In September 2004, the Courts issued their judgments, declaring the bond issues to be illegal and void, holding that defendants (including Morgan Stanley) had committed unspecified tortious acts, but awarding no damages. Morgan Stanley has appealed both judgments.

 

In April 2004, another proceeding was filed in the Indonesian District Courts by PT Lontar Papyrus against Morgan Stanley and 28 other defendants, alleging that the defendants violated injunctions issued by the Indonesian District Court in the first claim brought by PT Lontar Papyrus and conspired to cause the failure of plaintiff’s restructuring negotiations. Plaintiff seeks damages in respect of losses allegedly suffered. On January 3, 2005, Morgan Stanley entered an appearance before the Indonesian District Court.

 

In October 2004, an additional proceeding was filed in the Indonesian District Courts by APP International Finance Company BV, a member of the Asia Pulp & Paper Group and the issuer of the 1995 bond issue, against Morgan Stanley and eighteen other defendants, making allegations similar to those in the November 2003 claim brought by PT Lontar Papyrus. Plaintiff seeks damages in respect of losses allegedly suffered.

 

NASD Matter.

 

On November 18, 2004, the NASD enforcement staff informed Morgan Stanley that it had made a preliminary determination to recommend that a disciplinary action be brought against MSDWI in connection with the staff’s investigation of fee-based brokerage accounts. The potential disciplinary action, which would allege NASD Rule violations, concerns Morgan Stanley’s opening and maintenance of certain Choice accounts, the fees charged for certain such accounts and the content of certain Choice marketing materials.

 

Variable Annuity Matters.

 

On January 20, 2005, a putative class action complaint was filed in the United States District Court for the Southern District of California against Morgan Stanley and MSDWI alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and of Section 206 of the Investment Advisers Act of 1940. The complaint alleges that MSDWI had undisclosed contingent fee sharing agreements with insurance companies issuing variable annuities, and that MSDWI breached its fiduciary duties to plaintiffs and made misstatements and omissions of material fact in connection with the allegedly undisclosed fee agreements. The complaint seeks,

 

     23    LOGO


Table of Contents

among other things, unspecified compensatory damages and injunctive or equitable relief including restitution and disgorgement, attorneys’ fees and costs. MSDWI has also received a request for information and documents from the NASD, and a subpoena from the Commonwealth of Massachusetts, regarding issues relating to variable annuity sales and marketing practices.

 

(b) The following matters were terminated during the quarter ended November 30, 2004:

 

SEC Matter.

 

On November 4, 2004, Morgan Stanley reached a final settlement with the SEC to resolve an informal accounting investigation by executing an offer of settlement and agreeing to entry of a cease-and-desist order. The SEC found that Morgan Stanley valued certain impaired aircraft in its aircraft leasing business in late 2001, late 2002 and early 2003, and certain bonds in its high-yield bond portfolio in late 2000, in a manner that did not comply with generally accepted accounting principles, and thus violated financial reporting, recordkeeping and internal controls provisions of the federal securities laws. The resolution does not involve any restatement of past financial statements, any monetary penalty or any allegation of fraud.

 

New York Stock Exchange Matter.

 

On December 3, 2004, Morgan Stanley executed two stipulations of facts and consent to penalty (one with respect to Morgan Stanley’s failure to comply with certain prospectus delivery requirements, operational deficiencies and other matters, and the other with respect to employee defalcations, including the Carlos Soto matter). The first stipulation included a fine of $13 million and the second a fine of $6 million. On December 9, 2004, a hearing panel of the NYSE accepted both settlements.

 

* * *

 

Other.

 

In addition to the matters described above, in the normal course of business, Morgan Stanley has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions, and other litigation, arising in connection with its activities as a global diversified financial services institution. Certain of the legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

Morgan Stanley is also involved, from time to time, in other reviews, investigations and proceedings by governmental and self-regulatory agencies (both formal and informal) regarding Morgan Stanley’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including Morgan Stanley.

 

Morgan Stanley contests liability and/or the amount of damages in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Morgan Stanley cannot predict with certainty the loss or range of loss related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief might be. Subject to the foregoing, Morgan Stanley believes, based on current knowledge and after consultation with counsel, that the outcome of each such pending matter will not have a material adverse effect on the consolidated financial condition of Morgan Stanley, although the outcome could be material to Morgan Stanley’s or a business segment’s operating results for a particular future period, depending on, among other things, the level of Morgan Stanley’s or a business segment’s income for such period.

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

None.

 

LOGO   24    


Table of Contents

Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Morgan Stanley’s common stock trades on the NYSE and The Pacific Exchange. At November 30, 2004, Morgan Stanley had approximately 125,000 holders of record; however, Morgan Stanley believes the number of beneficial owners of common stock exceeds this number.

 

Set forth below, for each of the last eight fiscal quarters, is the low and high sales prices per share of Morgan Stanley’s common stock as reported by Bloomberg Financial Markets and the amount of any cash dividends declared per share of Morgan Stanley’s common stock.

 

     Low
Sale Price


   High
Sale Price


   Dividends

Fiscal 2004:

                    

Fourth Quarter

   $ 47.30    $ 53.78    $ 0.25

Third Quarter

   $ 46.80    $ 54.64    $ 0.25

Second Quarter

   $ 50.61    $ 62.22    $ 0.25

First Quarter

   $ 55.02    $ 61.60    $ 0.25

Fiscal 2003:

                    

Fourth Quarter

   $ 47.81    $ 58.07    $ 0.23

Third Quarter

   $ 42.42    $ 50.49    $ 0.23

Second Quarter

   $ 32.46    $ 48.03    $ 0.23

First Quarter

   $ 34.32    $ 46.70    $ 0.23

 

     25    LOGO


Table of Contents

The table below sets forth the information with respect to purchases made by or on behalf of Morgan Stanley of its common stock during the fourth quarter of our fiscal year ended November 30, 2004.

 

Issuer Purchases of Equity Securities

(dollars in millions, except per share amounts)

 

Period


   Total
Number of
Shares
Purchased


   Average Price
Paid Per
Share


   Total Number of
Shares Purchased
As Part of Publicly
Announced Plans
or Programs (C)


   Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs


 

Month #1 (Sept. 1, 2004—Sept. 30, 2004)

                         

Equity Anti-dilution Program (A)

   869,470    $ 49.5403    869,470      (A )

Capital Management Program (B)

   —        N/A    —      $ 600  

Employee Transactions (D)

   3,613,911    $ 52.4356    N/A      N/A  

Month #2 (Oct. 1, 2004—Oct. 31, 2004)

                         

Equity Anti-dilution Program (A)

   9,334,850    $ 48.8998    9,334,850      (A )

Capital Management Program (B)

   —        N/A    —      $ 600  

Employee Transactions (D)

   187,522    $ 50.2587    N/A      N/A  

Month #3 (Nov. 1, 2004—Nov. 30, 2004)

                         

Equity Anti-dilution Program (A)

   3,636,176    $ 51.8660    3,636,176      (A )

Capital Management Program (B)

   —        N/A    —      $ 600  

Employee Transactions (D)

   87,386    $ 50.9655    N/A      N/A  

Total

                         

Equity Anti-dilution Program (A)

   13,840,496    $ 49.7193    13,840,496      (A )

Capital Management Program (B)

   —        N/A    —      $ 600  

Employee Transactions (D)

   3,888,819    $ 52.2976    N/A      N/A  

(A) Morgan Stanley’s board of directors authorized this program to purchase common stock to help offset the dilutive impact of grants and exercises of awards under Morgan Stanley’s equity-based compensation and benefit plans. The program was publicly announced on January 7, 1999 and has no set expiration or termination date. There is no maximum amount of shares that may be purchased under the program.
(B) Morgan Stanley’s board of directors authorized this program to purchase common stock for capital management purposes. The program was publicly announced on February 12, 1998 at which time up to $3 billion of stock was authorized to be purchased. The program was subsequently increased by $1 billion on December 18, 1998, $1 billion on December 20, 1999 and $1.5 billion on June 20, 2000. This program has a remaining capacity of $600 million at November 30, 2004 and has no set expiration or termination date.
(C) Share purchases under publicly announced programs are made pursuant to open-market purchases, Rule 10b5-1 plans or privately negotiated transactions (including with employee benefit plans) as market conditions warrant and at prices Morgan Stanley deems appropriate.
(D) Includes: (1) shares delivered or attested to in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options (granted under employee stock compensation plans) who exercised options; (2) restricted shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares; and (3) shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units. Morgan Stanley’s employee stock compensation plans provide that the value of the shares delivered or attested, or withheld, shall be the average of the high and low price of Morgan Stanley’s common stock on the date the relevant transaction occurs.

 

LOGO   26    


Table of Contents

Item 6.    Selected Financial Data.

 

MORGAN STANLEY

 

SELECTED FINANCIAL DATA

(dollars in millions, except share and per share data)

 

     Fiscal Year(1)

 
     2004

    2003

    2002

    2001

    2000

 

Income Statement Data:

                                        

Revenues:

                                        

Investment banking

   $ 3,341     $ 2,440     $ 2,478     $ 3,413     $ 5,008  

Principal transactions:

                                        

Trading

     5,525       6,192       3,479       5,503       7,361  

Investments

     512       86       (31 )     (316 )     193  

Commissions

     3,264       2,887       3,191       3,066       3,566  

Fees:

                                        

Asset management, distribution and administration

     4,412       3,731       3,953       4,238       4,420  

Merchant and cardmember

     1,318       1,379       1,420       1,349       1,256  

Servicing

     1,993       2,015       2,080       1,888       1,489  

Interest and dividends

     18,590       15,744       15,879       24,132       21,233  

Other

     594       506       724       586       592  
    


 


 


 


 


Total revenues

     39,549       34,980       33,173       43,859       45,118  

Interest expense

     14,859       12,856       12,710       20,720       18,145  

Provision for consumer loan losses

     925       1,267       1,336       1,052       810  
    


 


 


 


 


Net revenues

     23,765       20,857       19,127       22,087       26,163  
    


 


 


 


 


Non-interest expenses:

                                        

Compensation and benefits

     9,880       8,545       7,940       9,376       10,899  

Other

     7,200       6,507       6,214       7,033       6,748  

Restructuring and other charges

     —         —         235       —         —    
    


 


 


 


 


Total non-interest expenses

     17,080       15,052       14,389       16,409       17,647  
    


 


 


 


 


Gain on sale of business

     —         —         —         —         35  
    


 


 


 


 


Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change

     6,685       5,805       4,738       5,678       8,551  

Losses from unconsolidated investees

     328       279       77       30       33  

Provision for income taxes

     1,803       1,562       1,575       2,022       3,036  

Dividends on preferred securities subject to mandatory redemption

     45       154       87       50       28  
    


 


 


 


 


Income from continuing operations before cumulative effect of accounting change

     4,509       3,810       2,999       3,576       5,454  
    


 


 


 


 


Discontinued operations:

                                        

(Loss)/gain from discontinued operations

     (38 )     (38 )     (18 )     6       3  

Income tax benefit/(provision)

     15       15       7       (2 )     (1 )
    


 


 


 


 


(Loss)/gain on discontinued operations

     (23 )     (23 )     (11 )     4       2  
    


 


 


 


 


Income before cumulative effect of accounting change

     4,486       3,787       2,988       3,580       5,456  

Cumulative effect of accounting change

     —         —         —         (59 )     —    
    


 


 


 


 


Net income

   $ 4,486     $ 3,787     $ 2,988     $ 3,521     $ 5,456  
    


 


 


 


 


Earnings applicable to common shares(2)

   $ 4,486     $ 3,787     $ 2,988     $ 3,489     $ 5,420  
    


 


 


 


 


 

     27    LOGO


Table of Contents
     Fiscal Year(1)

 
     2004

    2003

    2002

    2001

    2000

 

Per Share Data:

                                        

Basic earnings per common share:

                                        

Income from continuing operations before cumulative effect of accounting change

   $ 4.17     $ 3.54     $ 2.77     $ 3.26     $ 4.95  

Loss from discontinued operations

     (0.02 )     (0.02 )     (0.01 )     —         —    

Cumulative effect of accounting change

     —         —         —         (0.05 )     —    
    


 


 


 


 


Basic earnings per common share

   $ 4.15     $ 3.52     $ 2.76     $ 3.21     $ 4.95  
    


 


 


 


 


Diluted earnings per common share:

                                        

Income from continuing operations before cumulative effect of accounting change

   $ 4.08     $ 3.47     $ 2.70     $ 3.16     $ 4.73  

Loss from discontinued operations

     (0.02 )     (0.02 )     (0.01 )     —         —    

Cumulative effect of accounting change

     —         —         —         (0.05 )     —    
    


 


 


 


 


Diluted earnings per common share

   $ 4.06     $ 3.45     $ 2.69     $ 3.11     $ 4.73  
    


 


 


 


 


Book value per common share

   $ 25.95       22.93       20.24       18.64     $ 16.91  

Dividends per common share

   $ 1.00       0.92       0.92       0.92     $ 0.80  

Balance Sheet and Other Operating Data:

                                        

Total assets

   $ 775,410       602,843       529,499       482,628     $ 421,279  

Consumer loans, net

     20,226       19,382       23,014       19,677       21,743  

Total capital(3)

     110,793       82,769       65,936       61,633       49,637  

Long-term borrowings(3)

     82,587       57,902       44,051       40,917       30,366  

Shareholders’ equity

     28,206       24,867       21,885       20,716       19,271  

Return on average common shareholders’ equity

     16.8 %     16.5 %     14.1 %     18.0 %     30.9 %

Average common and equivalent shares(2)

     1,080,121,708       1,076,754,740       1,083,270,783       1,086,121,508       1,095,858,438  

(1) Certain prior-period information has been reclassified to conform to the current year’s presentation.
(2) Amounts shown are used to calculate basic earnings per common share.
(3) These amounts exclude the current portion of long-term borrowings and include Capital Units and junior subordinated debt issued to capital trusts.

 

LOGO   28    


Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Introduction.

 

Morgan Stanley (the “Company”) is a global financial services firm that maintains leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services. The Company’s Institutional Securities business includes securities underwriting and distribution; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; 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; principal investing and real estate investment management; aircraft financing activities; providing benchmark indices and risk management analytics; and research. The Company’s Individual Investor Group business provides comprehensive brokerage, investment and financial services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s Credit Services business offers Discover®-branded cards and other consumer finance products and services, including residential mortgage loans, and includes the operation of Discover Network, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services business segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

The Company’s results of operations for the 12 months ended November 30, 2004 (“fiscal 2004”), November 30, 2003 (“fiscal 2003”) and November 30, 2002 (“fiscal 2002”) are discussed below.

 

     29    LOGO


Table of Contents

Results of Operations.

 

Executive Summary.

 

Financial Information.

 

     Fiscal Year

 
     2004

    2003(1)

    2002(1)

 

Net revenues (dollars in millions):

                        

Institutional Securities

   $ 13,063     $ 11,211     $ 9,119  

Individual Investor Group

     4,615       4,242       4,268  

Investment Management

     2,738       2,276       2,506  

Credit Services

     3,634       3,427       3,557  

Intersegment Eliminations

     (285 )     (299 )     (323 )
    


 


 


Consolidated net revenues

   $ 23,765     $ 20,857     $ 19,127  
    


 


 


Income before taxes(2) (dollars in millions):

                        

Institutional Securities

   $ 4,097     $ 3,645     $ 2,655  

Individual Investor Group

     371       464       120  

Investment Management

     827       482       656  

Credit Services

     1,272       1,093       1,178  

Intersegment Eliminations

     118       121       129  
    


 


 


Consolidated income before taxes

   $ 6,685     $ 5,805     $ 4,738  
    


 


 


Consolidated net income (dollars in millions)

   $ 4,486     $ 3,787     $ 2,988  
    


 


 


Basic earnings per common share:

                        

Income from continuing operations

   $ 4.17     $ 3.54     $ 2.77  

Loss from discontinued operations

     (0.02 )     (0.02 )     (0.01 )
    


 


 


Basic earnings per common share

   $ 4.15     $ 3.52     $ 2.76  
    


 


 


Diluted earnings per common share:

                        

Income from continuing operations

   $ 4.08     $ 3.47     $ 2.70  

Loss from discontinued operations

     (0.02 )     (0.02 )     (0.01 )
    


 


 


Diluted earnings per common share

   $ 4.06     $ 3.45     $ 2.69  
    


 


 


Statistical Data.

