# MORGAN STANLEY SMITH BARNEY LLC X-17A-5 (2021-02-26) — Broker-dealer annual report
- Company: MORGAN STANLEY SMITH BARNEY LLC
- Form: X-17A-5
- Filed: 2021-02-26
- Accession: 0001193125-21-060903
- CIK: 1457496
- File #: 8-68191
- Website: deloitte.com
Original filing: https://www.sec.gov/Archives/edgar/data/1457496/000119312521060903/d67983dfull.pdf
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# **MORGAN STANLEY SMITH BARNEY LLC (SEC I.D. No. 8-68191)**
# **CONSOLIDATED STATEMENT OF FINANCIAL CONDITION AS OF DECEMBER 31, 2020 AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
**\*\*\*\*\*\*\*\***
**Filed pursuant to Rule 17a-5(e)(3) under the Securities Exchange Act of 1934 as a PUBLIC DOCUMENT.**
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**Deloitte & Touche LLP** 30 Rockefeller Plaza New York, NY 10112 USA
Tel: +1 212 492 4000 Fax: +1 212 489 1687 www.deloitte.com
# **REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
To the Board of Directors and Member of Morgan Stanley Smith Barney LLC
# **Opinion on the Financial Statement**
We have audited the accompanying consolidated statement of financial condition of Morgan Stanley Smith Barney LLC and subsidiaries (the "Company") as of December 31, 2020, and the related notes (collectively referred to as the "financial statement"). In our opinion, the financial statement presents fairly, in all material respects, the financial position of the Company as of December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
# **Basis for Opinion**
The financial statement is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statement is free of material misstatement, whether due to error or fraud.
Our audit included performing procedures to assess the risks of material misstatement of the financial statement, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statement. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statement. We believe our audit of the financial statement provides a reasonable basis for our opinion.
February 26, 2021
We have served as the Company's auditor since 2009.
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# **MORGAN STANLEY SMITH BARNEY LLC CONSOLIDATED STATEMENT OF FINANCIAL CONDITION As of December 31, 2020 (In millions of dollars)**
| ASSETS | |
|----------------------------------------------------------------------------|--------------|
| Cash | \$
675 |
| Cash deposited with clearing organizations or segregated under federal and | |
| other regulations or requirements | 916 |
| Financial instruments owned, at fair value | 738 |
| Securities purchased under agreements to resell | 8,012 |
| Securities borrowed | 761 |
| Receivables: | |
| Customers | 10,941 |
| Brokers, dealers and clearing organizations | 74 |
| Employee loans (net of \$165 allowance for credit losses) | 3,075 |
| Fees, interest and other | 529 |
| Affiliates | 36 |
| Goodwill | 4,609 |
| Intangible assets (net of accumulated amortization of \$2,860) | 1,090 |
| Other assets | 849 |
| Total assets | \$
32,305 |
| | |
| LIABILITIES AND MEMBER'S EQUITY | |
| Financial instruments sold, not yet purchased, at fair value | \$
11 |
| Securities sold under agreements to repurchase | 805 |
| Securities loaned | 886 |
| Payables: | |
| Customers | 9,438 |
| Brokers, dealers and clearing organizations | 235 |
| Interest and dividends | 19 |
| Affiliates | 450 |
| Other liabilities and accrued expenses | 5,919 |
| Borrowings (includes \$15 at fair value) | 1,039 |
| Total liabilities | 18,802 |
| | |
| Contingent liabilities (See Note 12) | |
| Subordinated liabilities | 1,400 |
| Member's equity | 12,103 |
|---------------------------------------|--------------|
| Total liabilities and member's equity | \$
32,305 |
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# **MORGAN STANLEY SMITH BARNEY LLC NOTES TO CONSOLIDATED STATEMENT OF FINANCIAL CONDITION As of December 31, 2020 (In millions of dollars, except where noted)**
# **1. Introduction and Basis of Presentation**
## **The Company**
MSSB, together with its wholly owned subsidiaries (the "Company"), provides a wide variety of financial products and services to a large and diversified group of clients and customers, including financial institutions and individuals. The Company offers financial advisor-led brokerage and investment advisory services; self-directed brokerage services covering various investment alternatives; financial and wealth planning services; workplace services including stock plan administration; annuity and insurance products; cash management; and retirement plan services through a network of approximately sixteen thousand financial advisors in the U.S. The Company also performs sales and trading activities, primarily on an agency basis, in the equity and fixed income businesses and new issue distribution of fixed income and equity products. See the "Glossary of Common Terms and Acronyms" for the definition of certain terms and acronyms used throughout the notes to the consolidated statement of financial condition.
MSSB is registered with the SEC as a wealth management brokerdealer and an investment adviser. The Company is also registered as an introducing broker with the CFTC and clears futures transactions through an affiliate, MS&Co. MSSB is also a member of FINRA, SIPC and various securities exchanges.
MSSB is a wholly owned subsidiary of MSDHI (the "Parent"), which is an indirect subsidiary of Morgan Stanley (the "Ultimate Parent").
#### **Basis of Financial Information**
The consolidated statement of financial condition are prepared in accordance with U.S. GAAP, which requires the Company to make estimates and assumptions regarding the valuations of certain financial instruments, the valuation of goodwill and intangible assets, the outcome of legal and tax matters, deferred tax assets, ACL, and other matters that affect its consolidated statement of financial condition and related disclosures. The Company believes that the estimates utilized in the preparation of its consolidated statement of financial condition are prudent and reasonable. Actual results could differ materially from these estimates.
The Company has evaluated subsequent events for adjustment to or disclosure in the consolidated statement of financial condition through the date of this report and the Company has not identified any recordable or disclosable events, not otherwise reported in the consolidated statement of financial condition or the notes thereto, except for the below.
On February 18, 2021, the Company transferred its Employee loans to an affiliated service entity, MSSBF. On the same day, as a result of the transfer, the Company repaid its \$1,400 Subordinated liabilities with the Parent and paid a \$1,600 Dividend to the Parent.
For information related to Employee Loans and Subordinated liabilities, see Notes 8 and 11, respectively.
#### **Consolidation**
The consolidated statement of financial condition include the accounts of MSSB and its wholly owned licensed insurance subsidiaries in which MSSB has a controlling financial interest.
At December 31, 2020, the Company's consolidated subsidiaries reported \$18 of assets, \$15 of liabilities and \$3 of equity on a stand-alone basis.
All material intercompany balances and transactions with its subsidiaries have been eliminated in consolidation.
# **2. Significant Accounting Policies**
# **Fair Value of Financial Instruments**
Instruments within Financial instruments owned and Financial instruments sold, not yet purchased, are measured at fair value, either as required or allowed by accounting guidance. These financial instruments represent the Company's trading positions to facilitate customer transactions and include both cash and derivative products.
The fair value of OTC financial instruments, including derivative contracts related to financial instruments is presented in the accompanying consolidated statement of financial condition on a net-by-counterparty basis, when appropriate. Additionally, the Company nets the fair value of cash collateral paid or received against the fair value amounts recognized for net derivative positions executed with the same counterparty under the same master netting agreement.
# *Fair Value Measurement – Definition and Hierarchy*
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (*i.e*., the "exit price") in an orderly transaction between market participants at the measurement date.
Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, assumptions are set to reflect those that the Company believes market participants would use in pricing the asset or liability at the measurement date. Where the Company manages a group of financial assets, financial liabilities and nonfinancial items accounted for as derivatives on the basis of its net exposure to either market risk or credit risk, the Company measures the fair value of that group of financial instruments
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consistently with how market participants would price the net risk exposure at the measurement date.
In determining fair value, the Company uses various valuation approaches and establishes a hierarchy for inputs used in measuring fair value that requires the most observable inputs be used when available.
Observable inputs are inputs that market participants would use in pricing the asset or liability that were developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect assumptions the Company believes other market participants would use in pricing the asset or liability that are developed based on the best information available in the circumstances. The fair value hierarchy is broken down into three levels based on the observability of inputs as follows, with Level 1 being the highest and Level 3 being the lowest.
*Level 1*. Valuations based on quoted prices in active markets that the Company has the ability to access for identical assets or liabilities. Valuation adjustments and block discounts are not applied to Level 1 instruments. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
*Level 2.* Valuations based on one or more quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
*Level 3.* Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
The availability of observable inputs can vary from product to product and is affected by a wide variety of factors, including the type of product, whether the product is new and not yet established in the marketplace, the liquidity of markets and other characteristics particular to the product. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3 of the fair value hierarchy.
The Company considers prices and inputs that are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or from Level 2 to Level 3 of the fair value hierarchy.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the total fair value amount is disclosed in the level appropriate for the lowest level input that is significant to the total fair value of the asset or liability.
# *Valuation Techniques*
Many cash instruments and OTC derivative contracts have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that a party is willing to pay for an asset. Ask prices represent the lowest price that a party is willing to accept for an asset. The Company carries positions at the point within the bid-ask range that meets its best estimate of fair value. For offsetting positions in the same financial instrument, the same price within the bid-ask spread is used to measure both the long and short positions.
Fair value for many cash instruments and OTC derivative contracts is derived using pricing models. Pricing models take into account the contract terms as well as multiple inputs, including, where applicable, commodity prices, equity prices, interest rate yield curves, credit curves, correlation, creditworthiness of the counterparty, creditworthiness of the Company, option volatility and currency rates.
See Note 4 for a description of valuation techniques applied to the major categories of financial instruments measured at fair value.
#### **Offsetting of Derivative Instruments**
In connection with its derivative activities, the Company generally enters into master netting agreements and collateral agreements with its counterparties. These agreements provide the Company with the right, in the event of a default by the counterparty, to net a counterparty's rights and obligations under the agreement and to liquidate and set off cash collateral against any net amount owed by the counterparty. Derivatives with enforceable master netting agreements are reported net of cash collateral received and posted.
For information related to offsetting of derivatives and certain collateralized transactions, see Notes 5 and 7, respectively.
#### **Income Taxes**
Deferred tax assets and liabilities are recorded based upon the temporary differences between the financial statement and income tax bases of assets and liabilities using currently enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income tax expense (benefit) in the period that includes the enactment date. Such effects are recorded in Provision for income taxes regardless of where deferred taxes were originally recorded.
The Company recognizes net deferred tax assets to the extent that it believes these assets are more likely than not to be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. When performing the assessment, the Company considers all types of deferred tax assets in combination with each other, regardless of the origin of the underlying temporary difference. If a deferred tax asset is determined to be unrealizable, a valuation
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allowance is established. If the Company subsequently determines that it would be able to realize deferred tax assets in excess of their net recorded amount, it would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
Uncertain tax positions are recorded on the basis of a two-step process whereby (i) the Company determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position, and (ii) for those tax positions that meet this threshold, the Company recognizes the largest amount of tax benefit that is more likely than not to be realized upon ultimate settlement with the related tax authority.
# **Cash**
Cash represents funds deposited with financial institutions.
# **Cash Deposited with Clearing Organizations or Segregated Under Federal and Other Regulations or Requirements**
Cash deposited with clearing organizations or segregated under federal and other regulations or requirements ("restricted cash") includes cash segregated in compliance with federal and other regulations and funds deposited by customers.
# **Contracts with Customers**
Receivables from contracts with customers are recognized across the various types of Receivables balances in the consolidated statement of financial condition when the underlying performance obligations have been satisfied and the Company has the right per the contract to bill the customer. Contract assets are recognized in Other assets when the Company has satisfied its performance obligations but payment is conditional and Other liabilities and accrued expenses when the Company has collected payment from a customer based on the terms of the contract but the underlying performance obligations are not yet satisfied.
# **Collateralized Financings**
Securities borrowed, Securities purchased under agreements to resell ("reverse repurchase agreements"), Securities loaned and Securities sold under agreements to repurchase ("repurchase agreements") are treated as collateralized financings. Reverse repurchase agreements and repurchase agreements are carried on the consolidated statement of financial condition at the amounts of cash paid or received, plus accrued interest. Where appropriate, repurchase agreements and reverse repurchase agreements with the same counterparty are reported on a net basis. Securities borrowed and Securities loaned are recorded at the amount of cash collateral advanced or received.
# **Receivables and Payables – Customers**
Receivables from customers primarily include margin loans (net of related customer cash and short sale proceeds). Payables to customers primarily include amounts from cash and short sale activity (net of related customer margin loans), and margin requirements.
Customers' securities transactions are recorded on a settlement date basis. Securities owned by customers, including those that collateralize margin loans, are not reflected on the consolidated statement of financial condition.
# **Receivables and Payables – Brokers, Dealers and Clearing Organizations**
Receivables from and payables to brokers, dealers and clearing organizations primarily include margin requirements, amounts on unsettled trades, and amounts for securities failed to deliver by the Company to the purchaser or failed to receive by the Company from the seller by the settlement date. Receivables and payables arising from unsettled trades are reported on a net basis.
# **Employee Loans**
Employee loans are reported at outstanding principal adjusted for any ACL. The ACL represents an estimate of expected credit losses over the entire life of employee loans.
# **Goodwill and Intangible Assets**
The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests goodwill for impairment at the reporting unit level. For both the annual and interim tests, the Company has the option to either (a) perform a *quantitative* impairment test or (b) first perform a *qualitative* assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, in which case the quantitative test would be performed.
When performing a *quantitative* impairment test, the Company compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit is less than its carrying amount, the goodwill impairment loss is equal to the excess of the carrying value over the fair value, limited by the carrying amount of goodwill allocated to that reporting unit.
The estimated fair value of the reporting unit is derived based on valuation techniques the Company believes market participants would use for the reporting unit. The estimated fair values are generally determined by utilizing a discounted cash flow methodology.
See Note 9 for further information on Goodwill and Intangible assets.
# **Deferred Compensation Plans**
Eligible current and former employees of the Company and affiliates participate in various deferred stock-based and cashbased compensation plans
The deferred cash-based compensation plans provide a return to the plan participants based upon the performance of various referenced investments.
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The Company enters into a variety of OTC derivative contracts with affiliates to economically hedge certain obligations under the deferred cash-based compensation plans. Changes in value of such contracts are recorded in Principal transactions.