                        

Book value per common share(3)

   $ 25.95     $ 22.93     $ 20.24  

Return on average common equity

     16.8 %     16.5 %     14.1 %

Effective income tax rate

     28.5 %     29.0 %     34.4 %

Consolidated assets under management or supervision (dollars in billions):

                        

Equity

   $ 251     $ 207     $ 172  

Fixed income

     130       123       127  

Money market

     87       64       66  

Other(4)

     79       68       55  
    


 


 


Total(5)

   $ 547     $ 462     $ 420  
    


 


 


Worldwide employees

     53,284       51,196       55,726  

 

LOGO   30    


Table of Contents
Statistical Data (Continued).    Fiscal Year

 
     2004

    2003(1)

    2002(1)

 

Institutional Securities:

                        

Mergers and acquisitions completed transactions (dollars in billions)(6):

                        

Global market volume

   $ 353.0     $ 207.8     $ 347.8  

Market share

     25.4 %     19.2 %     28.3 %

Rank

     2       3       2  

Mergers and acquisitions announced transactions (dollars in billions)(6):

                        

Global market volume

   $ 385.1     $ 241.9     $ 193.6  

Market share

     21.7 %     20.0 %     18.3 %

Rank

     4       2       3  

Global equity and equity-linked issues (dollars in billions)(6):

                        

Global market volume

   $ 54.3     $ 39.6     $ 25.2  

Market share

     10.7 %     10.2 %     7.9 %

Rank

     1       3       4  

Global debt issues (dollars in billions)(6):

                        

Global market volume

   $ 359.5     $ 367.0     $ 270.2  

Market share

     6.9 %     7.4 %     6.9 %

Rank

     2       3       5  

Pre-tax profit margin(7)

     31 %     31 %     28 %

Individual Investor Group:

                        

Global representatives

     10,962       11,086       12,546  

Total client assets (dollars in billions)

   $ 602     $ 565     $ 516  

Fee-based assets as a percentage of total client assets

     26 %     23 %     21 %

Pre-tax profit margin(7)

     8 %     11 %     3 %

Investment Management:

                        

Assets under management or supervision (dollars in billions)

   $ 424     $ 357     $ 337  

Percent of fund assets in top half of Lipper rankings(8)

     71 %     57 %     62 %

Pre-tax profit margin(7)

     30 %     21 %     26 %

Pre-tax profit margin(7) (excluding private equity)

     26 %     22 %     28 %

Credit Services (dollars in millions, unless otherwise noted)(9):

                        

Period-end credit card loans—Owned

   $ 19,724     $ 18,930     $ 22,153  

Period-end credit card loans—Managed

   $ 48,261     $ 48,358     $ 51,143  

Average credit card loans—Owned

   $ 17,608     $ 19,531     $ 20,659  

Average credit card loans—Managed

   $ 47,387     $ 50,864     $ 49,835  

Net principal charge-off rate—Owned

     5.53 %     6.05 %     6.06 %

Net principal charge-off rate—Managed

     6.00 %     6.60 %     6.19 %

Transaction volume (dollars in billions)

   $ 99.6     $ 97.9     $ 97.3  

Pre-tax profit margin(7)

     35 %     32 %     33 %

(1) Certain prior-period information has been reclassified to conform to the current year’s presentation.
(2) Amounts represent income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations.
(3) Book value per common share equals shareholders’ equity of $28,206 million at November 30, 2004, $24,867 million at November 30, 2003 and $21,885 million at November 30, 2002, divided by common shares outstanding of 1,087 million at November 30, 2004, 1,085 million at November 30, 2003 and 1,081 million at November 30, 2002.
(4) Amounts include alternative investment vehicles.
(5) Revenues and expenses associated with these assets are included in the Company’s Investment Management, Individual Investor Group and Institutional Securities segments.
(6) Source: Thomson Financial, data as of January 7, 2005—The data for fiscal 2004, fiscal 2003 and fiscal 2002 are for the periods from January 1 to December 31, 2004, January 1 to December 31, 2003 and January 1 to December 31, 2002, respectively, as Thomson Financial presents these data on a calendar-year basis.
(7) Percentages represent income before taxes and discontinued operations, excluding losses from unconsolidated investees, as a percentage of net revenues.
(8) Source: Lipper, one-year performance as of November 30, 2004, November 30, 2003 and November 30, 2002, respectively.
(9) Managed data include owned and securitized credit card loans. For an explanation of managed data and a reconciliation of credit card loan and asset quality data, see “Credit Services—Managed General Purpose Credit Card Loan Data” herein.

 

     31    LOGO


Table of Contents

Fiscal 2004 Performance.

 

Company Results.  The Company recorded net income of $4,486 million and diluted earnings per share of $4.06 in fiscal 2004, both 18% increases from the prior year. Net revenues (total revenues less interest expense and the provision for loan losses) rose 14% to $23.8 billion in fiscal 2004, and the return on average common equity was 16.8% compared with 16.5% in the prior year.

 

Non-interest expenses of $17.1 billion increased 13% from the prior year, primarily due to higher compensation expense and professional services expense associated with increased business activity and additional legal and regulatory costs. Compensation and benefits expense in fiscal 2004 reflected an additional year of amortization of equity-based awards (see “Equity-Based Compensation Program” herein).

 

The Company’s effective tax rate was 28.5% in fiscal 2004 compared with 29.0% in fiscal 2003. The decrease reflected higher domestic tax credits and certain miscellaneous items, partially offset by higher tax rates applicable to non-U.S. earnings (see Note 16 to the consolidated financial statements).

 

At fiscal year-end, the Company had 53,284 employees worldwide, an increase of 4% from the prior year, reflecting the recovering global economy, increased business activity, and additional personnel associated with increased regulatory and compliance efforts that existed in fiscal 2004.

 

Subsequent to fiscal year-end, the Company’s Board of Directors declared a $0.27 quarterly dividend per common share, an 8% increase from the $0.25 per common share declared the previous quarter.

 

Institutional Securities.  The Company’s Institutional Securities business recorded income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations of $4.1 billion, a 12% increase from a year ago. Net revenues rose 17% to $13.1 billion, driven by record revenues in fixed income and significant increases in advisory fees and equity underwriting revenues. Non-interest expenses rose 19% to $9.0 billion, reflecting higher incentive-based compensation costs, professional services and other expense categories associated with increased business activity.

 

Advisory revenues rose 75% from last year to $1.2 billion, reflecting a significant increase in the Company’s market share in completed merger and acquisition transactions from 19% to 25% and a 29% increase in industry-wide completed merger and acquisition activity (according to Thomson Financial). Underwriting revenues rose 29% from last year to $1.9 billion with equity, high-yield and securitized products driving the increase in revenues. Equity underwriting revenues rose 55% compared with the prior year.

 

Fixed income sales and trading revenues were $5.6 billion, up 4% from a record performance in the prior year. The increase was driven by a record year in commodities and improved results in credit products. Commodities benefited from tight oil supplies, growing demand and global political instability that drove energy prices and volatilities higher. Credit products benefited from increased customer flows and favorable trading conditions. Revenues from interest rate and currency products declined slightly from last year’s record revenues, primarily due to lower revenues from cash and derivative products. Equity sales and trading revenues rose 13% from last year to $4.1 billion. Prime brokerage had a record year driven by robust growth in client asset balances. Revenues from equity cash products increased, reflecting higher market volumes, while revenues from equity derivatives increased modestly despite continued low levels of volatility.

 

Individual Investor Group.  The Individual Investor Group recorded pre-tax income of $371 million, down 20% from the prior year, largely driven by higher non-interest expenses. In the fourth quarter of fiscal 2004, the Company changed its method of accounting to recognize certain asset management and account fees and related expenses over the relevant contract period as compared with when billed. This change decreased net revenues by

 

LOGO   32    


Table of Contents

$107 million, non-interest expenses by $27 million and pre-tax income by $80 million for both the full year and quarterly results (see “Asset Management and Account Fees” herein).

 

Net revenues for fiscal 2004 were $4.6 billion, a 9% increase over a year ago, reflecting higher asset management, distribution and administration fees driven primarily by an increase in client assets in fee-based accounts. Commission revenues also increased from the prior year due to higher equity market volumes. Total non-interest expenses were $4.2 billion, a 12% increase from a year ago. The increase was driven by higher compensation expense and higher professional services expense, including sub-advisory, consulting and legal costs. Total client assets increased to $602 billion, up 7% from the prior fiscal year-end. In addition, client assets in fee-based accounts increased 21% from the prior fiscal year-end to $157 billion and increased as a percentage of total client assets to 26% from 23% a year ago. At fiscal year-end, the number of global representatives was 10,962, a decline of 124 over the past year.

 

Investment Management.  Investment Management recorded pre-tax income of $827 million, a 72% increase from last year. The increase reflected a 20% increase in net revenues to $2.7 billion driven by an increase in asset management fees and higher investment gains. Non-interest expenses increased 7% from the prior year to $1.9 billion, largely due to higher compensation expense and an increase in professional services expense driven by higher consulting, sub-advisory and legal costs. Assets under management at fiscal year-end were $424 billion, up $67 billion, or 19% from a year ago as a result of both market appreciation and positive net flows. At fiscal year-end, the percentage of the Company’s fund assets performing in the top half of the Lipper rankings was 71% over one year, 75% over three years and 73% over five years. Performance for the one- and three-year time periods was significantly better than a year ago. Principal transaction investment gains for the year were $248 million, a $229 million increase from a year ago, with the largest gains associated with the Company’s holdings in Vanguard Health Systems, Inc. and Ping An Insurance (Group) Company of China, Ltd.

 

Credit Services.  Credit Services pre-tax income was a record $1,272 million, an increase of 16% from last year. The increase in earnings on a managed basis was driven by a decline in the provision for loan losses, reflecting improved credit quality, which more than offset lower net interest income and merchant and cardmember fees. Non-interest expenses were relatively flat from the prior year as higher marketing expenses were offset by lower compensation costs. The managed credit card net charge-off rate decreased 60 basis points from a year ago to 6.00%, benefiting from the effect of the Company’s credit quality and collection initiatives and an industry-wide improvement in credit quality. The managed over 30-day delinquency rate decreased 142 basis points to 4.55% from a year ago, and the managed over 90-day delinquency rate was 64 basis points lower than a year ago at 2.18%. Managed credit card loans were $48.3 billion at year-end, virtually unchanged from a year ago. On a managed basis, net interest income fell $246 million from a year ago to $4.4 billion, reflecting lower average credit card loan balances, partially offset by an increase in the interest rate spread. Merchant and cardmember fees decreased $136 million on a managed basis, largely as a result of lower late and overlimit fees.

 

Fiscal 2005 Performance Priorities.    One of the performance priorities of the Company in fiscal 2005 is to regain a premium return on equity as compared with its competitors by focusing on areas of business with strong potential for growth and leveraging the strengths and capabilities of the Company’s business segments. Each of the Company’s businesses segments will also focus on key initiatives in fiscal 2005.

 

Institutional Securities will continue to focus on enhancing client relationships, maintaining or improving market share and increasing profitability through investing in growth markets and improving capital and risk efficiency.

 

The Individual Investor Group will focus on generating revenue growth and gathering assets. One of the group’s top priorities is margin improvement over the next two years.

 

Investment Management’s primary objective will be to improve operating leverage through revenue growth. Investment Management will focus on building key growth areas where it is currently underrepresented, including separately managed accounts, multi-discipline accounts and alternative investment products; capturing

 

     33    LOGO


Table of Contents

more flows, primarily as a result of improved fund performance and standings; and continuing to concentrate assets under the best performing managers. In fiscal 2005, Investment Management may experience slower growth in fee revenues due to fee reductions across certain products and because a large percentage of product sales in fiscal 2004 were in institutional fixed income and liquidity fund products, which generally generate lower fees than equity products. In addition, lower principal investment gains are expected going forward as the Company reduces its private equity business.

 

Credit Services will continue to focus on growing both profitability and customer receivable balances and creating a competitive advantage with its proprietary network. The Company believes there is potential to capitalize on the recent U.S. Supreme Court decision, rejecting an appeal by Visa and MasterCard in U.S. v. Visa/MasterCard, which allows financial institutions to issue credit and debit cards on the Discover Network. In January 2005, the Company announced that it had signed its first third-party issuance with GE Consumer Finance to issue the Wal-Mart Discover card on the Discover Network. In addition, the Company believes that its acquisition of PULSE EFT Association, Inc. (“PULSE®”), which was completed in January 2005, will result in a leading electronic payments company offering a full range of products and services for financial institutions, consumers and merchants.

 

Global Market and Economic Conditions in Fiscal 2004.

 

Global economic growth was generally favorable for most of fiscal 2004, particularly driven by the U.S. and China. The level of activity in the global capital markets was also higher than in fiscal 2003. Significant investor uncertainty, however, persisted throughout the fiscal year due to concerns about the pace of economic growth, inflationary pressures, higher oil prices and higher levels of geopolitical risk. At the end of fiscal 2004, most global financial markets rallied in response to positive economic developments, primarily in the U.S.

 

In the first half of fiscal 2004, the U.S. economy benefited from accommodative fiscal and monetary policies, supported by productivity gains. Corporate earnings were generally strong, and consumer confidence rose as the U.S. labor market strengthened due to job creation and a decline in unemployment. The second half of fiscal 2004 began with a mid-year slowdown due, in part, to soaring energy prices, the expected pace of inflation and cautious business investment before regaining momentum at the end of fiscal 2004. Major equity market indices had a mixed year, declining mid-year due to higher energy prices, concern over continued turmoil in Iraq and global geopolitical tension, which depressed market sentiment and activity. The equity markets rallied at the end of the year due to positive economic developments, a positive earnings outlook and the resolution of the U.S. presidential election. During fiscal 2004, the unemployment rate declined to 5.4%, its lowest level since September 2001. In response to indications of inflationary pressures, the Federal Reserve Board (the “Fed”) raised both the overnight lending rate and the discount rate on four separate occasions by an aggregate of 1.00% during the fiscal year. Subsequent to fiscal year-end, the Fed raised both the overnight lending rate and the discount rate by an aggregate of 0.50%.

 

In Europe, the recovery of economic activity continued despite consistently higher oil prices, which had a considerable impact on inflation rates. The recovery in Europe was led by productivity gains in France and Spain, while economic conditions in Germany and Italy were less robust. The European Central Bank (the “ECB”) left the benchmark interest rate unchanged during fiscal 2004 as the level of interest rates remained low by historical standards. The ECB remains concerned about the level of inflation and the strength of the euro relative to the U.S. dollar and its negative impact on demand for exports. In the U.K., the labor market continued to strengthen, and business investment continued to grow. There were, however, some indications of a slowdown in the housing market, while the growth in consumer spending moderated. During fiscal 2004, the Bank of England raised the benchmark interest rate by an aggregate of 1.00%.

 

Japan’s economy demonstrated signs of recovery during the first half of fiscal 2004, primarily driven by higher exports, consumer spending and industrial production. In the second half of fiscal 2004, the increase in exports and production showed signs of abating, as a rising Japanese yen against the U.S. dollar and higher oil prices

 

LOGO   34    


Table of Contents

diminished demand for exports. In China, there were signs that its economic growth rate may have been slowing, though the pace of expansion nevertheless remained rapid. Economies elsewhere in Asia also generally improved.

 

As fiscal 2005 began, global economic and market conditions continued to be generally favorable, including a strong level of announced merger and acquisition transactions. As fiscal 2005 progresses, investors will continue to be focused on a number of important developments, such as corporate earnings, inflation and interest rates, energy prices and geopolitical risks.

 

Business Segments.

 

The remainder of “Results of Operations” is presented on a business segment basis before discontinued operations. Substantially all of the operating revenues and operating expenses of the Company can be directly attributed to its business segments. Certain revenues and expenses have been allocated to each business segment, generally in proportion to its respective revenues or other relevant measures.

 

As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an Intersegment Eliminations category to reconcile the segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations represents the effect of timing differences associated with the revenue and expense recognition of commissions paid by Investment Management to the Individual Investor Group associated with sales of certain products and the related compensation costs paid to Individual Investor Group’s representatives. Income before taxes recorded in Intersegment Eliminations was $118 million, $121 million and $129 million in fiscal 2004, fiscal 2003 and fiscal 2002, respectively.