#### **Accounting Updates Adopted in 2020**
## *Reference Rate Reform*
The Company adopted the *Reference Rate Reform* accounting update. There was no impact to the Company's consolidated statement of financial condition upon initial adoption.
This accounting update provides optional accounting relief to entities with contracts or other transactions that reference LIBOR or other interest rate benchmarks for which the referenced rate is expected to be discontinued or replaced. The Company is applying the accounting relief as relevant contract modifications are made during the course of the reference rate reform transition period. The optional relief generally allows for contract modifications solely related to the replacement of the reference rate to be accounted for as a continuation of the existing contract instead of as an extinguishment of the contract, and would therefore not trigger certain accounting impacts that would otherwise be required. The optional relief ends December 31, 2022.
# *Financial Instruments––Credit Losses*
The Company adopted the *Financial Instruments––Credit Losses* accounting update.
This accounting update impacted the impairment model for certain financial assets measured at amortized cost by requiring a CECL methodology to estimate expected credit losses over the entire life of the financial asset, recorded at inception or purchase. CECL replaced the incurred loss model previously applicable to other receivables carried at amortized cost, such as employee loans.
For certain portfolios, the company determined that there are *de minimis* or zero expected credit losses; for example, for lending and financing transactions, such as customer receivables representing margin loans, Securities borrowed, Securities purchased under agreements to resell and certain other portfolios where collateral arrangements are being followed.
At transition on January 1, 2020, the adoption of this accounting update resulted in an increase in the ACL of \$124 with a corresponding reduction in Member's equity of \$94, net of tax. The adoption impact was attributable to employee loans. See Note 8 for details on employee loans, including amounts reflected in the consolidated statement of financial condition.
The following discussion highlights changes to the Company's accounting policies as a result of this adoption.
#### **Instruments Measured at Amortized Cost**
#### *Allowance for Credit losses*
The ACL for financial instruments measured at amortized cost represents an estimate of expected credit losses over the entire life of the financial instrument.
Factors considered by management when determining the ACL include payment status, fair value of collateral, expected payments of principal and interest, as well as internal or external information relating to past events, current conditions and reasonable and supportable forecasts. With regards to employee loans, the relationship between the timing of a termination event and the collection from such event is a determining factor in the forecasting of future collections in deriving the ACL. At the conclusion of the Company's reasonable and supportable forecast period of 13 quarters, there is a gradual reversion back to historical averages.
The ACL is measured considering all available information relevant to assessing the collectability of cash flows. Generally, the Company applies a probability of default/loss given default model, under which the ACL is calculated as the product of probability of default, loss given default and exposure at default. These parameters are forecast for each collective group of assets using a scenario-based statistical model and at the conclusion of the Company's reasonable and supportable forecast period of 13 quarters, the parameters gradually revert back to historical averages.
Additionally, the Company can elect to use an approach to measure the ACL using the fair value of collateral where the borrower is required to, and reasonably expected to, continually adjust and replenish the amount of collateral securing the instrument to reflect changes in the fair value of such collateral. The Company has elected to use this approach for Customer receivables representing margin loans, Securities purchased under agreements to resell and Securities borrowed.
Credit quality indicators considered in developing the ACL for Employee loans include employment status, which includes those currently employed by the Company and for which the Company can deduct any unpaid amounts due to it through certain compensation arrangements, and those no longer employed by the Company where such compensation arrangements are no longer applicable.
Qualitative and environmental factors such as economic and business conditions, the nature and volume of the portfolio, lending terms, and the volume and severity of past due loans are also considered in the ACL calculations.
*Recognition.* The Company recognizes its ACL and provision for credit losses for employee loans as a contra-asset.
# *Nonaccrual*
The Company places financial instruments, such as employee loans, margin loans, securities borrowed, and other receivables,
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on nonaccrual status if principal or interest is past due for a period of 90 days or more or payment of principal or interest is in doubt unless the obligation is well-secured and in the process of collection. For any instrument with accrued interest receivable separately recorded, when the instrument is placed on nonaccrual status, the Company reverses any unpaid interest accrued. Principal and interest payments received on nonaccrual instruments are applied to principal if there is doubt regarding the ultimate collectability of principal. If neither principal, nor interest collection, is in doubt and the instruments are brought current, instruments are generally placed on accrual status.
#### *ACL Charge-offs*
The principal balance of a financial instrument is charged off in the period it is deemed uncollectible resulting in a reduction in the ACL and the balance of the financial instrument in the consolidated statement of financial condition. Accrued interest receivable balances that are separately recorded from the related financial instruments are charged off when the related financial instrument is placed on nonaccrual. Accordingly, the Company elected not to measure an ACL for accrued interest receivables.
#### **Accounting Development Updates**
The FASB has issued certain accounting updates that apply to the Company. Accounting updates not listed below were assessed and determined to be either not applicable or are not expected to have a significant impact on the Company's consolidated statement of financial condition.
*Simplifying the Accounting for Income Taxes*. In December 2019, the FASB amended the guidance to simplify the accounting for income taxes as part of its initiative to reduce complexity in accounting standards. The amendments remove certain exceptions to the general income tax accounting principles and provides for both consistency in application of and simplification for other areas within U.S. GAAP by clarifying and amending existing guidance. The adoption of this accounting guidance is not expected to have a material impact on the Company's consolidated statement of financial condition. This update was effective as of January 1, 2021.
# **3. Related Party Transactions**
The Company enters into transactions with the Firm ("Ultimate Parent and its consolidated subsidiaries") in order to, among other things, manage risk, facilitate client demand, satisfy regulatory and liquidity requirements, and fund business activities. These transactions include OTC derivatives and collateralized financings, as described in Notes 5 and 7, respectively.
The Company also obtains funding as well as subordinated liabilities from the Ultimate Parent and the Parent as described in Notes 10 and 11, respectively.
During 2020, the Company paid \$1,650 of dividends to the Parent.
The Company is a party to deposit sweep agreements with MSBNA and MSPBNA, both bank affiliates. Under these sweep agreements, each bank sources certain deposits from the Company. These deposits are primarily garnered through the Deposit Program whereby certain cash balances are primarily swept into separate money market deposit accounts and demand deposit accounts.
The Company participates in various deferred stock-based and cash-based compensation plans for the benefit of certain current and former employees, as described in Note 14, as well as employee benefit plans as described in Note 15. The Company enters into OTC derivative contracts with affiliates to economically hedge certain obligations under the deferred cashbased compensation plans. See Note 5 for additional disclosures on fair value and notional amounts related to the derivatives associated with these deferred compensation plans, included within equity contracts. Additionally, the Company has recognized liabilities to the Ultimate Parent for the deferred stockbased compensation plans which are recorded in Other liabilities and accrued expenses on the consolidated statement of financial condition.
The Company has agreements with affiliates for other activities, including a tax sharing agreement with the Ultimate Parent as described in Note 16, global transfer pricing policies, and other activities as described further below. Unsettled amounts for these activities are recorded within Receivables from or Payables to affiliates, are payable on demand, and bear interest at rates established by the treasury function of the Firm. These rates are periodically reassessed and are generally intended to approximate the rate of interest that the Firm incurs in funding its business.
The Company applies global transfer pricing policies among affiliates. These policies are consistent with 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The Firm has also engaged in negotiations of Advanced Pricing Agreements with selected tax authorities in respect of its key transfer pricing methodologies.
The Company has various agreements with an affiliated brokerdealer, MS&Co., in which MSSB provides certain sales and distribution services for MS&Co.'s equities and fixed income trading activities, and MS&Co. provides certain sales and trading services to the Company.
The Company has agreements with affiliated service entities, MSSG and MSSBF. MSSG provides the Company with certain services including infrastructure group support, healthcare and life insurance benefits for the employees of the Company, information processing, communications, and occupancy and equipment. MSSBF provides other services including information processing, communications, and occupancy and equipment.
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| | At December 31, 2020 | | | | | | |
|---------------------------------------------------|----------------------|-------|--|--|--|--|--|
| Assets and receivables from affiliated companies: | | | | | | | |
| Restricted cash | \$ | 85 | | | | | |
| Financial instruments owned, at fair value | | 718 | | | | | |
| Reverse repurchase agreements | | 8,012 | | | | | |
| Securities borrowed | | 761 | | | | | |
| Receivables - Affiliates | | 36 | | | | | |
| Other assets | | 36 | | | | | |
**At December 31, 2020 Liabilities and payables to affiliated companies:** Repurchase agreements \$ 805 Securities loaned 886 Payables - Affiliates 450 Other liabilities and accrued expenses 568 Borrowings 681
Subordinated liabilities 1,400
# **4. Fair Values**
#### **Fair Value Measurements**
#### **Assets and Liabilities Measured at Fair Value**
| | At December 31, 2020 | | | | | | | | |
|-----------------------------------------------------|----------------------|---------|----|---------|----|---------|----------|----|-------|
| | | Level 1 | | Level 2 | | Level 3 | Netting1 | | Total |
| Assets at fair value | | | | | | | | | |
| Financial instruments owned: | | | | | | | | | |
| Corporate and other debt | \$ | - | \$ | 21 | \$ | -
\$ | - | \$ | 21 |
| Corporate equities2 | | 1 | | - | | - | - | | 1 |
| Derivative contracts: | | | | | | | | | |
| Foreign exchange | | - | | 21 | | - | - | | 21 |
| Equity3 | | - | | 703 | | - | - | | 703 |
| Netting1 | | - | | (8) | | - | - | | (8) |
| Total derivative contracts | | - | | 716 | | - | - | | 716 |
| Total financial instruments owned | \$ | 1 | \$ | 737 | \$ | -
\$ | - | \$ | 738 |
| Liabilities at fair value | | | | | | | | | |
| Financial instruments sold, not yet purchased: | | | | | | | | | |
| Corporate and other debt | \$ | - | \$ | 2 | \$ | -
\$ | - | \$ | 2 |
| Corporate equities2 | | 1 | | - | | - | - | | 1 |
| Derivative contracts: | | | | | | | | | |
| Foreign exchange | | - | | 21 | | - | - | | 21 |
| Netting1 | | - | | (8) | | - | (5) | | (13) |
| Total derivative contracts | | - | | 13 | | - | (5) | | 8 |
| Borrowings | | - | | 15 | | - | | | 15 |
| Total financial instruments sold, not yet purchased | \$ | 1 | \$ | 30 | \$ | -
\$ | (5) | \$ | 26 |
1. For positions with the same counterparty that cross over the levels of the fair value hierarchy, both counterparty netting and cash collateral netting are included in the column titled "Netting". Positions classified within the same level that are with the same counterparty are netted within the column for that level. For further information on derivative instruments, see Note 5.
2. For trading purposes, the Company holds or sells short equity securities issued by entities in diverse industries and of varying sizes.
3. Represents fair value of derivative assets associated with deferred compensation plans as mentioned in Note 3.
#### **Valuation Techniques for Assets and Liabilities Measured at Fair Value**
#### **Corporate and other debt**
*Corporate Bonds*
Valuation Techniques:
- Fair value is determined using recently executed transactions, market price quotations, bond spreads, CDS spreads obtained from independent external parties, such as vendors and brokers, adjusted for any basis difference between cash and derivative instruments.
- The spread data used are for the same maturity as the bond. If the spread data do not reference the issuer, then data that reference a comparable issuer are used. When positionspecific external price data are not observable, fair value is determined based on either benchmarking to comparable instruments or cash flow models with yield curves, bond or
single name CDS spreads and recovery rates as significant inputs.
Valuation Hierarchy Classification:
Level 2 - if value based on observable market data for comparable instruments
# **Corporate Equities**
- Valuation Techniques:
- Fair value is determined based on quoted prices from the exchange. To the extent these securities are actively traded, valuation adjustments are not applied.
- Valuation Hierarchy Classification:
- Level 1
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## **Derivative Contracts**
*OTC Derivative Contracts*
- Valuation Techniques:
- OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, equity prices or commodity prices.
- 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 formulas, such as the Black-Scholes option-pricing model, simulation models or a combination thereof. Many pricing models do not entail material subjectivity as the methodologies employed do not necessitate significant
judgment since model inputs may be observed from actively quoted markets, as is the case for generic interest rate swaps, many equity, commodity and foreign currency option contracts. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industrry.
- Valuation Hierarchy Classification:
- Level 2 when valued using observable inputs or where the unobservable input is not deemed significant.
For further information on the valuation techniques for OTC derivative products, see Note 2.
#### **Financial Instruments Not Measured at Fair Value**
| At December 31, 2020 | | | | | | | | | | |
|---------------------------------------------|----|----------------|----|---------|----|---------|------------|---------|----|--------|
| | | | | | | | Fair Value | | | |
| | | Carrying Value | | Level 1 | | Level 2 | | Level 3 | | Total |
| Financial Assets | | | | | | | | | | |
| Cash | \$ | 675 | \$ | 675 | \$ | - | \$ | - | \$ | 675 |
| Restricted cash | | 916 | | 916 | | - | | - | | 916 |
| Reverse repurchase agreements | | 8,012 | | - | | 8,012 | | - | | 8,012 |
| Securities borrowed | | 761 | | - | | 761 | | - | | 761 |
| Receivables:1 | | | | | | | | | | |
| Customers | | 10,941 | | - | | 10,941 | | - | | 10,941 |
| Brokers, dealers and clearing organizations | | 74 | | - | | 74 | | - | | 74 |
| Employee loans | | 3,075 | | - | | - | | 3,041 | | 3,041 |
| Affiliates | | 36 | | - | | 36 | | - | | 36 |
| Other assets | | 58 | | - | | 58 | | - | | 58 |
| Financial Liabilities | | | | | | | | | | |
| Repurchase agreements | \$ | 805 | | - | \$ | 805 | \$ | - | \$ | 805 |
| Securities loaned | | 886 | | - | | 886 | | - | | 886 |
| Payables:1 | | | | | | | | | | |
| Customers | | 9,438 | | - | | 9,438 | | - | | 9,438 |
| Brokers, dealers and clearing organizations | | 235 | | - | | 235 | | - | | 235 |
| Affiliates | | 450 | | - | | 450 | | - | | 450 |
| Other liabilities and accrued expenses | | 976 | | - | | 976 | | - | | 976 |
| Borrowings | | 1,024 | | - | | 1,025 | | - | | 1,025 |
| Subordinated liabilities | | 1,400 | | - | | 1,454 | | - | | 1,454 |
1. Accrued interest and dividend receivables and payables have been excluded. Carrying values approximate fair values for these receivables and payables.