 

Certain reclassifications have been made to prior-period segment amounts to conform to the current year’s presentation.

 

     35    LOGO


Table of Contents

INSTITUTIONAL SECURITIES

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in millions)

Revenues:

                    

Investment banking

   $ 3,008    $ 2,096    $ 2,179

Principal transactions:

                    

Trading

     5,007      5,541      2,837

Investments

     269      63      42

Commissions

     1,998      1,748      2,033

Asset management, distribution and administration fees

     144      92      91

Interest and dividends

     16,367      13,381      13,056

Other

     392      283      396
    

  

  

Total revenues

     27,185      23,204      20,634

Interest expense

     14,122      11,993      11,515
    

  

  

Net revenues

     13,063      11,211      9,119
    

  

  

Non-interest expenses

     8,966      7,566      6,464
    

  

  

Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations

     4,097      3,645      2,655

Losses from unconsolidated investees

     328      279      77

Dividends on preferred securities subject to mandatory redemption

     45      154      87
    

  

  

Income before taxes and discontinued operations

   $ 3,724    $ 3,212    $ 2,491
    

  

  

 

Investment Banking.    Investment banking revenues are derived from the underwriting of securities offerings and fees from advisory services. Investment banking revenues were as follows:

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in millions)

Advisory fees from merger, acquisition and restructuring transactions

   $ 1,156    $ 662    $ 961

Equity underwriting revenues

     993      640      543

Fixed income underwriting revenues

     859      794      675
    

  

  

Total investment banking revenues

   $ 3,008    $ 2,096    $ 2,179
    

  

  

 

Investment banking revenues increased 44% in fiscal 2004, primarily reflecting higher revenues from merger, acquisition and restructuring and equity underwriting transactions. Higher revenues from fixed income underwriting transactions also contributed to the increase. In fiscal 2003, investment banking revenues decreased 4%, reflecting lower revenues from merger, acquisition and restructuring activities, partially offset by higher revenues from fixed income and equity underwriting transactions.

 

In fiscal 2004, advisory fees from merger, acquisition and restructuring transactions increased 75% to $1.2 billion, the first time advisory fees exceeded $1.0 billion since fiscal 2001. Conditions in the worldwide merger and acquisition markets rebounded throughout fiscal 2004, reflecting improved conditions in the global equity markets. There was $1.8 trillion of transaction activity announced during calendar-year 2004 (according to Thomson Financial, data as of January 7, 2005) as compared with $1.2 trillion in calendar-year 2003. During calendar-year 2004, the total amount of the Company’s announced merger and acquisition transaction volume was approximately $385 billion as compared with approximately $242 billion in the prior calendar year. The 59% increase primarily resulted from an increase in average transaction size and higher volumes as an improved global economy resulted in increased transaction activity. Industry-wide completion volumes also rose by 29% vs. the prior calendar-year period, while the Company’s volume of completed transactions increased nearly 70%.

 

LOGO   36    


Table of Contents

The Company’s fiscal 2004 revenues from merger and acquisition transactions were derived from several sectors, including financial services, technology, media and telecommunications, manufacturing and healthcare. In fiscal 2003, conditions in the worldwide merger and acquisition markets were difficult throughout most of the year. Such conditions included weak corporate earnings as companies began the year focusing on cost reduction instead of business expansion. In addition, the depressed level of fiscal 2002 merger and acquisition announcements had a direct impact on completed volumes during fiscal 2003, resulting in reduced advisory revenues. These conditions improved during the fourth quarter of fiscal 2003, when the global economy demonstrated signs of recovery and the equity markets rallied.

 

The worldwide market for equity underwriting transactions in fiscal 2004 improved significantly from fiscal 2003, while the volume of fixed income underwritings continued to remain steady throughout fiscal 2004.

 

Equity underwriting revenues increased 55% in fiscal 2004, largely due to the resurgence of the initial public offerings market. The global equity markets experienced renewed investor demand for initial public offerings, particularly in the U.S., and the Company’s participation in these transactions more than outpaced the industry-wide increase in transaction volume. The Company’s equity underwriting revenues reflected increases from the financial services, healthcare, media and telecommunications, and technology sectors. In fiscal 2003, equity underwriting revenues increased 18% from fiscal 2002. In the first half of fiscal 2003, equity underwriting revenues increased from relatively depressed levels, primarily led by a high level of convertible offerings. Rising equity markets contributed to a more favorable equity underwriting environment in the second half of fiscal 2003, with a significant increase in global transaction activity, particularly in the technology, financial services and utility sectors.

 

Fixed income underwriting revenues increased 8% in fiscal 2004 and 18% in fiscal 2003, primarily reflecting favorable conditions in the global fixed income markets throughout both fiscal years. Although the Fed increased overnight interest rates in fiscal 2004, longer-term interest rates remained at historically low levels. The attractive debt financing environment contributed to higher revenues as issuers continued to take advantage of low financing costs. The Company’s revenues from global high-yield and securitized fixed income transactions were higher in both periods. In fiscal 2003, issuers took advantage of the lowest interest rates in nearly 45 years and relatively tight credit spreads. Fiscal 2003 also reflected higher revenues from investment grade products as compared with the prior year.

 

The backlog of merger, acquisition and restructuring transactions and equity and fixed income underwriting transactions is subject to the risk that transactions may not be completed due to unforeseen economic and market conditions, adverse developments regarding one of the parties to the transaction, a failure to obtain required regulatory approval, or a decision on the part of the parties involved not to pursue a transaction at the current time. At the end of fiscal 2004, the backlog of equity and fixed income underwriting transactions was higher as compared with the end of the prior fiscal year, generally reflecting improved global market and economic conditions. Although the merger, acquisition and restructuring transactions backlog was slightly lower at the end of fiscal 2004 as compared with the end of fiscal 2003, the calendar year-over-year comparison improved during the month of December 2004, as a result of the Company’s role advising on a number of significant transactions announced during the month.

 

Sales and Trading Revenues.    Sales and trading revenues are composed of principal transaction trading revenues, commissions and net interest revenues. In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions and net interest revenues in the aggregate. In addition, decisions relating to principal transactions in securities are based on an overall review of aggregate revenues and costs associated with each transaction or series of transactions. This review includes, among other things, an assessment of the potential gain or loss associated with a trade, including any associated commissions, the interest income or expense associated with financing or hedging the Company’s positions and other related expenses.

 

The components of the Company’s sales and trading revenues are described below:

 

Principal Transactions.    Principal transaction trading revenues include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s positions. The Company also engages in proprietary trading activities for its own account.

 

     37    LOGO


Table of Contents

Principal transaction trading revenues include changes in the fair value of embedded derivatives in the Company’s structured borrowings. Prior to fiscal 2004, such amounts were included in interest expense (see Note 8 to the consolidated financial statements). Prior period information has been reclassified to conform to the current year’s presentation. Principal transaction trading revenues included $54 million and $749 million that were previously recorded as decreases to interest expense in fiscal 2003 and fiscal 2002, respectively. These reclassifications had no impact on net revenues.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and options.

 

Net Interest.    Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including financial instruments owned and financial instruments sold, not yet purchased, reverse repurchase and repurchase agreements, trading strategies, customer activity in the Company’s prime brokerage business, and the prevailing level, term structure and volatility of interest rates. Reverse repurchase and repurchase agreements and securities borrowed and securities loaned transactions may be entered into with different customers using the same underlying securities, thereby generating a spread between the interest revenue on the reverse repurchase agreements or securities borrowed transactions and the interest expense on the repurchase agreements or securities loaned transactions.

 

Total sales and trading revenues increased 7% in fiscal 2004 and 35% in fiscal 2003, reflecting higher equity and fixed income sales and trading revenues.

 

Sales and trading revenues include the following:

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in millions)

Equities

   $ 4,067    $ 3,591    $ 3,528

Fixed income(1)

     5,555      5,356      3,245

(1) Amounts include interest rate and currency products, credit products and commodities. Amounts exclude aircraft financing and corporate lending activities.

 

Equity sales and trading revenues increased 13% in fiscal 2004 driven by record revenues in the prime brokerage business and higher revenues from cash and derivative products. The prime brokerage business experienced significant growth in global customer balances, which resulted in record-setting annual revenues. Revenues from equity cash products rose, in part, due to increased cash flows into U.S. equity mutual funds. Revenues from equity derivatives increased modestly despite low levels of equity market volatility. Commission revenues increased slightly despite intense competition and a continued shift toward electronic trading.

 

Equity sales and trading revenues increased 2% in fiscal 2003, reflecting higher revenues from derivative products, certain proprietary trading activities and prime brokerage services, offset by lower revenues from cash products. Toward the end of fiscal 2003, equity sales and trading revenues benefited from rising market indices, increased cash flows into equity mutual funds and higher equity new issue volume. For the full fiscal year, however, U.S. market volumes and market volatility were generally lower as compared with fiscal 2002, and commission revenues were impacted by a shift toward electronic trading.

 

Fixed income sales and trading revenues increased 4% to a record level in fiscal 2004 driven by higher revenues from commodities and credit products, partially offset by lower revenues from interest rate and currency products. Commodities revenues increased 20% to record levels, primarily associated with activities in the energy sector where tight oil supplies, growing demand and global political instability drove energy prices and volatilities higher. Credit product revenues, which increased 6%, reflected record revenues from securitized products as the Company benefited from increased securitization flows in commercial and residential whole loans and favorable trading conditions. Lower revenues from investment grade products partially offset the increase. Interest rate and currency product revenues decreased 7% from last year’s record levels due to lower revenues from cash and derivative products. In addition, in the second half of fiscal 2004, mixed U.S. economic data coupled with higher global energy prices and concerns about the strength of economic growth resulted in market conditions that the Company did not take advantage of, which adversely affected revenues from certain

 

LOGO   38    


Table of Contents

interest rate products. These decreases were partially offset by record results in foreign exchange and emerging markets, reflecting higher levels of volatility and strong customer volume. In fiscal 2004 and fiscal 2003, 63% and 54% of fixed income sales and trading revenues were recorded in the first half of each respective fiscal year.

 

Fixed income sales and trading revenues increased 65% in fiscal 2003, reflecting volatile markets, significant new issue activity and higher client transaction volumes. The increase in revenues was broad-based and included higher revenues from the Company’s credit product, interest rate and currency product, and commodities groups. Credit product revenues increased 67%, reflecting strong capital markets activity and higher revenues from residential and commercial mortgage loan securitization activities, investment grade corporate and global high-yield fixed income securities. Interest rate and currency product revenues increased 39%, primarily reflecting a generally favorable trading environment, a sharp rise in interest rates in the third quarter of fiscal 2003, higher derivative volumes and increased interest rate volatility in both the U.S. and European markets. Higher revenues from currency products, primarily due to higher market volatility and a declining U.S. dollar, also contributed to the increase. Commodities revenues increased 168% to record levels. The increase was primarily associated with activities in the energy sector, reflecting higher levels of volatility in certain energy markets, higher customer flow activity and increased trading activity in support of client securitizations.

 

In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues include the net interest expense associated with the Company’s aircraft financing activities, as well as net revenues from corporate lending activities. In fiscal 2004, revenues from corporate lending activities increased by approximately $110 million, reflecting growth in the loan portfolio and improved conditions in the commercial lending market, partially offset by mark-to-market valuations associated with new loans made in fiscal 2004. Lower net interest expense associated with aircraft financing activities contributed to the increase in sales and trading revenues. In fiscal 2003, sales and trading revenues from corporate lending activities increased by approximately $170 million due to lower markdowns as compared with fiscal 2002, reflecting tighter credit spreads as conditions in the credit market improved. In addition, lower net interest expense associated with aircraft financing activities contributed to the increase in sales and trading revenues.

 

Principal Transactions-Investments.    Principal transaction net investment revenue aggregating $269 million was recognized in fiscal 2004 as compared with $63 million in fiscal 2003. The increase in fiscal 2004 was primarily related to gains associated with the Company’s real estate and principal investment activities. Fiscal 2004’s results included a gain on the sale of an investment in TradeWeb, an electronic trading platform. Fiscal 2003’s results primarily included gains on the Company’s real estate investments, partially offset by losses in other principal investments.

 

Financial instruments purchased in principal investment transactions generally are held for appreciation and are not readily marketable. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, estimates of the fair value of the investments involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions.

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include revenues from asset management services, primarily fees associated with the Company’s real estate fund investment activities.

 

Asset management, distribution and administration fees increased 57% and 1% in fiscal 2004 and fiscal 2003, respectively. The increase in fiscal 2004 was due to higher fees associated with real estate investment and advisory activities, primarily due to the acquisition of a majority of the U.S. real estate equity investment management business of Lend Lease Corporation in November 2003 (see “Business Acquisitions and Asset Sales” herein).

 

Other.    Other revenues consist primarily of net rental and other revenues associated with the Company’s aircraft financing business, as well as revenues from providing benchmark indices and risk management analytics associated with Morgan Stanley Capital International Inc. (“MSCI”) and Barra, Inc. (“Barra”) (see “Business Acquisitions and Asset Sales” herein).

 

     39    LOGO


Table of Contents

Other revenues increased 39% in fiscal 2004. The increase was primarily attributable to Barra, which was acquired on June 3, 2004. Other revenues decreased 29% in fiscal 2003. The decrease was primarily attributable to lower revenues from the Company’s aircraft financing business, reflecting a decline in lease rates. The decrease also reflected the inclusion of a gain in fiscal 2002 (of which $53 million was allocated to the Institutional Securities segment) related to the Company’s sale of an office tower.

 

Conditions in the commercial aircraft industry were generally more favorable in fiscal 2004 as compared with the prior year. Operating lease rates from the Company’s aircraft financing activities have shown improvement during the second half of fiscal 2004 for many aircraft types. At the end of the year, the number of the Company’s aircraft that were off-lease or not committed to a lease transaction had decreased significantly from the prior year. However, unanticipated events, including the sale of additional aircraft or impairment charges, could have an adverse impact on the results of the aircraft financing business. For additional information on the aircraft financing business, see “Discontinued Operations” herein.

 

Non-Interest Expenses.    Non-interest expenses increased 19% in fiscal 2004. Compensation and benefits expense increased 23% due to higher incentive-based compensation resulting from higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses increased 12%. Occupancy and equipment expense increased 16%, primarily due to higher rental costs, primarily in London. Brokerage, clearing and exchange fees increased 16%, primarily reflecting increased trading activity. Professional services expense increased 43%, primarily due to higher consulting costs including the implementation of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”) and the Consolidated Supervised Entities Rule (the “CSE Rule”) (see “Regulatory Developments” herein). Legal and employee recruitment costs increased due to higher business activity. There were also increased costs for outside legal counsel due to certain regulatory and litigation matters. Marketing and business development expense increased 24% due to higher travel and entertainment costs. Other expenses decreased 16%, primarily reflecting a lower aircraft impairment charge of $107 million in fiscal 2004 as compared with $271 million in fiscal 2003. Fiscal 2003 also included a $17 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 18 to the consolidated financial statements). Other expenses also included approximately $25 million relating to Institutional Securities’ share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the New York Stock Exchange, Inc. (the “NYSE”) relating to the prospectus delivery requirements, operational deficiencies, employee defalcations and other matters. In addition, other expenses included legal accruals of approximately $110 million related to the Parmalat Matter and IPO Allocation Matters (see “Legal Proceedings” in Part I, Item 3).

 

Fiscal 2003’s total non-interest expenses increased 17%. Compensation and benefits expense increased 20%. Compensation and benefits expense included a $220 million net benefit related to the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123.” This net benefit was composed of a $352 million benefit related to expensing equity-based compensation awards over a longer service period, partially offset by a $132 million charge relating to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding this benefit, compensation and benefits expense increased 26%, primarily due to higher incentive-based compensation, reflecting higher net revenues. Excluding compensation and benefits expense, non-interest expenses increased 13% from fiscal 2002. Brokerage, clearing and exchange fees increased 13%, primarily reflecting higher global securities trading volumes. Other expenses increased 111%, primarily reflecting higher costs associated with the Company’s aircraft financing business, including a higher asset impairment charge of $271 million (as compared with $70 million in fiscal 2002) and higher aircraft repossession costs, as well as a $17 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 18 to the consolidated financial statements). The increase in other expenses also reflected accruals of approximately $180 million for loss contingencies related to IPO Allocation Matters and the LVMH Litigation (see “Legal Proceedings” in Part I, Item 3). The increase in non-interest expenses was partially offset by restructuring and other charges of $117 million that were recorded in fiscal 2002 (see “Restructuring and Other Charges” herein).