The previous table excludes certain financial instruments such as postretirement benefits and all non-financial assets and liabilities.
# **5. Derivative Instruments**
The Company may trade exchange-traded futures and options, as well as OTC swaps, forwards, options and other derivatives referencing, among other things, interest rates, equities, currencies, and bonds. The Company uses these instruments to economically hedge their client facilitation activity and obligations under certain deferred cash-based compensation plans. The Company does not apply hedge accounting.
The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies include diversification of risk exposures and hedging. Hedging activities consist of the purchase or sale of positions in related securities and financial instruments, including a variety of derivative products (*e.g*., futures, forwards, swaps and options).
| | Derivative at December 31, 2020 | | | | | | | | | |
|----------------------------|---------------------------------|---------------------|-------|--------------|---------------|-----|-------------|-----|--|--|
| | | | Asset | | | | Liabilities | | | |
| | | Fair Value Notional | | | Fair Value | | Notional | | | |
| | | Bilateral OTC | | | Bilateral OTC | | | | | |
| Derivative contracts | | | | | | | | | | |
| Foreign exchange | \$ | 21 \$ | | 788 | \$ | 21 | \$ | 788 | | |
| Equity1 | | 703 | | 3,296 | | - | | - | | |
| Total gross derivative | | | | | | | | | | |
| contracts | | | | 724 \$ 4,084 | | 21 | \$ | 788 | | |
| Counterparty netting | | (8) | | | | (8) | | | | |
| Cash collateral netting | | - | | | | (5) | | | | |
| Total derivative assets \$ | | 716 | | | \$ | 8 | | | | |
1. Bilateral OTC Equity contracts represent derivative assets associated with deferred compensation plans, as mentioned in Note 3.
{10}------------------------------------------------
# **6. Contracts with Customers**
Receivables from contracts with customers, which are included across the various types of Receivables balances on the Company's consolidated statement of financial condition, arise when the Company has both recorded revenues and has the right per the contract to bill customers. At December 31, 2020, the balance related to Receivables from contracts with customers was \$1,802.
# **7. Collateralized Transactions**
The Company enters into reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions with affiliates to, among other things, acquire securities to cover short positions and settle other securities obligations, accommodate customers' needs, finance its inventory positions, and meet regulatory and liquidity requirements.
The Company manages credit exposure arising from such transactions by, in appropriate circumstances, entering into master netting agreements and collateral agreements with its counterparties. These agreements provide the Company with the right to net a counterparty's rights and obligations under the agreement and to liquidate and set-off collateral held by the Company against the net amount owed by the counterparty.
The Company's policy is generally to take possession of securities purchased or borrowed in connection with reverse repurchase agreements and securities borrowed transactions, respectively, and to receive cash and securities delivered under repurchase agreements or securities loaned transactions (with rights of rehypothecation).
The Company also monitors the fair value of the underlying securities as compared with the related receivable or payable, including accrued interest, and requests or posts additional collateral, as provided under the applicable agreement to ensure such transactions are adequately collateralized, or the return of excess collateral.
The risk related to a decline in the market value of collateral pledged or received is managed by setting appropriate marketbased margin requirements. Increases in collateral margin calls on repurchase agreements and securities loaned transactions (collectively, "secured financing payables") due to market value declines may be mitigated by increases in collateral margin calls on reverse repurchase agreements and securities borrowed transactions with similar quality collateral. Additionally, the Company may request lower quality collateral pledged be replaced with higher quality collateral through collateral substitution rights in the underlying agreements.
The Company actively manages its secured financing payables in a manner that reduces the potential refinancing risk of secured financing payables of less liquid assets and also considers the quality of collateral when negotiating collateral eligibility with counterparties. The Company utilizes shorter-term secured financing payables for highly liquid assets and establishes longer tenor limits for less liquid assets, for which funding may be at risk in the event of a market disruption.
#### **Offsetting of Collateralized Transactions**
| | At December 31, 2020 | | | | | | | | |
|-----------------------------------------|----------------------|------------------|--|-------------------|------|-----------------------------|--|---------------------------|----------------|
| | | Gross
Amounts | | Amounts
Offset | | Net
Amounts
Presented | | Amounts
Not
Offset1 | Net
Amounts |
| Assets
Reverse
repurchase | | | | | | | | | |
| agreements | \$ | 8,012 \$ | | | - \$ | 8,012 \$ | | (7,789) \$ | 223 |
| Securities
borrowed | | 761 | | - | | 761 | | (742) | 19 |
| Liabilities
Repurchase
agreements | \$ | 805 \$ | | | - \$ | 805 \$ | | (805) \$ | - |
| Securities
loaned | | 886 \$ | | - | | 886 \$ | | (859) | 27 |
1. Amounts relate to master netting agreements that have been determined by the Company to be legally enforceable in the event of default but where certain other criteria are not met in accordance with applicable offsetting accounting guidance.
For information related to offsetting of derivatives, see Note 5.
#### **Gross Secured Financing Payables by Remaining Contractual Maturity**
| | At December 31, 2020 | | | | | | | | | |
|------------------------------------------------------|----------------------|-----------------------|----|----------------------|---------------|---|-----------------|---|----|-------|
| | | Overnight
and Open | | Less than
30 Days | 30-90
Days | | Over
90 Days | | | Total |
| Repurchase
agreements | \$ | 805 | \$ | - | \$ | - | \$ | - | \$ | 805 |
| Securities
loaned | \$ | 886 | \$ | - | \$ | - | \$ | - | \$ | 886 |
| Total included
in the
offsetting
disclosure | \$ | 1,691 | \$ | - | \$ | - | \$ | - | \$ | 1,691 |
#### **Gross Secured Financing Payables by Class of Collateral Pledged**
| | At December 31, 2020 | | | |
|---------------------------------------------|----------------------|-------|--|--|
| Repurchase agreements | | | | |
| Corporate equities | \$ | 280 | | |
| Corporate and other debt | | 525 | | |
| Total | \$ | 805 | | |
| Securities loaned
Corporate equities | \$ | 749 | | |
| Corporate and other debt | | 132 | | |
| Other sovereign government obligations | | 5 | | |
| Total | \$ | 886 | | |
| Total included in the offsetting disclosure | \$ | 1,691 | | |
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#### **Fair Value of Collateral Received with Right to Sell or Repledge**
| | At December 31, 2020 |
|-------------------------------------------------------|----------------------|
| Collateral received with right to sell or
repledge | \$
21,113 |
| Collateral that was sold or repledged1 | 4,712 |
1. Does not include securities segregated under federal and other regulations or requirements.
The Company receives collateral in the form of securities in connection with reverse repurchase agreements, securities borrowed, and customer margin loans. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to collateralize repurchase agreements, securities loaned, and derivatives, as well as for delivery to counterparties to cover short positions held by customers.
#### **Securities Segregated for Regulatory Purposes**
Securities deposited with clearing organizations or segregated under federal and other regulations or requirements are sourced from reverse repurchase agreements in the Company's consolidated statement of financial condition. At December 31, 2020, the amount of securities segregated was \$5,067.
#### **Customer Margin Lending**
The Company provides margin lending arrangements which allow customers to borrow against the value of qualifying securities. Customer receivables representing margin loans are included within Receivables - Customers in the Company's consolidated statement of financial condition. Under these agreements and transactions, the Company receives collateral, including U.S. Treasury and agency securities, other sovereign government obligations, corporate and other debt, and corporate equities. Margin loans are collateralized by customer-owned securities held by the Company. The Company monitors required margin levels and established credit terms daily and, pursuant to such guidelines, requires customers to deposit additional collateral, or reduce positions, when necessary.
Margin loans are extended on a demand basis and generally are not committed facilities. Factors considered in the review of margin loans are the amount of the loan, the intended purpose, the degree of leverage being employed in the account and the amount of collateral, as well as an overall evaluation of the portfolio to ensure proper diversification or, in the case of concentrated positions, appropriate liquidity of the underlying collateral or potential hedging strategies to reduce risk.
Underlying collateral for margin loans is reviewed with respect to the liquidity of the proposed collateral positions, valuation of securities, historic trading range, volatility analysis and an evaluation of industry concentrations. For these transactions, adherence to the Company's collateral policies significantly limits its credit exposure in the event of a customer default. The Company may request additional margin collateral from customers if appropriate and, if necessary, may sell securities that have not been paid for or purchase securities sold but not delivered from customers. At December 31, 2020, the balance related to customer receivables representing margin loans (net of related customer cash and short sale proceeds) was \$9,616.
# **8. Loans and Related Allowance for Credit Losses**
#### **Employee Loans**
| | At December 31, 2020 |
|------------------------------------------|----------------------|
| Currently employed by the Company1
\$ | 3,100 |
| No longer employed by the Company2 | 140 |
| Employee loans
\$ | 3,240 |
| ACL | (165) |
| Employee loans, net of ACL
\$ | 3,075 |
| Remaining repayment term, weighted | |
| average in years | 5.3 |
1. These loans are predominantly current.
2. These loans are predominantly past due for a period of 90 days or more.
Employee loans are granted in conjunction with a program established primarily to recruit certain Wealth Management representatives, are full recourse and generally require periodic repayments, and are due in full upon termination of employment with the Company. These loans are recorded in Receivables - Employee loans in the consolidated statement of financial condition. The Company establishes the ACL for amounts it does not consider recoverable. The ACL was calculated under the CECL methodology. See Note 2 for a description of the CECL allowance methodology, including credit quality indicators, for employee loans.
# **9. Goodwill and Intangibles**
The Company completed its annual goodwill impairment test as of July 1, 2020. There have been no changes in the carrying amount of the Company's goodwill, which was \$4,609 at December 31, 2020. Adverse market or economic events could result in impairment charges in future periods.
# **10. Borrowings**
Borrowings of \$1,039 at December 31, 2020 primarily consist of unsecured borrowings from the Ultimate Parent, at variable rates and maturing in less than 12 months, as well as cash overdrafts.
#### **Interest on Borrowings**
The interest rates for the borrowings from affiliates are established by the treasury function of the Firm, are periodically reassessed, and are intended to approximate the rate of interest that the Firm incurs in funding its business.
# **11. Subordinated Liabilities**
Subordinated liabilities consist of a \$1,400 subordinated loan agreement with the Parent. The interest rate on the drawn balance of the subordinated loan is calculated daily and paid on a quarterly basis, using the Fed Funds annual rate (published daily) plus 152 basis points. The maturity date, interest rate and book
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value of the outstanding balance at December 31, 2020 are as follows:
| | | Interest | | |
|--------------------------|------------------|----------|------------|-------|
| Subordinated Liabilities | Maturity Date | Rate | Book Value | |
| Subordinated Loan | October 21, 2024 | 1.61% | \$ | 1,400 |
# **12. Commitments, Guarantees and Contingencies**
## **Commitments**
#### *Types of Commitments*
*Central Counterparty*. At December 31, 2020, the Company has outstanding commitments of \$14, with original maturities of five years or more. These commitments relate to the Company's membership in certain clearinghouses and are contingent upon the default of a clearinghouse member or other stress events.
#### **Guarantees**
The Company has obligations under certain guarantee arrangements, including contracts and indemnity agreements that contingently require the Company to make payments to the guaranteed party based on changes in an underlying measure (such as an interest or foreign exchange rate, security or commodity price, an index or the occurrence or non-occurrence of a specified event) related to an asset, liability or equity security of a guaranteed party.
*Derivative Contracts.* Certain derivative contracts meet the accounting definition of a guarantee, including certain written options and contingent forward contracts. At December 31, 2020, the Company has no material derivatives meeting the definition of a guarantee. The Company evaluates collateral requirements for all derivatives, including derivatives that do not meet the accounting definition of a guarantee. For the effects of cash collateral and counterparty netting, see Note 5.
In certain situations, collateral may be held by the Company for those contracts that meet the definition of a guarantee. Generally, the Company sets collateral requirements by counterparty so that the collateral covers various transactions and products and is not allocated specifically to individual contracts. Also, the Company may recover amounts related to the underlying asset delivered to the Company under the derivative contract.
*Indemnities.* The Company provides indemnities to two affiliates, MSBNA and MSPBNA related to services that certain employees and vendors of the Company provide for business activities conducted by these affiliates. MSBNA and MSPBNA have the right to seek indemnification from the Company for losses arising out of the provision of such services by the Company, its employees or its vendors, including for any operational losses caused by human error, failed process management, information technology malfunctions/limitations, fraud, or violations of legal or regulatory requirements. The maximum potential amount of future payment that the Company could be required to make under these indemnities cannot be estimated. The Company has not recorded any contingent liability in its consolidated statement of financial condition for these indemnities.
## **Contingencies**
#### *Legal*
In addition to the matters described below, in the normal course of business, the Company 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 financial services institution. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or are in financial distress. While the Company has identified below a proceeding that the Company believes to be material, individually or collectively, there can be no assurance that additional material losses will not be incurred from claims that have not yet been asserted or are not yet determined to be material.
The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding the Company's business, and involving, among other matters, sales and trading activities, financial products or offerings sold by the Company, and accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief.
The Company contests liability and/or the amount of damages as appropriate in each pending matter. Where available information indicates that it is probable a liability had been incurred at the date of the consolidated statement of financial condition and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income.
In many proceedings and investigations, however, it is inherently difficult to determine whether any loss is probable or even possible, or to estimate the amount of any loss. The Company cannot predict with certainty if, how or when such proceedings or investigations will be resolved or what the eventual settlement, fine, penalty or other relief, if any, may be, particularly for proceedings and investigations where the factual record is being developed or contested or where plaintiffs or government entities seek substantial or indeterminate damages, restitution, disgorgement or penalties. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, determination of issues related to class certification and the calculation of damages or other relief, and by addressing novel or unsettled legal questions relevant to the proceedings or investigations in question, before a loss or additional loss or range of loss or additional range of loss can be reasonably estimated for a proceeding or investigation.