 

LOGO   40    


Table of Contents

INDIVIDUAL INVESTOR GROUP

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2004


    Fiscal
2003


   Fiscal
2002


 
     (dollars in millions)  

Revenues:

                       

Investment banking

   $ 290     $ 305    $ 267  

Principal transactions:

                       

Trading

     518       651      642  

Investments

     (5 )     4      (42 )

Commissions

     1,327       1,231      1,278  

Asset management, distribution and administration fees

     2,038       1,613      1,577  

Interest and dividends

     409       370      446  

Other

     194       217      294  
    


 

  


Total revenues

     4,771       4,391      4,462  

Interest expense

     156       149      194  
    


 

  


Net revenues

     4,615       4,242      4,268  
    


 

  


Non-interest expenses

     4,244       3,778      4,148  
    


 

  


Income before taxes

   $ 371     $ 464    $ 120  
    


 

  


 

Investment Banking.    Investment banking revenues are derived from the Individual Investor Group’s distribution of equity and fixed income securities underwritten by the Institutional Securities business, as well as underwritings of Unit Investment Trust products. Investment banking revenues decreased 5% in fiscal 2004 and increased 14% in fiscal 2003. The decrease in fiscal 2004 was primarily due to lower revenues from fixed income underwriting transactions, partially offset by higher revenues from underwriting Unit Investment Trust products. The increase in fiscal 2003 was primarily due to higher revenues from equity underwriting transactions reflecting higher volumes and from the underwriting of Unit Investment Trust products.

 

Principal Transactions.    Principal transactions include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s positions. The Company maintains certain inventory positions primarily to facilitate customer transactions. Principal transaction trading revenues decreased 20% in fiscal 2004, primarily due to lower revenues from fixed income products, reflecting lower customer transaction activity in corporate, municipal and government fixed income securities. Principal transaction trading revenues increased 1% in fiscal 2003, reflecting higher revenues from fixed income products, partially offset by lower revenues from equity products. The increase in fixed income products reflected higher revenues from investment grade corporate fixed income securities, as individual investor activity increased. The decrease in revenues from equity products reflected the difficult conditions that existed in the equity markets during the first half of fiscal 2003.

 

Principal transaction net investment losses aggregating $5 million were recorded in fiscal 2004 as compared with net gains of $4 million in fiscal 2003. Principal transaction net investment losses aggregating $42 million were recorded in fiscal 2002. Fiscal 2002’s results primarily reflected the write-down of an equity investment related to the Company’s European individual securities business.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and OTC equity securities and sales of mutual funds, futures, insurance products and options. Commission revenues increased 8% in fiscal 2004 and decreased 4% in fiscal 2003. The increase in fiscal 2004 reflected higher customer trading volumes as compared with fiscal 2003 due to improved equity market conditions. The decrease in fiscal 2003 was due to lower customer trading volumes as individual investor participation in the U.S. equity markets declined.

 

     41    LOGO


Table of Contents

Net Interest.    Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including customer margin loans and securities borrowed and securities loaned transactions. Net interest revenues increased 14% in fiscal 2004 and decreased 12% in fiscal 2003. The increase in fiscal 2004 was primarily due to higher net interest revenues from brokerage services provided to individual customers as a result of an increase in the level of margin loans. The decrease in fiscal 2003 was primarily due to lower net interest revenues as a result of a decrease in the level of margin loans, partially offset by a decline in interest expense due to a decrease in the Company’s average cost of borrowings.

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include revenues from individual investors electing a fee-based pricing arrangement. Asset management, distribution and administration fees also include revenues from asset management services and fees for investment management services provided to segregated customer accounts pursuant to various contractual arrangements in connection with the Company’s Investment Consulting Services (“ICS”) business. The Company receives fees for services it provides in distributing certain open-ended mutual funds. These fees are based on either the average daily fund net asset balances or average daily aggregate net fund sales and are affected by changes in the overall level and mix of assets under management or supervision.

 

Asset management, distribution and administration fees increased 26% in fiscal 2004 and increased 2% in fiscal 2003. In fiscal 2004, an increase in client asset balances resulted in higher fees from investors electing fee-based pricing arrangements, including separately managed and Morgan Stanley ChoiceSM accounts. The change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein) partially offset the increase in fiscal 2004 by $67 million. The increase in fiscal 2003 was primarily attributable to higher fees from investors electing fee-based pricing arrangements, reflecting an increase in client assets toward the end of fiscal 2003. This increase was offset by lower fees from promoting and distributing mutual funds, reflecting a decrease in individual investors’ average mutual fund asset levels and a less favorable asset mix that generated lower fees.

 

In fiscal 2004, client asset balances increased to $602 billion at November 30, 2004 from $565 billion at November 30, 2003. At November 30, 2002, client asset balances were $516 billion. The increase in client asset balances in both periods was primarily due to market appreciation, reflecting improvement in the global financial markets. Client assets in fee-based accounts rose 21% to $157 billion at November 30, 2004 and increased as a percentage of total client assets to 26% from 23% in the prior year. Client assets in fee-based accounts rose 21% to $130 billion at November 30, 2003 and increased as a percentage of total client assets to 23% from 21% in the prior year.

 

Other.    Other revenues primarily include customer account fees and other service fees. Other revenues decreased 11% in fiscal 2004 and 26% in fiscal 2003. The change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein) decreased other revenues by $40 million in fiscal 2004, which was partially offset by higher revenues from customer service and account fees. The decrease in fiscal 2003 was primarily due to approximately $100 million of proceeds received in connection with the sale of the Company’s self-directed online brokerage accounts (see “Business Acquisitions and Asset Sales” herein) in fiscal 2002. The decrease was partially offset by higher revenues from customer service and account fees.

 

Non-Interest Expenses.    Non-interest expenses increased 12% in fiscal 2004. The increase was primarily due to higher compensation and benefits expense, which increased 9%. The increase reflected higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). This increase was partially offset by a reduction in compensation expense of $27 million associated with the change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein). Excluding compensation and benefits expense, non-interest expenses increased 19%. Marketing and business development expense increased 20% due to an increase in advertising costs. Professional services expense increased 48%, largely due to higher sub-advisory fees associated with increased asset and revenue growth, as well as higher consulting and legal fees

 

LOGO   42    


Table of Contents

resulting from the implementation of SOX 404 and the CSE Rule and an increase in costs for outside legal counsel due to regulatory and litigation matters. Information processing and communications expense decreased 11% due to lower data processing costs. Other expenses increased 46%, primarily resulting from an increase in legal and regulatory expenses, including approximately $25 million relating to the Individual Investor Group’s share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the NYSE relating to the prospectus delivery requirements, operational deficiencies, employee defalcations (including the Carlos Soto matter) and other matters (see “Legal Proceedings” in Part I, Item 3).

 

Non-interest expenses decreased 9% in fiscal 2003. The decrease was attributable to lower compensation and benefits expense, which decreased 7%, principally reflecting lower employment levels, as well as a net benefit of $28 million related to the adoption of SFAS No. 123. This net benefit was composed of a $55 million benefit related to expensing equity-based compensation awards over a longer service period, partially offset by $27 million related to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses decreased 13%. Occupancy and equipment expense decreased 12%, reflecting the results of the Company’s initiative to consolidate its branch locations. Information processing and communications expense decreased 10%, reflecting lower data processing and telecommunications expenses. Marketing and business development expense decreased 30% due to lower advertising costs. Other expenses increased 7%. Litigation costs increased, reflecting higher costs in fiscal 2003 due to mutual fund regulatory settlements, coupled with a benefit in fiscal 2002 from the resolution of a mutual fund litigation matter. These increases were partially offset by costs recorded in fiscal 2002 associated with the sale of the Company’s self-directed online brokerage accounts (see “Business Acquisitions and Asset Sales” herein). The decrease in non-interest expenses was also due to restructuring and other charges of $112 million in fiscal 2002 (see “Restructuring and Other Charges” herein).

 

     43    LOGO


Table of Contents

INVESTMENT MANAGEMENT

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


 
     (dollars in millions)  

Revenues:

                      

Investment banking

   $ 43    $ 39    $ 32  

Principal transactions:

                      

Investments

     248      19      (31 )

Commissions

     27      18      17  

Asset management, distribution and administration fees

     2,390      2,177      2,435  

Interest and dividends

     8      —        14  

Other

     28      29      40  
    

  

  


Total revenues

     2,744      2,282      2,507  

Interest expense

     6      6      1  
    

  

  


Net revenues

     2,738      2,276      2,506  
    

  

  


Non-interest expenses

     1,911      1,794      1,850  
    

  

  


Income before taxes

   $ 827    $ 482    $ 656  
    

  

  


 

Investment Banking.    Investment Management generates investment banking revenues primarily from the underwriting of Unit Investment Trust products. Investment banking revenues increased 10% in fiscal 2004 and 22% in fiscal 2003. The increase in both periods was primarily due to a higher volume of Unit Investment Trust sales. Unit Investment Trust sales volume increased 28% to $5.5 billion in fiscal 2004 and increased 10% to $4.3 billion in fiscal 2003.

 

Principal Transactions.    Investment Management principal transaction revenues consist primarily of gains and losses on investments associated with the Company’s private equity activities and net gains and losses on capital investments in certain of the Company’s investment funds.

 

Principal transaction net investment gains aggregating $248 million were recognized in fiscal 2004 as compared with gains of $19 million in fiscal 2003. Fiscal 2004’s results were primarily related to net gains on certain investments in the Company’s private equity portfolio, including Vanguard Health Systems, Inc. and Ping An Insurance (Group) Company of China, Ltd. Fiscal 2003’s results were primarily related to gains in the Company’s private equity portfolio and reflected improved market conditions from the difficult market conditions that existed in fiscal 2002.

 

Financial instruments purchased in principal investment transactions generally are held for appreciation and are not readily marketable. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, estimates of the fair value of the investments involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions.

 

During fiscal 2004, a team of investment professionals from the private equity business established an independent private equity firm that will manage, through a long-term sub-advisory role, the Morgan Stanley Capital Partners (“MSCP”) funds. The Company will continue as general partner for the MSCP funds and retain its limited partner interests. The Company will operate its other existing principal and real estate investment vehicles (that are included in the Investment Management and Institutional Securities business segments) as before and will actively pursue additional principal investing opportunities for its clients.

 

LOGO   44    


Table of Contents

Commissions.    Investment Management primarily generates commission revenues from dealer and distribution concessions on sales of certain funds as well as certain allocated commission revenues. Commission revenues increased 50% in fiscal 2004 and 6% in fiscal 2003. The increase in fiscal 2004 reflected an increase in commissionable sales of certain fund products. In fiscal 2003, the increase was associated with a higher sales volume of insurance products.

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees primarily include revenues from the management and supervision of assets, including fees for distributing certain open-ended mutual funds and management fees associated with the Company’s private equity activities. These fees arise from investment management services the Company provides to investment vehicles pursuant to various contractual arrangements. The Company receives fees primarily based upon mutual fund daily average net assets or quarterly assets for other vehicles.

 

Investment Management’s period-end and average customer assets under management or supervision were as follows:

 

     At November 30,

   Average for

     2004

   2003(1)

   2002(1)

   Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in billions)

Assets under management or supervision by distribution channel:

                                         

Retail

   $ 202    $ 193    $ 186    $ 199    $ 186    $ 197

Institutional

     222      164      151      191      152      155
    

  

  

  

  

  

Total

   $ 424    $ 357    $ 337    $ 390    $ 338    $ 352
    

  

  

  

  

  

Assets under management or supervision by asset class:

                                         

Equity

   $ 200    $ 167    $ 138    $ 185    $ 142    $ 150

Fixed income

     114      111      118      114      116      119

Money market

     83      60      64      68      63      67

Other(2)

     27      19      17      23      17      16
    

  

  

  

  

  

Total

   $ 424    $ 357    $ 337    $ 390    $ 338    $ 352
    

  

  

  

  

  


(1) Certain prior-year information has been reclassified to conform to the current year’s presentation.
(2) Amounts include alternative investment vehicles.

 

Activity in Investment Management’s customer assets under management or supervision during fiscal 2004 and fiscal 2003 were as follows (dollars in billions):

 

Balance at November 30, 2002

   $ 337  

Net flows excluding money markets

     (9 )

Net flows from money markets

     (6 )

Net market appreciation

     35  
    


Total net increase

     20  
    


Balance at November 30, 2003

     357  

Net flows excluding money markets

     8  

Net flows from money markets

     21  

Net market appreciation

     38  
    


Total net increase

     67  
    


Balance at November 30, 2004

   $ 424  
    


 

     45    LOGO


Table of Contents

Asset management, distribution and administration fees increased 10% in fiscal 2004 and decreased 11% in fiscal 2003. The increase in fiscal 2004 reflected higher fund management and administration fees associated with a 15% increase in average assets under management or supervision. The increase in revenues also reflected a more favorable average asset mix, including a greater percentage of equity assets under management, partially offset by an increase in institutional fixed income and liquidity fund products, which generate lower fees than equity products. In fiscal 2003, the decrease primarily reflected lower distribution, fund management, and administration and redemption fees resulting from lower average assets under management or supervision, a less favorable average asset mix and lower redemptions of certain open-ended funds.

 

Non-Interest Expenses.    Fiscal 2004’s total non-interest expenses increased 7%. Compensation and benefits expense increased 21%, primarily reflecting higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses were relatively unchanged from fiscal 2003. Professional services expense increased 45%, primarily reflecting an increase in sub-advisory, legal and consulting fees, including costs associated with the establishment of the independent private equity firm that will manage the MSCP funds through a long-term sub-advisory role. Marketing and business development expense decreased 22%, primarily due to lower promotional costs. Brokerage, clearing and exchange fees decreased 7%, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in recent periods due to a decrease in sales of certain open-ended funds.

 

Fiscal 2003’s total non-interest expenses decreased 3%. Compensation and benefits expense decreased 4%, principally reflecting a decrease in employment levels, as well as a net benefit of $12 million related to the adoption of SFAS No. 123. This net benefit was composed of a $24 million benefit related to expensing equity-based compensation awards over a longer service period, partially offset by $12 million related to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses decreased 3% from fiscal 2002. Brokerage, clearing and exchange fees decreased 10%, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in the current year due to a decrease in past sales. Other expenses increased 126%, primarily due to legal accruals associated with mutual fund regulatory settlements in fiscal 2003. In addition, fiscal 2002’s other expenses included the net benefit from certain legal matters, including the resolution of a mutual fund litigation matter.

 

LOGO   46    


Table of Contents

CREDIT SERVICES

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in millions)

Fees:

                    

Merchant and cardmember

   $ 1,318    $ 1,379    $ 1,420

Servicing

     1,993      2,015      2,080

Other

     17      15      30
    

  

  

Total non-interest revenues

     3,328      3,409      3,530
    

  

  

Interest revenue

     1,893      2,091      2,413

Interest expense

     662      806      1,050
    

  

  

Net interest income

     1,231      1,285      1,363

Provision for consumer loan losses

     925      1,267      1,336
    

  

  

Net credit income

     306      18      27
    

  

  

Net revenues

     3,634      3,427      3,557
    

  

  

Non-interest expenses

     2,362      2,334      2,379
    

  

  

Income before taxes

   $ 1,272    $ 1,093    $ 1,178
    

  

  

 

Merchant and Cardmember Fees.    Merchant and cardmember fees include revenues from fees charged to merchants on credit card sales, as well as charges to cardmembers for late payment fees, overlimit fees, balance transfer fees, credit protection fees and cash advance fees, net of cardmember rewards. Cardmember rewards include various reward programs, including the Cashback Bonus award program, pursuant to which the Company pays certain cardmembers a percentage of their purchase amounts based upon a cardmember’s level and type of purchases.

 

Merchant and cardmember fees decreased 4% in fiscal 2004 and 3% in fiscal 2003. The decrease in fiscal 2004 was due to lower late payment and overlimit fees and higher cardmember rewards, net of estimated future forfeitures, partially offset by higher balance transfer fees and merchant discount revenues. The decline in late payment and overlimit fees reflected fewer late fee occurrences and a decline in the number of accounts charged an overlimit fee, partially offset by lower charge-offs of such fees. Late fee occurrences were lower primarily due to a decline during fiscal 2004 in the over 30-day delinquency rates. Overlimit fees declined due to fewer overlimit accounts and the Company’s modification of its overlimit fee policies and procedures in response to industry-wide regulatory guidance. The increase in net cardmember rewards reflected the impact of promotional programs and record sales volume. Balance transfer fees increased as a result of the Company’s continued focus on improving balance transfer profitability. The increase in merchant discount revenue was due to record sales volume. The decrease in merchant and cardmember fees in fiscal 2003 was due to a decline in late payment fees and higher cardmember rewards, partially offset by higher merchant discount revenue. The decline in late payment fees reflected fewer late fee occurrences and higher charge-offs of late payment fees. The increase in cardmember rewards reflected higher Cashback Bonus costs due to merchant partner programs and increased sales volume. The increase in merchant discount revenue was due to increased sales volume and an increase in the average merchant discount rate.

 

Servicing Fees.    Servicing fees are revenues derived from consumer loans that have been sold to investors through asset securitizations and mortgage whole loan sales. Cash flows from the interest yield and cardmember fees generated by securitized general purpose credit card loans and the interest yield generated by securitized mortgage loans are used to pay investors in these loans a predetermined fixed or floating rate of return on their investment, to reimburse investors for losses of principal resulting from charged-off loans and to pay the Company a fee for servicing the loans. Any excess cash flows remaining are paid to the Company. The servicing fees and excess net cash flows paid to the Company are reported as servicing fees in the consolidated statements

 

     47    LOGO


Table of Contents

of income. The sale of general purpose credit card and mortgage loans through asset securitizations, therefore, has the effect of converting portions of net credit income and fee income to servicing fees.

 

The table below presents the components of servicing fees:

 

     Fiscal
2004


   Fiscal
2003


   Fiscal
2002


     (dollars in millions)

Merchant and cardmember fees

   $ 652    $ 727    $ 690

Other revenue

     33      94      50
    

  

  

Total non-interest revenues

     685      821      740
    

  

  

Interest revenue

     3,910      4,174      4,061

Interest expense

     730      802      887
    

  

  

Net interest income

     3,180      3,372      3,174

Provision for consumer loan losses

     1,872      2,178      1,834
    

  

  

Net credit income

     1,308      1,194      1,340
    

  

  

Servicing fees

   $ 1,993    $ 2,015    $ 2,080
    

  

  

 

Servicing fees are affected by the level of securitized loans and mortgage whole loan sales, the spread between the net interest yield on the securitized loans and the yield paid to the investors, the rate of credit losses on securitized loans and the level of cardmember fees earned from securitized general purpose credit card loans. Servicing fees decreased 1% in fiscal 2004 and 3% in fiscal 2003. The decrease in fiscal 2004 reflected lower cardmember fees, net interest cash flows and other revenue, partially offset by a lower provision for consumer loan losses. Cardmember fees declined due to lower late payment and overlimit fees, partially offset by higher balance transfer fees and lower fee net charge-offs. The decrease in net interest cash flows was largely attributable to a lower level of average securitized general purpose credit card loans. The decrease in the provision for consumer loan losses was attributable to a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio and a lower level of average securitized general purpose credit card loans. In fiscal 2003, the decrease in servicing fees was due to higher credit losses associated with a higher level of average securitized general purpose credit card loans and a higher rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio. The decrease was partially offset by higher net interest cash flows and cardmember fees on securitized general purpose credit card loans associated with a higher level of average securitized general purpose credit card loans and higher other revenue.

 

The Other revenue component of servicing fees includes net securitization gains and losses on general purpose credit card loans and mortgage loans, gains and losses on mortgage whole loan sales and net revenues from mortgage servicing rights on mortgage whole loan sales. The decrease in the Other revenue component of servicing fees in fiscal 2004 was attributable to lower levels of general purpose credit card and mortgage loan securitization transactions and higher net gain amortization related to prior securitization transactions, partially offset by higher gains associated with mortgage whole loan sales as compared with fiscal 2003. The increase in Other revenue in fiscal 2003 was attributable to higher levels of general purpose credit card and mortgage loan securitization transactions, offset, in part, by higher net gain amortization related to prior securitization transactions.

 

The following table presents net proceeds received from consumer loan sales:

 

     Fiscal
2004


   Fiscal
2003


     (dollars in millions)

General purpose credit card asset securitizations

   $ 3,714    $ 5,666

Mortgage loan securitization transactions

     —        1,191

Mortgage whole loan sales

     3,876      4,007
    

  

Net proceeds from consumer loan sales

   $ 7,590    $ 10,864
    

  

 

LOGO   48    


Table of Contents

The credit card asset securitization transactions completed in fiscal 2004 have expected maturities ranging from approximately three to seven years from the date of issuance.

 

Net Interest Income.    Net interest income represents the difference between interest revenue derived from consumer loans and short-term investment assets and interest expense incurred to finance those loans and assets. Assets, consisting primarily of consumer loans, currently earn interest revenue at both fixed rates and market-indexed variable rates. The Company incurs interest expense at fixed and floating rates. Interest expense also includes the effects of any interest rate contracts entered into by the Company as part of its interest rate risk management program. This program is designed to reduce the volatility of earnings resulting from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules of consumer loans as well as the Company’s right, with notice to cardmembers, to reprice certain fixed rate consumer loans to a new interest rate in the future.

 

Net interest income decreased 4% in fiscal 2004 from fiscal 2003 due to a decline in interest revenue that was partially offset by lower interest expense. The decline in interest revenue was primarily due to a decrease in average general purpose credit card loans. The decrease in interest expense was primarily due to a lower level of average interest bearing liabilities and a decrease in the Company’s average cost of borrowings. The Company’s average cost of borrowings was 4.01% for fiscal 2004 as compared with 4.33% for fiscal 2003. The decline in the average cost of borrowings reflected the favorable impact of replacing certain maturing fixed rate debt with lower cost financing.

 

Net interest income decreased 6% in fiscal 2003 from the prior-year period, as a decline in interest revenue was partially offset by lower interest expense. The decline in interest revenue was due to a lower yield on general purpose credit card loans and a decrease in average general purpose credit card loans. The lower yield on general purpose credit card loans was primarily due to lower interest rates offered to new cardmembers and certain existing cardmembers and a higher level of net interest charge-offs. The decrease in average general purpose credit card loans was primarily due to a higher level of securitized loans and higher payments by cardmembers, partially offset by record levels of sales volume. The decrease in interest expense was primarily due to a decrease in the Company’s average cost of borrowings and a lower level of average interest bearing liabilities. The Company’s average cost of borrowings was 4.33% for fiscal 2003 as compared with 5.29% for fiscal 2002. The decline in the average cost of borrowings reflected the Fed’s aggressive easing of interest rates that began in fiscal 2001 and the favorable impact of replacing certain maturing fixed rate debt with lower cost financing, reflecting the lower interest rate environment in fiscal 2003.

 

     49    LOGO


Table of Contents

The following tables present analyses of Credit Services average balance sheets and interest rates in fiscal 2004, fiscal 2003 and fiscal 2002 and changes in net interest income during those fiscal years:

 

Average Balance Sheet Analysis.

 

     Fiscal 2004

    Fiscal 2003

    Fiscal 2002

 
     Average
Balance


    Rate

    Interest

    Average
Balance


    Rate

    Interest

    Average
Balance


    Rate

    Interest

 
     (dollars in millions)  

ASSETS

                                                                  

Interest earning assets:

                                                                  

General purpose credit card loans

   $ 17,608     10.05 %   $ 1,770     $ 19,531     10.02 %   $ 1,956     $ 20,659     11.03 %   $ 2,279  

Other consumer loans

     1,304     5.33       69       1,530     5.45       83       1,229     5.99       73  

Investment securities

     116     0.66       1       73     0.88       1       60     1.46       1  

Other

     2,527     2.11       53       2,668     1.90       51       2,451     2.45       60  
    


       


 


       


 


       


Total interest earning assets

     21,555     8.78       1,893       23,802     8.79       2,091       24,399     9.89       2,413  

Allowance for loan losses

     (972 )                   (967 )                   (890 )              

Non-interest earning assets

     2,582                     2,511                     2,534                
    


               


               


             

Total assets

   $ 23,165                   $ 25,346                   $ 26,043                
    


               


               


             

LIABILITIES AND SHAREHOLDER’S EQUITY

                                                                  

Interest bearing liabilities:

                                                                  

Interest bearing deposits

                                                                  

Savings

   $ 688     1.05 %   $ 7     $ 810     1.01 %   $ 8     $ 1,018     1.56 %   $ 16  

Brokered

     8,601     5.07       436       10,523     5.28       556       9,732     6.01       584  

Other time

     2,154     3.33       72       1,620     4.38       71       2,037     5.10       104  
    


       


 


       


 


       


Total interest bearing deposits

     11,443     4.50       515       12,953     4.90       635       12,787     5.51       704  

Other borrowings

     5,078     2.90       147       5,676     3.02       171       7,053     4.91       346  
    


       


 


       


 


       


Total interest bearing liabilities

     16,521     4.01       662       18,629     4.33       806       19,840     5.29       1,050  

Shareholder’s equity/other liabilities

     6,644                     6,717                     6,203                
    


               


               


             

Total liabilities and shareholder’s equity

   $ 23,165                   $ 25,346                   $ 26,043                
    


               


               


             

Net interest income

                 $ 1,231                   $ 1,285                   $ 1,363  
                  


               


               


Net interest margin(1)

                   5.71 %                   5.40 %                   5.59 %

Interest rate spread(2)

           4.77 %                   4.46 %                   4.60 %        

(1) Net interest margin represents net interest income as a percentage of total interest earning assets.
(2) Interest rate spread represents the difference between the rate on total interest earning assets and the rate on total interest bearing liabilities.

 

LOGO   50    


Table of Contents

Rate/Volume Analysis.

 

     Fiscal 2004 vs. Fiscal 2003

    Fiscal 2003 vs. Fiscal 2002

 

Increase/(Decrease) due to Changes in:


   Volume

    Rate

    Total

    Volume

    Rate

    Total

 
     (dollars in millions)  

Interest Revenue

                                                

General purpose credit card loans

   $ (191 )   $ 5     $ (186 )   $ (125 )   $ (198 )   $ (323 )

Other consumer loans

     (12 )     (2 )     (14 )     17       (7 )     10  

Other

     (3 )     5       2       5       (14 )     (9 )
                    


                 


Total interest revenue

     (196 )     (2 )     (198 )     (59 )     (263 )     (322 )
                    


                 


Interest Expense

                                                

Interest bearing deposits:

                                                

Savings

     (1 )     —         (1 )     (3 )     (5 )     (8 )

Brokered

     (102 )     (18 )     (120 )     48       (76 )     (28 )

Other time

     23       (22 )     1       (21 )     (12 )     (33 )
                    


                 


Total interest bearing deposits

     (74 )     (46 )     (120 )     9       (78 )     (69 )

Other borrowings

     (18 )     (6 )     (24 )     (68 )     (107 )     (175 )
                    


                 


Total interest expense

     (91 )     (53 )     (144 )     (64 )     (180 )     (244 )
                    


                 


Net interest income

   $ (105 )   $ 51     $ (54 )   $ 5     $ (83 )   $ (78 )
    


 


 


 


 


 


 

In response to industry-wide regulatory guidance, the Company has increased minimum payment requirements on certain general purpose credit card loans. The Company believes that the adjustments made in fiscal 2004 comply with the guidance. However, bank regulators have broad discretion on the application of the guidance, and changes in such guidance or its application by the regulators could impact future levels of general purpose credit card loans and related interest and fee revenue and charge-offs.

 

Provision for Consumer Loan Losses.    The provision for consumer loan losses is the amount necessary to establish the allowance for consumer loan losses at a level that the Company believes is adequate to absorb estimated losses in its consumer loan portfolio at the balance sheet date. The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is primarily applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy and is established through a charge to the provision for consumer loan losses. In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. The Company regularly performs a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

 

The Company’s provision for consumer loan losses was $925 million and $1,267 million for fiscal 2004 and fiscal 2003, respectively. The Company’s allowance for consumer loan losses was $943 million at November 30, 2004 and $1,002 million at November 30, 2003.

 

The provision for consumer loan losses decreased 27% in fiscal 2004, primarily due to lower net principal charge-offs resulting from an improvement in credit quality, including lower bankruptcy charge-offs driven by a decline in U.S. personal bankruptcy filings. The decrease was also due to a lower level of average general purpose credit card loans. The Company reduced the allowance for consumer loan losses by approximately $60

 

     51    LOGO


Table of Contents

million in fiscal 2004 due to improvement in credit quality, including lower delinquency rates and dollars. In fiscal 2003, the provision for consumer loan losses decreased 5%, primarily due to a lower level of average general purpose credit card loans. In response to unfavorable trends in U.S. consumer bankruptcy filings and relatively high unemployment levels, the Company recorded a provision for consumer loan losses that exceeded the amount of net consumer loans charged off by approximately $70 million in fiscal 2003.

 

Delinquencies and Charge-offs.  General purpose credit card loans are considered delinquent when interest or principal payments become 30 days past due. General purpose credit card loans are charged off at the end of the month during which an account becomes 180 days past due, except in the case of bankruptcies, deceased cardmembers and fraudulent transactions, where loans are charged off earlier. Loan delinquencies and charge-offs are affected by changes in economic conditions, account collection management and policy changes and may vary throughout the year due to seasonal consumer spending and payment behaviors.

 

In fiscal 2004, net principal charge-off rates decreased in both the owned and managed portfolios as compared with fiscal 2003, reflecting improvements in portfolio credit quality and a lower level of bankruptcy filings (see “Managed General Purpose Credit Card Loan Data” herein). Delinquency rates in both the over 30- and over 90-day categories were lower in both the owned and managed portfolios at November 30, 2004 as compared with November 30, 2003, also reflecting improvements in portfolio credit quality.

 

In the second quarter of fiscal 2003, the Company changed its policy related to deceased cardmember accounts to charge off 60 days after notification as compared with charging off 180 days past due. This change accelerated charge-offs beginning in the third quarter of fiscal 2003 and increased charge-offs in the second half of fiscal 2003. During the second half of fiscal 2002 and the first half of fiscal 2003, the Company changed its re-age policy in response to industry-wide regulatory guidelines. A re-age is intended to assist delinquent cardmembers who have experienced financial difficulties by returning the account to current status. This change in the re-age policy, along with the economic challenges as evidenced by high levels of unemployment and U.S. bankruptcy filings, resulted in a significant decrease in the number of cardmembers eligible for re-age vs. comparable periods in fiscal 2002. During fiscal 2003, the Company’s re-age volume decreased by approximately 40% from fiscal 2002. The reduction in re-age volume was a contributing factor to the higher delinquencies and charge-off levels experienced in fiscal 2003 as compared with fiscal 2002.

 

In fiscal 2003, net principal charge-off rates increased in the managed portfolio as compared with fiscal 2002, reflecting the impact of lower re-age volume and the change in the Company’s deceased cardmember policy discussed above (see “Managed General Purpose Credit Card Loan Data” herein). In the U.S., high levels of unemployment, the seasoning of the Company’s general purpose credit card loan portfolio, a high level of bankruptcy filings and policy changes contributed to the higher net principal charge-off rate in the managed portfolio during fiscal 2003. In addition, these conditions impacted the Company’s delinquency rates in both the over 30- and over 90-day categories, which were higher in both the owned and managed portfolio at November 30, 2003 as compared with November 30, 2002. A lower level of general purpose credit card loan balances also negatively impacted delinquency and net principal charge-off rates in fiscal 2003.

 

The Company’s future charge-off rates and credit quality are subject to uncertainties that could cause actual results to differ materially from what has been discussed above. Factors that influence the provision for consumer loan losses include the level and direction of general purpose credit card loan delinquencies and charge-offs, changes in consumer spending and payment behaviors, bankruptcy trends, the seasoning of the Company’s general purpose credit card loan portfolio, interest rate movements and their impact on consumer behavior, and the rate and magnitude of changes in the Company’s general purpose credit card loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio.