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Subject to the foregoing, and other than the matters referred to in the following paragraphs, the Company believes, based on current knowledge and after consultation with counsel, that the outcome of such proceedings and investigations will not have a material adverse effect on the consolidated financial condition.
On May 27, 2014, the Company was named as a defendant in a civil case styled *Tracy Chen, as an aggrieved employee, v. Morgan Stanley Smith Barney LLC, et al.*, which is pending in Orange County Superior Court in California. Plaintiff seeks civil penalties on behalf of the State of California and all current and former California employees allegedly aggrieved by certain of the Company's policies, pursuant to the California Private Attorney General Act, Cal. Labor Code section 2699 et seq. Plaintiff asserts that the Company's expense reimbursement and final pay policies, and specifically, the Firm's Alternative Flexible Grid program, violate the California Labor Code under various factual and legal theories, including by passing the Company's costs of doing business onto Financial Advisors, and by paying some terminated Financial Advisors outside the statutorily prescribed time period for final wages. On August 31, 2017, the court denied both Plaintiff and the Company's motions for summary judgment regarding the legality of the Alternative Flexible Grid program. Plaintiff seeks per pay period remedies based on the number of impacted employees, attorneys' fees, and enhanced penalties for a "willful" violation, which can potentially include 25% of the amount found to have been unlawfully withheld. The total penalties sought are currently unspecified. On November 21, 2018, the parties in a related federal litigation against the Company *styled Brandon Harvey, individually and on behalf of others similarly situated, v. Morgan Stanley Smith Barney LLC*, pending in the United States District Court for the Northern District of California, reached a settlement in principle. The federal court settlement, if approved, would resolve the representative claims in Plaintiff's action, which has been stayed. On January 23, 2019, Plaintiff filed a motion opposing the settlement and seeking to intervene in the federal action. On March 3, 2020, the federal court entered final approval of the class and settlement and entered judgment dismissing all claims with prejudice. The federal court granted Plaintiff's motion to intervene for the limited purpose of receiving fees and awarded fees to both counsel for *Harvey* and counsel for Plaintiff. On March 23, 2020, Plaintiff filed a notice of appeal of the final approval and judgment to the Ninth Circuit. The appeal is currently pending. Plaintiff also filed a motion to lift the stay in state court, which was denied on August 6, 2020.
# **13. Risk Management**
The Company's risk management policies and related procedures are aligned with those of the Firm. These policies and related procedures are administered on a coordinated global and legal entity basis with consideration given to each subsidiary's, including the Company's, specific capital and regulatory requirements. For the Risk Management discussion which follows, the term "Company" includes the Ultimate Parent and its subsidiaries.
Risk is an inherent part of the Company's business activities. Management believes effective risk management is vital to the success of the Company's business activities. Accordingly, the Company has policies and procedures in place to identify, measure, monitor, advise, challenge and control the principal risks involved in the activities of its business and support functions.
The cornerstone of the Company's risk management philosophy is the pursuit of risk-adjusted returns through prudent risk-taking that protects the Company's capital base and franchise. This is implemented utilizing five key principles: integrity, comprehensiveness, independence, accountability, and transparency. To help ensure the efficacy of risk management, which is an essential component of the Company's reputation, senior management requires thorough and frequent communication and the appropriate escalation of risk matters. The fast-paced, complex, and constantly-evolving nature of global financial markets requires the Company to maintain a risk management culture that is incisive, knowledgeable about specialized products and markets, and subject to ongoing review and enhancement.
# **Risk Limits Framework**
Risk limits and quantitative metrics provide the basis for monitoring risk taking activity and avoiding outsized risk-taking. Risk limits and associated limit frameworks are reviewed on at least an annual basis, with more frequent updates as necessary. Board-level risk limits and approved frameworks address the most important Company-wide aggregations of risk, including, but not limited to credit and liquidity risks. Additional risk limits approved by risk management may address more specific types of risk and are bound by the higher-level Board risk limits.
# **Credit Risk**
Credit risk refers to the risk of loss arising when a borrower, counterparty or issuer does not meet its financial obligations to the Company. Credit Risk includes Country Risk, which is the risk that events in, or affect a foreign country (any country other than the U.S.) might adversely affect the Company. The Company primarily incurs credit risk exposure to institutions and individuals. This risk may arise from a variety of business activities, including, but not limited to, entering into swap or derivative contracts under which counterparties may have obligations to make payments to the Company; extending credit to clients through lending commitments; providing short- or longterm funding that is secured by physical or financial collateral whose value may at times be insufficient to fully cover the loan repayment amount; and posting margin and/or collateral to clearinghouses, clearing agencies, exchanges, banks, securities firms and other financial counterparties; placing funds on deposit at other financial institutions to support our clearing and settlement obligations; and investing or trading in securities and loan pools, whereby the value of these assets may fluctuate based on realized or expected defaults on the underlying obligations or loans. This type of risk requires credit analysis of specific counterparties, both initially and on an ongoing basis. The
{14}------------------------------------------------
Company also incurs credit risk through margin and other customer securities-based lending transactions, which are collateralized by securities.
The Company establishes practices to evaluate, monitor and control credit risk exposure both within and across business activities. The Company is responsible for ensuring timely and transparent communication of material credit risks, ensuring compliance with established limits, approving extensions of credit and escalating of risk concentrations to appropriate senior management. The Company's credit risk exposure is actively managed by credit professionals (and the Business Unit's Risk Management, as appropriate) who monitors risk exposures, including margin loans and credit-sensitive, higher risk transactions.
# **Operational Risk**
Operational risk refers to the risk of loss, or of damage to the Company's reputation, resulting from inadequate or failed processes or systems, from human factors or from external events (*e.g.,* fraud, theft, legal and compliance risks, cyber attacks or damage to physical assets). The Company may incur operational risk across the full scope of its business activities, including revenue-generating activities (*e.g.,* providing financial advice) and support and control groups (*e.g*., information technology and trade processing).
The Company's operational risk framework is established to identify, measure, monitor and control risk. Effective operational risk management is essential to reducing the impact of operational risk incidents and mitigating legal, regulatory and reputational risks. The framework is continually evolving to account for changes in the Company and to respond to the changing regulatory and business environment.
# **Model Risk**
Model risk refers to the potential for adverse consequences from decisions based on incorrect or misused model outputs. Model risk can lead to financial loss, poor business and strategic decision making or damage to the Company's reputation. The risk inherent in a model is a function of the materiality, complexity and uncertainty around inputs and assumptions. Model risk is generated from the use of models impacting financial statements, regulatory filings capital adequacy assessments and the formulation of strategy.
Sound model risk management is an integral part of the Company's Risk Management Framework. MRM is a distinct department in Risk Management responsible for the oversight of model risk. MRM establishes a model risk tolerance in line with the Ultimate Parent's risk appetite. The tolerance is based on an assessment of the materiality of the risk of financial loss or reputational damage due to errors in design, implementation and/or inappropriate use of models. The tolerance is monitored through model-specific and aggregate business-level assessments, which are based upon qualitative and quantitative factors.