 

Non-Interest Expenses.    Non-interest expenses increased 1% in fiscal 2004 from fiscal 2003. Compensation and benefits expense decreased 5% due to lower employee benefit costs, as well as lower salaries resulting from lower

 

LOGO   52    


Table of Contents

employment levels due, in part, to workforce reductions conducted during the fourth quarter of fiscal 2003. Excluding compensation and benefits expense, non-interest expenses increased 5%. Marketing and business development expense increased 20% due to increased marketing costs associated with account acquisition, merchant initiatives and advertising. Other expenses decreased 9%, primarily reflecting a decrease in certain operating expenses, including lower losses associated with cardmember fraud.

 

Fiscal 2003’s total non-interest expenses decreased 2% from fiscal 2002. Compensation and benefits expense increased 6%, reflecting an increase in personnel costs, including salaries and benefits, as well as costs associated with workforce reductions conducted during the fourth quarter of fiscal 2003. These costs included a charge of $35 million (pre-tax) associated with workforce reductions and facility consolidations that were conducted during the fourth quarter of fiscal 2003. The charge reflected several actions in response to slower industry growth and difficult consumer credit conditions and consisted of severance-related costs of $29 million and space-related and other costs of $6 million. The majority of these costs were paid by the end of the first quarter of fiscal 2004. Excluding compensation and benefits expense, non-interest expenses decreased 6%. Marketing and business development expense decreased 11% due to lower direct mail costs. Other expenses decreased 11%, primarily reflecting a decrease in certain operating expenses, including lower costs associated with cardmember fraud and merchant bankruptcies.

 

Other Matters.    On October 4, 2004, the U.S. Supreme Court rejected an appeal by Visa and MasterCard in U.S. v. Visa/MasterCard. The trial and appellate courts found that Visa and MasterCard rules and policies that prevented virtually all U.S. financial institutions from doing business with competing networks violated the antitrust laws. Now that these rules have been struck down as illegal, financial institutions (in addition to Discover Bank) will be able to issue credit and debit cards on the Discover Network. Following the Supreme Court decision, Credit Services filed a lawsuit in federal court in New York seeking damages for harm caused by the anti-competitive rules. In January 2005, the Company announced that it had signed its first third-party issuance with GE Consumer Finance to issue the Wal-Mart Discover card on the Discover Network.

 

On January 12, 2005, the Company completed its acquisition of PULSE (see “Business Acquisitions and Asset Sales” herein).

 

Seasonal Factors.    The credit card lending activities of Credit Services are affected by seasonal patterns of retail purchasing. Historically, a substantial percentage of general purpose credit card loan growth occurs in the fourth calendar quarter, followed by a flattening or decline of these loans in the following calendar quarter. Merchant fees, therefore, historically have tended to increase in the first fiscal quarter, reflecting higher sales activity in the month of December. Additionally, higher cardmember rewards incentives historically have been accrued for as a reduction of merchant and cardmember fee revenues in the first fiscal quarter, reflecting seasonal growth in retail sales volume.

 

Managed General Purpose Credit Card Loan Data.    The Company analyzes its financial performance on both a “managed” loan basis and as reported under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) (“owned” loan basis). Managed loan data assume that the Company’s securitized loan receivables have not been sold and present the results of the securitized loan receivables in the same manner as the Company’s owned loans. The Company operates its Credit Services business and analyzes its financial performance on a managed basis. Accordingly, underwriting and servicing standards are comparable for both owned and securitized loans. The Company believes that managed loan information is useful to investors because it provides information regarding the quality of loan origination and credit performance of the entire managed portfolio and allows investors to understand the related credit risks inherent in owned loans and retained interests in securitizations. In addition, investors often request information on a managed basis, which provides a more meaningful comparison with industry competitors.

 

     53    LOGO


Table of Contents

The following table provides a reconciliation of owned and managed average loan balances, interest yields and interest rate spreads for the periods indicated:

 

Reconciliation of General Purpose Credit Card Loan Data (dollars in millions)

 

     Fiscal 2004

    Fiscal 2003

    Fiscal 2002

 
     Average
Balance


   Interest
Yield


    Interest
Rate
Spread


    Average
Balance


   Interest
Yield


    Interest
Rate
Spread


    Average
Balance


   Interest
Yield


    Interest
Rate
Spread


 

General Purpose Credit Card Loans:

                                                         

Owned

   $ 17,608    10.05 %   6.04 %   $ 19,531    10.02 %   5.69 %   $ 20,659    11.03 %   5.74 %

Securitized

     29,779    12.90 %   10.56 %     31,333    13.13 %   10.64 %     29,176    13.79 %   10.78 %
    

              

              

            

Managed

   $ 47,387    11.84 %   8.92 %   $ 50,864    11.93 %   8.77 %   $ 49,835    12.64 %   8.71 %
    

              

              

            

 

The following tables present a reconciliation of owned and managed general purpose credit card loans and delinquency and net charge-off rates:

 

Reconciliation of General Purpose Credit Card Loan Asset Quality Data (dollars in millions)

 

     Fiscal 2004

    Fiscal 2003

    Fiscal 2002

 
     Period-
End
Loans


   Delinquency
Rates


    Period-
End
Loans


   Delinquency
Rates


    Period-
End
Loans


   Delinquency
Rates


 
        Over
30
Days


    Over
90
Days


       Over
30
Days


    Over
90
Days


       Over
30
Days


    Over
90
Days


 

General Purpose Credit Card Loans:

                                                         

Owned

   $ 19,724    4.08 %   1.97 %   $ 18,930    5.36 %   2.53 %   $ 22,153    5.32 %   2.41 %

Securitized

     28,537    4.87 %   2.34 %     29,428    6.36 %   3.01 %     28,990    6.45 %   2.85 %
    

              

              

            

Managed

   $ 48,261    4.55 %   2.18 %   $ 48,358    5.97 %   2.82 %   $ 51,143    5.96 %   2.66 %
    

              

              

            

 

     Fiscal 2004

    Fiscal 2003

    Fiscal 2002

 

Net Principal Charge-offs:

                  

Owned

   5.53 %   6.05 %   6.06 %

Securitized

   6.28 %   6.95 %   6.29 %

Managed

   6.00 %   6.60 %   6.19 %

 

     Fiscal 2004

    Fiscal 2003

    Fiscal 2002

 

Net Total Charge-offs (inclusive of interest and fees):

                  

Owned

   7.68 %   8.33 %   7.97 %

Securitized

   9.01 %   9.75 %   8.51 %

Managed

   8.51 %   9.20 %   8.28 %

 

LOGO   54    


Table of Contents

Business Acquisitions and Asset Sales.

 

On January 12, 2005, the Company completed the acquisition of PULSE, an Automated Teller Machine/debit network currently serving banks, credit unions and savings institutions in the U.S. The Company believes that the combination of the PULSE and Discover Network will create a leading electronic payments company offering a full range of products and services for financial institutions, consumers and merchants. As of the date of acquisition, the results of PULSE will be included within the Credit Services business segment.

 

On June 3, 2004, the Company completed the acquisition of Barra, a global leader in delivering risk management systems and services to managers of portfolio and firm-wide investment risk. The Company believes that the combination of MSCI, a majority-owned subsidiary of the Company, and Barra created a leading global provider of benchmark indices and risk management analytics. Since the date of acquisition, the results of Barra have been included within the Institutional Securities business segment. The acquisition price was $41.00 per share in cash, or an aggregate consideration of approximately $800 million. The Company recorded goodwill and other intangible assets totaling $663 million in connection with the acquisition (see Note 24 to the consolidated financial statements).

 

In fiscal 2003, the Company acquired selected components of the U.S. real estate equity advisory businesses of Lend Lease Corporation, an Australia-based company. The financial statement impact related to this acquisition, which is included in the Company’s Institutional Securities segment, was not significant.

 

In fiscal 2002, the Company sold its self-directed online brokerage accounts to Bank of Montreal’s Harrisdirect. The Company recorded gross proceeds of approximately $100 million (included within Other revenues) and related costs of approximately $50 million (included within Non-interest expenses) in the Individual Investor Group segment.

 

In fiscal 2002, the Company recorded a pre-tax gain of $73 million related to the sale of a 1 million square-foot office tower in New York City. The pre-tax gain is included within the Institutional Securities ($53 million), Individual Investor Group ($7 million) and Investment Management ($13 million) segments. The allocation was based upon occupancy levels originally planned for the building.

 

Discontinued Operations.

 

As described in Note 25 to the consolidated financial statements, in the third quarter of fiscal 2004, the Company recorded a pre-tax loss of $42 million in its Institutional Securities business related to the write-down of certain aircraft that were subject to a probable sale and, accordingly, have been designated as “held for sale” in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The revenues and expenses associated with these aircraft have been classified as discontinued operations for all periods presented. As of February 3, 2005, all of the aircraft referred to above were sold.

 

The table below provides information regarding the pre-tax loss on discontinued operations and the aircraft impairment charges that are included in these amounts (dollars in millions):

 

     Fiscal Year

     2004

   2003

   2002

Pre-tax loss on discontinued operations

   $ 38    $ 38    $ 18

Aircraft impairment charges

     2      16      4

 

The pre-tax loss on discontinued operations for fiscal 2003 also included a $19 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 18 to the consolidated financial statements). The Company may sell additional aircraft from time to time.

 

     55    LOGO


Table of Contents

Income Tax Examinations.

 

The Company is under continuous examination by the Internal Revenue Service (the “IRS”) and other tax authorities in certain countries, such as Japan and the United Kingdom, and states in which the Company has significant business operations, such as New York. The tax years under examination vary by jurisdiction; for example, the current IRS examination covers 1994-1998. Assuming current progress, the Company expects this IRS examination to be completed in fiscal 2005. The Company regularly assesses the likelihood of additional assessments in each of the taxing jurisdictions resulting from these and subsequent years’ examinations. Tax reserves have been established, which the Company believes to be adequate in relation to the potential for additional assessments. Once established, reserves are adjusted only when there is more information available or when an event occurs necessitating a change to the reserves. The resolution of tax matters will not have a material effect on the consolidated financial condition of the Company, although a resolution could have a material impact on the Company’s consolidated statement of income for a particular future period and on the Company’s effective tax rate.

 

Restructuring and Other Charges.

 

In the fourth quarter of fiscal 2002, the Company recognized restructuring and other charges of $235 million (pre-tax). The charge reflected several actions that were intended to resize and refocus certain business areas in order to address the difficult conditions then existing in the global financial markets. Such conditions, including significantly lower levels of investment banking activity and decreased retail investor participation in the equity markets, had an adverse impact on the Company’s results of operations, particularly in its Institutional Securities and Individual Investor Group businesses.

 

The fiscal 2002 charge consisted of space-related costs of $162 million and severance-related costs of $73 million. The space-related costs were attributable to the closure or subletting of excess office space, primarily in the U.S. and the U.K., as well as the Company’s decision to consolidate its Individual Investor Group branch locations. The majority of the space-related costs consisted of rental charges and the write-off of furniture, fixtures and other fixed assets at the affected office locations. The severance-related costs were attributable to workforce reductions. The Company reduced the number of its employees by approximately 2,200 during the fourth quarter of fiscal 2002, primarily in the Institutional Securities and Individual Investor Group businesses. The majority of the severance-related costs consisted of severance payments provided to the affected individuals.

 

At November 30, 2004, the remaining liability associated with these charges was approximately $75 million, which was included in Other liabilities and accrued expenses in the consolidated statement of financial condition. The liability will continue to be reduced as the leases on the office locations referred to above expire.

 

Equity-Based Compensation Program.

 

Effective December 1, 2002, the Company adopted SFAS No. 123, as amended by SFAS No. 148, using the prospective adoption method (see Note 2 to the consolidated financial statements). The Company now records compensation expense based upon the fair value of stock-based awards (both deferred stock and stock options). Prior to fiscal 2003, the Company accounted for its stock-based awards under the intrinsic value approach in accordance with Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the approach in APB 25 and the terms of the Company’s plans in prior years, the Company recognized compensation expense for deferred stock awards in the year of grant; however, no compensation expense was generally recognized for stock option grants.

 

As a result of the adoption of SFAS No. 123, the Company is recognizing the fair value of equity-based awards granted in fiscal 2003 and fiscal 2004 over service periods of three and four years, including the year of grant. Prior to fiscal 2003, the service period for stock-based awards was deemed to be the year of grant. The effect of expensing stock-based awards over a longer period of service reduced compensation expense recorded for deferred stock awards by $438 million in fiscal 2003 as compared with fiscal 2002. In addition, in connection with the adoption of SFAS No. 123, the Company recorded compensation expense of $176 million based on the

 

LOGO   56    


Table of Contents

fair value of stock options granted in fiscal 2003. The net impact of these revisions reduced the Company’s compensation and benefits expense by $262 million in fiscal 2003 and increased net income by $177 million (or $0.16 per share) in fiscal 2003 as compared with fiscal 2002.

 

As a result of amortizing the cost of equity-based awards over their respective service periods (including the year of grant), fiscal 2004’s compensation and benefits expense included the amortization of equity-based awards granted in both fiscal 2004 and fiscal 2003. Fiscal 2003’s compensation and benefits expense only included the amortization of equity-based awards granted in fiscal 2003. The net amount of compensation and benefits expense recognized by the Company related to its equity-based awards (deferred stock and stock options) was approximately $650 million in fiscal 2004 and approximately $285 million in fiscal 2003.

 

In December 2004, the Financial Accounting Standards Board (the “FASB”) made certain revisions to SFAS No. 123 that will impact the Company’s compensation and benefits expense in fiscal 2005 and future periods (see “New Accounting Developments – Stock-Based Compensation” herein).

 

Asset Management and Account Fees.

 

Prior to the fourth quarter of fiscal 2004, the Company was improperly recognizing certain management fees, account fees and related compensation expense paid at the beginning of the relevant contract periods, which is when such fees were billed. In the fourth quarter of fiscal 2004, the Company changed its method of accounting for such fees to properly recognize such fees and related expenses over the relevant contract period, generally quarterly or annually. As a result of the change, the Company’s results in the fourth quarter of fiscal 2004 included an adjustment to reflect the cumulative impact of the deferral of certain management fees, account fees and related compensation expense paid to representatives. The impact of this change reduced net revenues by $107 million, non-interest expenses by $27 million and income before taxes by $80 million, at both the Company and the Individual Investor Group segment in the fourth quarter of fiscal 2004. Such adjustment reduced net income by approximately $50 million and basic and diluted earnings per share by $0.05. If the above referenced fees and expenses had been recognized over the relevant contract period in the past, pre-tax income for the Company and the Individual Investor Group segment would have been lower by the following amounts:

 

     Decrease in
Pre-tax Income


 
     (dollars in
millions)
 

Quarter ended:

        

February 28, 2002

   $ (4.1 )

May 31, 2002

     (3.7 )

August 31, 2002

     (2.1 )

November 30, 2002

     (0.8 )
    


Fiscal 2002 total

     (10.7 )
    


February 28, 2003

     (5.2 )

May 31, 2003

     (1.3 )

August 31, 2003

     (4.2 )

November 30, 2003

     (2.0 )
    


Fiscal 2003 total

     (12.7 )
    


February 29, 2004

     (3.1 )

May 31, 2004

     (2.6 )

August 31, 2004

     (2.3 )

 

Investments in Unconsolidated Investees.

 

The Company invests in unconsolidated investees that own synthetic fuel production plants. The Company accounts for these investments under the equity method of accounting. The Company’s share of the operating

 

     57    LOGO


Table of Contents

losses generated by these investments is recorded within Losses from unconsolidated investees, and the tax credits and the tax benefits associated with these operating losses are recorded within the Company’s Provision for income taxes.

 

In fiscal 2004, fiscal 2003 and fiscal 2002, the losses from unconsolidated investees were more than offset by the respective tax credits and tax benefits on the losses. The table below provides information regarding the losses from unconsolidated investees, tax credits and tax benefits on the losses:

 

     Fiscal Year

     2004

   2003

   2002

     (dollars in millions)

Losses from unconsolidated investees

   $ 328    $ 279    $ 77

Tax credits

     351      308      109

Tax benefits on losses

     132      112      31

 

IRS field auditors are contesting the placed-in-service date of several synthetic fuel facilities owned by one of the Company’s unconsolidated investees (the “LLC”). To qualify for the tax credits under Section 29 of the Internal Revenue Code, the production facility must have been placed in service before July 1, 1998. The LLC is vigorously contesting the IRS proposed position. If the IRS ultimately prevails, it could have an adverse effect on the Company’s tax liability or results of operations. The Company has recognized cumulative tax credits of approximately $110 million associated with the LLC’s synthetic fuel facilities.

 

Pension Plans.

 

The Company made contributions of $120 million and $239 million to its defined benefit pension plans (U.S. and non-U.S.) in fiscal 2004 and fiscal 2003, respectively. These contributions were funded with cash from operations and were recorded as a component of prepaid pension benefit cost in the Company’s consolidated statements of financial condition. In addition, the Company, in consultation with its independent actuaries, lowered its expected long-term rate of return on U.S. plan assets (from 7.50% to 7.25%) for fiscal 2004 (see Note 15 to the consolidated financial statements). The impact of this change was not material to the Company’s consolidated results of operations in fiscal 2004.

 

The Company determines the amount of its pension contributions by considering the interaction of several factors. Such factors include the range of potential contributions (i.e., the Employee Retirement Income Security Act of 1974 (“ERISA”) minimum required contribution up to the maximum tax-deductible amount), the level of plan assets relative to plan liabilities, expected plan liquidity needs and expected future contribution requirements. At November 30, 2004, there were no minimum required ERISA contributions for the Company’s pension plan that is qualified under Section 401(a) of the Internal Revenue Code (the “Qualified Plan”). For its non-U.S. plans, the Company’s policy is to fund at least the amounts sufficient to meet minimum funding requirements under applicable employee benefit and tax regulations. Liabilities for benefits payable under its unfunded supplementary plans (the “Supplemental Plans”) are accrued by the Company and are funded when paid to the beneficiaries.

 

In accordance with U.S. GAAP, the Company recognizes pension expense before the payment of benefits to retirees occurs. This process involves making certain estimates and assumptions, including the discount rate and the expected long-term rate of return on plan assets.

 

The assumed discount rate, which reflects the rates at which pension benefits could be effectively settled, is used to measure the projected and accumulated benefit obligations and to calculate the service cost and interest cost. The assumed discount rate reflects the rates of return on available high-quality fixed-income investments that reflect the timing and amount of expected benefit payments. For its Qualified Plan, which comprised approximately 94% of the total assets of the Company’s pension plans at November 30, 2004, the Company

 

LOGO   58    


Table of Contents

estimates its discount rate based on both the absolute levels of and year-to-year changes in various high-quality bond indices, including the Moody’s Aa long-term rate bond yield.

 

The Company uses the expected long-term rate of return on plan assets to compute the expected return on assets. For its Qualified Plan, the Company annually reviews the expected long-term return based on changes in the target investment mix and economic environment from the previous year. It then compares its initial estimate (and adjusts, if necessary) with a portfolio return calculator model (the “Portfolio Model”) that produces a range of expected returns for the portfolio. Return assumptions are forward-looking gross returns that are not developed solely by an examination of historical returns. The Portfolio Model begins with the current U.S. Treasury yield curve, recognizing that expected returns on bonds are heavily influenced by the current level of yields. Corporate bond spreads and equity risk premiums, based on current market conditions, are then added to develop the return expectations for each asset class. Expenses that are expected to be paid from the investment return are reflected in the Portfolio Model as a percentage of plan assets. This includes investment and transaction fees that typically are paid from plan assets, added to the cost basis or subtracted from sale proceeds, as well as administrative expenses paid from the Qualified Plan.

 

The Company’s expected long-term rate of return on assets for its Qualified Plan for fiscal 2004 was based on the following expected asset allocation:

 

     Target Investment
Mix


    Expected Annual
Return(1)


 

Domestic equity:

            

Large capitalization

   30 %   8.0 %

Small capitalization

   10 %   8.6 %

International equity

   15 %   8.5 %

Fixed income:

            

Intermediate government/corporate

   22 %   4.1 %

Long-term government/corporate

   23 %   5.5 %

(1) These amounts do not include the impact of diversification on the overall expected portfolio return.

 

For its Qualified Plan, expected returns are computed using a market-related value of assets. For the market-related value of assets, a smoothed actuarial value of assets is used, equal to a moving average of market values in which investment income is recognized over a five-year period. Investment income equal to the expected return on the prior year’s market-related value of plan assets is recognized immediately. Any difference between the actual investment income (on a market-value basis) and the expected return is recognized over a five-year period in accordance with SFAS No. 87, “Employers’ Accounting for Pensions.” In addition, the market-related value of assets must be no greater than 120% and no less than 80% of the market value of assets.

 

The Company amortizes (as a component of pension expense) unrecognized net gains and losses over the average future service (generally 11 to 18 years) of active participants in each plan to the extent that the gain/loss exceeds 10% of the greater of the projected benefit obligation or the market-related value of plan assets. The loss amortization component of fiscal 2004 pension expense was approximately $38 million, and future amortization is not expected to have a material impact on the Company’s pension expense.

 

Insurance Recovery.

 

On September 11, 2001, the U.S experienced terrorist attacks targeted against New York City and Washington, D.C. The attacks in New York resulted in the destruction of the World Trade Center complex, where approximately 3,700 of the Company’s employees were located, and the temporary closing of the debt and equity financial markets in the U.S. Through the implementation of its business recovery plans, the Company relocated its displaced employees to other facilities.

 

     59    LOGO


Table of Contents

The Company has recognized costs related to the terrorist attacks pertaining to write-offs of leasehold improvements and destroyed technology and telecommunications equipment in the World Trade Center complex, employee relocation and certain other employee-related expenditures, and other business recovery costs. The costs were offset by estimated insurance recoveries.

 

The Company continues to be in negotiations with its insurance carriers related to the events of September 11, 2001. At the conclusion of these negotiations, the Company currently believes that the amounts it will recover under its insurance policies will be in excess of costs recognized for accounting purposes related to the terrorist attacks. As of November 30, 2004, the Company had not recorded a gain for the anticipated excess recovery.

 

Internal Control Over Financial Reporting.

 

SOX 404 requires that the Company make an assertion as to the effectiveness of its internal control over financial reporting beginning with its fiscal 2004 Annual Report on Form 10-K. The Company’s independent registered public accounting firm must attest to management’s assertion. In order to make its assertion, the Company was required to identify material financial and operational processes, document internal controls supporting the financial reporting process and evaluate the design and effectiveness of these controls. See “Management’s Report on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” in Part I, Item 9A.

 

The Company began preparing for its SOX 404 initiative prior to fiscal 2004. The Company formed a Project Management Office to facilitate ongoing internal control reviews, coordinate the process for these reviews, provide direction to the business and control groups involved in the initiative and assist in the assessment of internal control over financial reporting. The Company also formed a Steering Committee, comprised of senior personnel from its control groups, to set uniform guiding principles and policies, review the progress of the initiative, direct the efforts of the Project Management Office and update the Audit Committee of the Board of Directors on an ongoing basis. The Company also retained an accounting firm other than its independent registered public accounting firm to assist in its compliance with SOX 404.

 

The SOX 404 effort involved many of the Company’s employees around the world, including participation by the business areas and control groups. The Company viewed this evaluation of its internal control over financial reporting as more than a regulatory exercise—it was an opportunity to assess critically the financial control environment and make it even stronger. The Company incurred initial costs associated with its SOX 404 initiative in fiscal 2004 and expects to incur costs in the future, particularly as it coordinates the SOX 404 evaluation with other regulatory requirements to review and evaluate the control environment.

 

LOGO   60    


Table of Contents

Critical Accounting Policies.

 

The consolidated financial statements are prepared in accordance with U.S. GAAP, which require the Company to make estimates and assumptions (see Note 1 to the consolidated financial statements). The Company believes that of its significant accounting policies (see Note 2 to the consolidated financial statements), the following may involve a higher degree of judgment and complexity.

 

Fair Value.    Financial instruments owned and Financial instruments sold, not yet purchased, which include cash and derivative products, are recorded at fair value in the consolidated statements of financial condition, and gains and losses are reflected in principal trading revenues in the consolidated statements of income. Fair value is the amount at which financial instruments could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

 

The fair value of the Company’s Financial instruments owned and Financial instruments sold, not yet purchased are generally based on observable market prices, observable market parameters or derived from such prices or parameters based on bid prices or parameters for Financial instruments owned and ask prices or parameters for Financial instruments sold, not yet purchased. In the case of financial instruments transacted on recognized exchanges, the observable prices represent quotations for completed transactions from the exchange on which the financial instrument is principally traded. Bid prices represent the highest price a buyer is willing to pay for a financial instrument at a particular time. Ask prices represent the lowest price a seller is willing to accept for a financial instrument at a particular time.

 

A substantial percentage of the fair value of the Company’s Financial instruments owned and Financial instruments sold, not yet purchased is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary from product to product. Where available, observable market prices and pricing parameters in a product (or a related product) may be used to derive a price without requiring significant judgment. In certain markets, observable market prices or market parameters are not available for all products, and fair value is determined using techniques appropriate for each particular product. These techniques involve some degree of judgment.

 

The price transparency of the particular product will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of product, whether it is a new product and not yet established in the marketplace, and the characteristics particular to the transaction. Products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, products that are thinly traded or not quoted will generally have reduced to no price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market-makers willing to purchase and sell a product provides a source of transparency for products that otherwise are not actively quoted or during periods of market dislocation.

 

The Company’s cash products include securities issued by the U.S. government and its agencies and instrumentalities, other sovereign debt obligations, corporate and other debt securities, corporate equity securities, exchange traded funds and physical commodities. The fair value of these products is based principally on observable market prices or is derived using observable market parameters. These products generally do not entail a significant degree of judgment in determining fair value. Examples of products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters include securities issued by the U.S. government and its agencies and instrumentalities, exchange traded corporate equity securities, most municipal debt securities, most corporate debt securities, most high-yield debt securities, physical commodities, certain tradable loan products and most mortgage-backed securities.

 

In certain circumstances, principally involving loan products and other financial instruments held for securitization transactions, the Company determines fair value from within the range of bid and ask prices such

 

     61    LOGO


Table of Contents

that fair value indicates the value likely to be realized in a current market transaction. Bid prices reflect the price that the Company and others pay, or stand ready to pay, to originators of such assets. Ask prices represent the prices that the Company and others require to sell such assets to the entities that acquire the financial instruments for purposes of completing the securitization transactions. Generally, the fair value of such acquired assets is based upon the bid price in the market for the instrument or similar instruments. In general, the loans and similar assets are valued at bid pricing levels until structuring of the related securitization is substantially complete and such that the value likely to be realized in a current transaction is consistent with the price that a securitization entity will pay to acquire the financial instruments. Factors affecting securitized value and investor demand relating specifically to loan products include, but are not limited to, loan type, underlying property type and geographic location, loan interest rate, loan to value ratios, debt service coverage ratio, investor demand and credit enhancement levels.

 

In addition, some cash products exhibit little or no price transparency, and the determination of the fair value requires more judgment. Examples of cash products with little or no price transparency include certain high-yield debt, certain collateralized mortgage obligations, certain tradable loan products, distressed debt securities (i.e., securities of issuers encountering financial difficulties, including bankruptcy or insolvency) and equity securities that are not publicly traded. Generally, the fair value of these types of cash products is determined using one of several valuation techniques appropriate for the product, which can include cash flow analysis, revenue or net income analysis, default recovery analysis (i.e., analysis of the likelihood of default and the potential for recovery) and other analyses applied consistently.

 

The following table presents the valuation of the Company’s cash products by level of price transparency (dollars in millions):

 

     At November 30, 2004

   At November 30, 2003

     Assets

   Liabilities

   Assets

   Liabilities

Observable market prices, parameters or derived from observable prices or parameters

   $ 145,975    $ 66,948    $ 147,228    $ 75,058

Reduced or no price transparency

     9,725      827      9,942      148
    

  

  

  

Total

   $ 155,700    $ 67,775    $ 157,170    $ 75,206
    

  

  

  

 

The Company’s derivative products include exchange-traded and OTC derivatives. Exchange-traded derivatives have valuation attributes similar to the cash products valued using observable market prices or market parameters described above. OTC derivatives, whose fair value is derived using pricing models, include a wide variety of instruments, such as interest rate swap and option contracts, foreign currency option contracts, credit and equity swap and option contracts, and commodity swap and option contracts.

 

The following table presents the fair value of the Company’s exchange traded and OTC derivative assets and liabilities (dollars in millions):

 

     At November 30, 2004

   At November 30, 2003

     Assets

   Liabilities

   Assets

   Liabilities

Exchange traded

   $ 2,754    $ 4,815    $ 2,306    $ 3,091

OTC

     64,338      51,005      42,346      33,151
    

  

  

  

Total

   $ 67,092    $ 55,820    $ 44,652    $ 36,242
    

  

  

  

 

The fair value of OTC derivative contracts is derived primarily using pricing models, which may require multiple market input parameters. Where appropriate, valuation adjustments are made to account for credit quality and market liquidity. These adjustments are applied on a consistent basis and are based upon observable market data where available. In the absence of observable market prices or parameters in an active market, observable prices

 

LOGO   62    


Table of Contents

or parameters of other comparable current market transactions, or other observable data supporting a fair value based on a pricing model at the inception of a contract, fair value is based on the transaction price. The Company also uses pricing models to manage the risks introduced by OTC derivatives. Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be modeled using a series of techniques, including closed form analytic formulae, such as the Black-Scholes option pricing model, simulation models or a combination thereof, applied consistently. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. Pricing models take into account the contract terms, including the maturity, as well as market parameters such as interest rates, volatility and the creditworthiness of the counterparty.

 

Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swap and option contracts. A substantial majority of OTC derivative products valued by the Company using pricing models fall into this category. Other derivative products, typically the newest and most complex products, will require more judgment in the implementation of the modeling technique applied due to the complexity of the modeling assumptions and the reduced price transparency surrounding the model’s market parameters. The Company manages its market exposure for OTC derivative products primarily by entering into offsetting derivative contracts or other related financial instruments. The Company’s trading divisions, the Financial Control Department and the Market Risk Department continuously monitor the price changes of the OTC derivatives in relation to the hedges. For a further discussion of the price transparency of the Company’s OTC derivative products, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management—Credit Risk” in Part II, Item 7A.

 

The Company employs control processes to validate the fair value of its financial instruments, including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable market prices or market-based parameters wherever possible. In the event that market prices or parameters are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and the assumptions are reasonable. These control processes include reviews of the pricing model’s theoretical soundness and appropriateness by Company personnel with relevant expertise who are independent from the trading desks. Additionally, groups independent from the trading divisions within the Financial Control and Market Risk Departments participate in the review and validation of the fair values generated from pricing models, as appropriate. Where a pricing model is used to determine fair value, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the model. Consistent with market practice, the Company has individually negotiated agreements with certain counterparties to exchange collateral (“margining”) based on the level of fair values of the derivative contracts they have executed. Through this margining process, one party or both parties to a derivative contract provides the other party with information about the fair value of the derivative contract to calculate the amount of collateral required. This sharing of fair value information provides additional support of the Company’s recorded fair value for the relevant OTC derivative products. For certain OTC derivative products, the Company, along with other market participants, contributes derivative pricing information to aggregation services that synthesize the data and make it accessible to subscribers. This information is then used to evaluate the fair value of these OTC derivative products. For more information regarding the Company’s risk management practices, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A.

 

Transfers of Financial Assets.    The Company engages in securitization activities in connection with certain of its businesses. Gains and losses from securitizations are recognized in the consolidated statements of income when the Company relinquishes control of the transferred financial assets in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125,” and other related pronouncements. The gain or loss on the sale of financial assets depends, in part, on the previous carrying amount of the assets involved in the transfer, allocated between the assets sold and the retained interests based upon their respective fair values at the date of sale.

 

     63    LOGO


Table of Contents

In connection with its Institutional Securities business, the Company engages in securitization transactions to facilitate client needs and as a means of selling financial assets. The Company recognizes any interests in the transferred assets and any liabilities incurred in securitization transactions in its consolidated statements of financial condition at fair value. Subsequently, changes in the fair value of such interests are recognized in the consolidated statements of income.

 

In connection with its Credit Services business, the Company periodically sells consumer loans through asset securitizations and continues to service these loans. The present value of the future net servicing revenues that the Company estimates it will receive over the term of the securitized loans is recognized in income as the loans are securitized. A corresponding asset also is recorded and then amortized as a charge to income over the term of the securitized loans. The securitization gain or loss involves the Company’s best estimates of key assumptions, including forecasted credit losses, payment rates, forward yield curves and appropriate discount rates. The use of different estimates or assumptions could produce different financial results.

 

Allowance for Consumer Loan Losses.    The allowance for consumer loan losses in the Company’s Credit Services business is established through a charge to the provision for consumer loan losses. Provisions are made to reserve for estimated losses in outstanding loan balances. The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is primarily applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy.

 

In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. The Company regularly performs a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties. A provision for consumer loan losses is charged against earnings to maintain the allowance for consumer loan losses at an appropriate level. The use of different estimates or assumptions could produce different provisions for consumer loan losses (see “Credit Services—Provision for Consumer Loan Losses” herein).

 

Aircraft under Operating Leases.    The Company’s aircraft portfolio consists of aircraft to be held and used and aircraft that are to be disposed of by sale (“held for sale”).

 

Aircraft under operating leases that are to be held and used are stated at cost less accumulated depreciation and impairment charges. Depreciation is calculated on a straight-line basis over the estimated useful life of the aircraft asset, which is generally 25 years from the date of manufacture. In accordance with SFAS No. 144, the Company’s aircraft that are to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of the aircraft may not be recoverable. Under SFAS No. 144, the carrying value of an aircraft may not be recoverable if its projected undiscounted cash flows are less than its carrying value. If an aircraft’s projected undiscounted cash flows are less than its carrying value, the Company will recognize an impairment charge equal to the excess of the carrying value over the fair value of the aircraft. The fair value of the Company’s impaired aircraft is based upon the average market appraisal values obtained from independent appraisal companies. Estimates of future cash flows associated with the aircraft assets as well as the appraisals of fair value are critical to the determination of whether an impairment exists and the amount of the impairment charge, if any (see Note 18 to the consolidated financial statements).

 

Aircraft under operating leases that fulfill the criteria to be classified as held for sale in accordance with SFAS No. 144 are stated at the lower of carrying value (i.e., cost less accumulated depreciation and impairment

 

LOGO   64    


Table of Contents

charges) or fair value less estimated cost to sell. Depreciation expense is not recorded for aircraft that are classified as held for sale. The Company will recognize a charge for any initial or subsequent write-down to fair value less estimated cost to sell (see Notes 18 and 25 to the consolidated financial statements). A gain would be recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized (for a write-down to fair value less cost to sell).

 

Certain Factors Affecting Results of Operations.

 

The Company’s results of operations may be materially affected by market fluctuations and by economic factors. In addition, results of operations in the past have been, and in the future may continue to be, materially affected by many factors of a global nature, including political, economic and market conditions; the availability and cost of capital; the level and volatility of equity prices, commodity prices and interest rates; currency values and other market indices; technological changes and events; the availability and cost of credit; inflation; and investor sentiment and confidence in the financial markets. In addition, there has been a heightened level of legislative, legal and regulatory developments related to the financial services industry that potentially could increase costs, thereby affecting future results of operations. Such factors also may have an impact on the Company’s ability to achieve its strategic objectives on a global basis.

 

The Company’s Institutional Securities business, particularly its involvement in primary and secondary markets for all types of financial products, including derivatives, is subject to substantial positive and negative fluctuations due to a variety of factors that the Company cannot control or predict with great certainty, including variations in the fair value of securities and other financial products and the volatility and liquidity of global trading markets. Fluctuations also occur due to the level of global market activity, which, among other things, affects the size, number, and timing of investment banking client assignments and transactions and the realization of returns from the Company’s principal investments. Such factors also affect the level of individual investor participation in the financial markets, which impacts the results of the Individual Investor Group. The level of global market activity also could impact the flow of investment capital into or from assets under management and supervision and the way in which such capital is allocated among money market, equity, fixed income or other investment alternatives, which could cause fluctuations to occur in the Company’s Investment Management business. In the Company’s Credit Services business, changes in economic variables, such as the number and size of personal bankruptcy filings, the rate of unemployment, and the level of consumer confidence and consumer debt, may substantially affect consumer loan levels and credit quality, which, in turn, could impact the results of Credit Services.

 

The Company’s results of operations also may be materially affected by competitive factors. Included among the principal competitive factors affecting the Institutional Securities and Individual Investor Group businesses are the Company’s reputation, the quality of its personnel, its products, services and advice, capital commitments, relative pricing and innovation. Competition in the Company’s Investment Management business is affected by a number of factors, including the Company’s reputation, investment objectives, quality of investment professionals, relative performance of investment products, advertising and sales promotion efforts, fee levels, distribution channels, and types and quality of services offered. In the Credit Services business, competition centers on merchant acceptance of credit and debit cards, account acquisition and customer utilization of credit and debit cards, all of which are impacted by the types of fees, interest rates and other features offered.

 

The Company strives to increase market share in all of its businesses and evaluates the competitive position of its businesses by, among other things, monitoring various market share data. For example, in the Institutional Securities investment banking business, the Company monitors its market share in key areas such as announced and completed worldwide mergers and acquisitions, worldwide equity underwritings and worldwide debt underwritings. In the Institutional Securities sales and trading business, the Company monitors its market share via independent client surveys as well as its market share of global exchange and non-exchange volumes. In the Individual Investor Group business, the Company monitors its market share of client assets and the number of representatives. In the

 

     65    LOGO


Table of Contents

Investment Management business, the Company monitors its market share of assets under management or supervision and mutual fund flows among mutual fund managers. It also monitors the relative performance of its funds as determined by organizations such as Morningstar and Lipper. In the Credit Services business, the Company monitors its ranking in the number of merchant and cash access locations, the level of general purpose credit card loan balances outstanding, transaction volume and the credit quality of its loan portfolio.

 

The Company competes with commercial banks, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the Internet. The Company competes with some of its competitors globally and with others on a regional or product basis. Certain sectors of the financial services industry have become considerably more concentrated, as financial institutions involved in a broad range of financial services industries have been acquired by or merged into other firms. Such convergence could result in the Company’s competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. It is possible that competition may become even more intense as the Company continues to compete with financial institutions that may be larger, or better capitalized, or may have a stronger local presence in certain areas. In addition, the Company has experienced competition for qualified employees. The Company’s ability to sustain or improve its competitive position will substantially depend on its ability to continue to attract and retain qualified employees while managing compensation costs.

 

As a result of the above economic and competitive factors, net income and revenues in any particular period may not be representative of full-year results and may vary significantly from year to year and from quarter to quarter. The Company intends to manage its business for the long term and to mitigate the potential effects of market downturns by strengthening its competitive position in the global financial services industry through diversification of its revenue sources, enhancement of its global franchise, and management of costs and its capital structure. The Company’s overall financial results will continue to be affected by its ability and success in addressing client goals; maintaining high levels of profitable business activities; emphasizing fee-based products that are designed to generate a continuing stream of revenues; evaluating product pricing; managing risks, costs and its capital position; and maintaining its strong reputation and franchise. In addition, the complementary trends in the financial services industry of consolidation and globalization present, among other things, technological, risk management and other infrastructure challenges that will require effective resource allocation in order for the Company to remain competitive.

 

LOGO   66    


Table of Contents

Liquidity and Capital Resources.

 

The Company’s senior management establishes the overall liquidity and capital policies of the Company. Through various risk and control committees, the Company’s senior management reviews business performance relative to these policies, monitors the availability of alternative sources of financing, and oversees the liquidity and interest rate and currency sensitivity of the Company’s asset and liability position. These committees, along with the Company’s Treasury Department and other control groups, also assist in evaluating, monitoring and controlling the impact that the Company’s business activities have on its consolidated balance sheet, liquidity and capital structure, thereby helping to ensure that its business activities are integrated with the Company’s liquidity and capital policies. For a description of the Company’s other principal risks and how they are monitored and managed, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A.

 

The Company’s liquidity and funding risk management policies are designed to mitigate the potential risk that the Company may be unable to access adequate financing to service its financial obligations when they come due without material, adverse franchise or business impact. The key objectives of the liquidity and funding risk management framework are to support the successful execution of the Company’s business strategies while ensuring ongoing and sufficient liquidity through the business cycle and during periods of financial distress. The principal elements of the Company’s liquidity framework are the cash capital policy, the liquidity reserve and stress testing through the contingency funding plan. Comprehensive financing guidelines (collateralized funding, long-term funding strategy, surplus capacity, diversification, staggered maturities, committed credit facilities) support the Company’s target liquidity profile.

 

The Balance Sheet.

 

The Company monitors and evaluates the composition and size of its balance sheet. Given the nature of the Company’s market making and customer financing activities, the overall size of the balance sheet fluctuates from time to time. A substantial portion of the Company’s total assets consists of highly liquid marketable securities and short-term receivables arising principally from its Institutional Securities sales and trading activities. The highly liquid nature of these assets provides the Company with flexibility in financing and managing its business.

 

The Company’s total assets increased to $775.4 billion at November 30, 2004 from $602.8 billion at November 30, 2003. The increase was primarily due to increases in securities borrowed, securities purchased under agreements to resell, financial instruments owned (largely driven by derivative contracts), receivables from customers and cash and securities segregated under federal and other regulations. The increase in securities borrowed, securities purchased under agreements to resell and receivables from customers was largely due to growth in the Company’s equity financing related activities. The increase in derivative contracts was associated with interest rate, currency, equity and commodity derivative products due to increased customer flow and market activity. Cash and securities segregated under federal and other regulations increased due to increased levels of customer activity.

 

Balance sheet leverage ratios are one indicator of capital adequacy when viewed in the context of a company’s overall liquidity and capital policies. The Company views the adjusted leverage ratio as a more relevant measure of financial risk when comparing financial services firms and evaluating leverage trends. The Company has adopted a definition of adjusted assets that excludes certain self-funded assets considered to have minimal market, credit and/or liquidity risk. These low-risk assets generally are attributable to the Company’s matched book and securities lending businesses. Adjusted assets are calculated by reducing gross assets by aggregate resale agreements and securities borrowed less non-derivative short positions and assets recorded under certain provisions of SFAS No. 140 and FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), as revised. The adjusted leverage ratio reflects the deduction from shareholders’ equity of the amount of equity used to support goodwill and intangible assets (as the Company does not view this amount of equity as available to support its risk capital needs). In addition, the Company views junior subordinated debt issued to capital trusts as a component of its capital base given the inherent characteristics of the securities. These

 

     67    LOGO


Table of Contents

characteristics include the long dated nature (final maturity at issuance of 30 years extendible at the Company’s option by a further 19 years), the Company’s ability to defer coupon interest for up to 20 consecutive quarters and the subordinated nature of the obligations in the capital structure. The Company also receives rating agency equity credit for these securities.

 

The following table sets forth the Company’s total assets, adjusted assets and leverage ratios as of November 30, 2004 and November 30, 2003 and for the average month-end balances during fiscal 2004:

 

     Balance at

    Average Month-End
Balance


 
     November 30,
2004


    November 30,
2003


    Fiscal 2004

 
     (dollars in millions, except ratio data)  

Total assets

   $ 775,410     $ 602,843     $ 713,992  

Less: Securities purchased under agreements to resell

     (123,041 )     (78,205 )     (98,485 )

  Securities borrowed

     (208,349 )     (153,813 )     (191,767 )

Add:  Financial instruments sold, not yet purchased

     123,595       111,448       128,681  

Less: Derivative contracts sold, not yet purchased

     (55,820 )     (36,242 )     (43,433 )
    


 


 


Subtotal

     511,795       446,031       508,988  

Less: Segregated customer cash and securities balances

     (26,534 )     (20,705 )     (25,596 )

Assets recorded under certain provisions of SFAS No. 140 and FIN 46, as revised

     (44,895 )     (35,217 )     (39,728 )

Goodwill and intangible assets

     (2,199 )     (1,523 )     (1,761 )
    


 


 


Adjusted assets

   $ 438,167     $ 388,586     $ 441,903  
    


 


 


Shareholders’ equity

   $ 28,206     $ 24,867     $ 26,718  

Junior subordinated debt issued to capital trusts

     2,897       2,810       2,877  
    


 


 


Subtotal

     31,103       27,677       29,595  

Less: Goodwill and intangible assets

     (2,199 )     (1,523 )     (1,761 )
    


 


 


Tangible shareholders’ equity

   $ 28,904     $ 26,154     $ 27,834  
    


 


 


Leverage ratio(1)

     26.8 x     23.0 x     25.7 x
    


 


 


Adjusted leverage ratio(2)

     15.2 x     14.9 x     15.9 x
    


 


 



(1) Leverage ratio equals total assets divided by tangible shareholders’ equity.
(2) Adjusted leverage ratio equals adjusted assets divided by tangible shareholders’ equity.

 

The Company’s total capital consists of equity capital combined with long-term borrowings (debt obligations scheduled to mature in more than 12 months), junior subordinated debt issued to capital trusts, and Capital Units. At November 30, 2004, total capital was $110.8 billion, an increase of $28.0 billion from November 30, 2003.

 

During the 12 months ended November 30, 2004, the Company issued senior notes aggregating $38.2 billion, including non-U.S. dollar currency notes aggregating $8.3 billion. In connection with the note issuances, the Company has entered into certain transactions to obtain floating interest rates based primarily on short-term London Interbank Offered Rates (“LIBOR”) trading levels. At November 30, 2004, the aggregate outstanding principal amount of the Company’s Senior Indebtedness (as defined in the Company’s public debt shelf registration statements) was approximately $121 billion (including guaranteed obligations of the indebtedness of subsidiaries). The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.2 years at November 30, 2004. Subsequent to fiscal year-end and through February 4, 2005, the Company’s long-term borrowings (net of repayments) increased by approximately $8.6 billion.

 

Equity Capital Management Policies.    The Company’s senior management views equity capital as an important source of financial strength and, therefore, pursues a strategy of ensuring that the Company’s equity base

 

LOGO   68    


Table of Contents

adequately reflects and provides protection from the economic risks inherent in its businesses. Capital is required for, among other things, the Company’s inventories, underwritings, principal investments, consumer loans, bridge loans and other financings, and investments in fixed assets, including aircraft assets. The Company also considers return on common equity to be an important measure of its performance, in the context of both the particular business environment in which the Company is operating and its peer group’s results. In this regard, the Company actively manages its consolidated equity capital position based upon, among other things, business opportunities, capital availability and rates of return together with internal capital policies, regulatory requirements and rating agency guidelines and, therefore, in the future may expand or contract its equity capital base to address the changing needs of its businesses. The Company attempts to maintain total equity, on a consolidated basis, at least equal to the sum of its operating subsidiaries’ equity.

 

The Company uses an economic capital model to determine the amount of equity capital needed to support the risk of the Company’s business activities and to ensure that the Company remains adequately capitalized. Economic capital is defined as the amount of capital needed to run the business through the business cycle and satisfy the requirements of the market, regulators and rating agencies. The Company assigns economic capital to each business unit based primarily on regulatory capital usage and potential stress losses across various dimensions of market, credit, business and operational risks. Additional capital is assigned for goodwill, intangible assets, principal investment risk, and balance sheet usage as required to meet the Company’s leverage ratio targets. The Company’s framework for allocating economic capital is intended to align equity capital with the risks in each business, provide business managers with tools for measuring and managing risk, and allow senior management to evaluate risk-adjusted returns to facilitate resource allocation decisions. At November 30, 2004, the Company’s equity capital (which includes shareholders’ equity and junior subordinated debt issued to capital trusts) was $31.1 billion, an increase of $3.4 billion from November 30, 2003.

 

The Company returns internally generated equity capital that is in excess of the needs of its businesses to its shareholders through common stock repurchases and dividends. The Board of Directors has authorized the Company to purchase, subject to market conditions and certain other factors, shares of common stock for capital management purposes. There were no repurchases made under the capital management authorization during fiscal 2004. The unused portion of this authorization at January 31, 2005 was approximately $600 million. The Company also has an ongoing repurchase authorization in connection with awards granted under its equity-based compensation plans. During fiscal 2004, the Company purchased approximately $1,132 million of its common stock (approximately 23 million shares) through open market purchases at an average cost of $50.31 (see also “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” in Part II, Item 5). The Company currently anticipates that it will increase common stock repurchases pursuant to its equity anti-dilution program and expects that these repurchases will be between 35 million and 80 million shares for fiscal 2005. The actual amount of repurchases will be subject to market conditions and certain other factors. The Board of Directors determines the declaration and payment of dividends on a quarterly basis. In December 2004, the Board of Directors increased the quarterly dividend per common share by 8% to $0.27.