A guiding principle for managing model risk is the "effective challenge" of models. The effective challenge of models is defined as critical analysis by objective, informed parties who can identify model limitations and assumptions and drive appropriate changes. MRM provides effective challenge of models, independently validates and approves models for use, annually recertifies models, identifies and tracks remediation plans for model limitations and reports on model risk metrics. The department also oversees the development of controls to support a complete and accurate Firm-wide model inventory.
# **Liquidity Risk**
Liquidity risk refers to the risk that the Company will be unable to finance its operations due to a loss of access to the capital markets or difficulty in liquidating its assets. Liquidity risk also encompasses the Company's ability (or perceived ability) to meet its financial obligations without experiencing significant business disruption or reputational damage that may threaten its viability as a going concern. Generally the Company incurs liquidity and funding risk as a result of its trading, lending, investing and client facilitation activities.
The Company's Liquidity Risk Management Framework is critical to help ensure that the Company maintains sufficient liquidity reserves and durable funding sources to meet the Company's daily obligations and to withstand unanticipated stress events. The Liquidity Risk Department ensures transparency of material liquidity and funding risks, compliance with established risk limits and escalation of risk concentrations to appropriate senior management. To execute these responsibilities, the Liquidity Risk Department establishes limits in line with its risk appetite, identifies and analyzes emerging liquidity and funding risks to ensure such risks are appropriately mitigated, monitors and reports risk exposures against metrics and limits, and reviews the methodologies and assumptions underpinning its Liquidity Stress Tests to ensure sufficient liquidity and funding under a range of adverse scenarios.
# **Concentration Risk**
Substantially all of the collateral held by the Company for reverse repurchase agreements or bonds borrowed, which together represented approximately 25% of the Company's total assets at December 31, 2020, consist of securities issued by the U.S. government, federal agencies or other sovereign governments.
# **14. Employee Stock-Based Compensation Plans**
Eligible current and former employees of the Company and affiliates participate in several of the Ultimate Parent's stockbased compensation plans. The Ultimate Parent determines the fair value of stock-based awards based on the grant-date fair value of its common stock.
# *Restricted Stock Units*
RSUs are subject to vesting over time, generally four years from the date of award, contingent upon continued employment and subject to restrictions on sale, transfer or assignment until
{15}------------------------------------------------
conversion to common stock. All or a portion of an award may be forfeited if employment is terminated before the end of the relevant vesting period or canceled after the relevant vesting period in certain situations. Recipients of RSUs may have voting rights, at the Ultimate Parent's discretion, and generally receive dividend equivalents if the awards vest. The Ultimate Parent determines the fair value of RSUs based on the grant-date fair value of its common stock, measured as the volume-weighted average price on the date of grant. Certain awards provide the Ultimate Parent discretion to claw back or cancel all or a portion of the award under specified circumstances.
## *Performance-based Stock Units*
PSUs will vest and convert to shares of common stock only if the Ultimate Parent satisfies predetermined performance and marketbased conditions over a three-year performance period. The number of PSUs that will vest ranges from 0% to 150% of the target award based on the extent to which the Ultimate Parent achieves the specified performance goals. PSUs have vesting, restriction, forfeiture, and cancellation provisions that are generally similar to those of RSUs. The Ultimate Parent determines the fair value of PSUs with non-market performance conditions based on the grant-date fair value of its common stock, measured as the volume-weighted average price on the date of grant. PSUs that contain market-based conditions are valued using a Monte Carlo valuation model.
# **15. Employee Benefit Plans**
Eligible current and former employees of the Company and affiliates participate in employee benefit plans sponsored by the Parent.
# *Pension Plans*
The pension and postretirement plans, which are recorded on MS&Co. with associated employee costs charged to MSSB, have generally ceased future benefit accruals.
The pension plans generally provide pension benefits that are based on each employee's years of credited service and on compensation levels specified in the plans.
# *Morgan Stanley 401(k) Plan*
The Company's employees meeting certain eligibility requirements may participate in the Morgan Stanley 401(k) Plan sponsored by the Parent. Eligible employees receive discretionary 401(k) matching cash contributions as determined annually by the Firm. In 2020, the Company matched employee contributions up to 4% of eligible 2020 pay, up to the IRS limit. Matching contributions were invested among available funds according to each participant's investment direction on file. Eligible employees with eligible pay less than or equal to one hundred thousand dollars also received a fixed contribution under the 401(k) Plan equal to 2% of eligible 2020 pay. Transition contributions relating to acquired entities or frozen employee benefit plans are allocated to certain eligible employees.
# **16. Income Taxes**
The Company is a single-member limited liability company that is treated as a disregarded entity for federal income tax purposes. As such the Company has a Tax Sharing Agreement with the Ultimate Parent in order to record its related current and deferred federal, state and local taxes. The Company is included in the consolidated federal income tax return filed by the Ultimate Parent. Federal income taxes have generally been provided on a modified separate entity basis. The Company is included in the combined state and local income tax returns with the Ultimate Parent and certain other subsidiaries of the Ultimate Parent. State and local income taxes have been provided on separate entity income at the effective tax rate of the Company's combined filing group.
In accordance with the terms of the Tax Sharing Agreement, current taxes (federal, combined and unitary states) are settled periodically with the Ultimate Parent, who pays these taxes on behalf of the Company.
#### **Deferred Tax Assets and Liabilities**
| | At December 31, 2020 |
|-----------------------------------------------|----------------------|
| Gross deferred tax assets: | |
| Employee compensation and benefit plans | \$
862 |
| ACL and other reserves | 93 |
| Total deferred tax assets | 955 |
| Deferred tax assets valuation allowance | (2) |
| Deferred tax assets after valuation allowance | 953 |
| Gross deferred tax liabilities: | |
| Intangibles and Goodwill | 308 |
| Fixed Assets | 7 |
| Total deferred tax liabilities | 315 |
| Net deferred tax assets | \$
638 |
Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities and are measured using the applicable enacted tax rates and laws that will be in effect when such differences are expected to reverse. The Company's net deferred tax asset is included in Other assets within the consolidated statement of financial condition.
The Company believes the recognized net deferred tax assets (after valuation allowance) of \$638 at December 31, 2020 is more likely than not to be realized based on expectations of future taxable income in the jurisdictions in which it operates.
The Company is subject to the income and indirect tax laws of the U.S., its states and municipalities in which the Company has significant business operations. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. The Company must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes and the expense for indirect taxes and must also make estimates about when certain items affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be settled with the taxing authority upon
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examination or audit. The Company periodically evaluates the likelihood of assessments in each taxing jurisdiction resulting from current and subsequent years' examinations, and unrecognized tax benefits related to potential losses that may arise from tax audits are established in accordance with the relevant accounting guidance. Once established, unrecognized tax benefits are adjusted when there is more information available or when an event occurs requiring a change.
| Rollforward of Unrecognized Tax Benefits | |
|------------------------------------------|--|
| | |
| Balance at December 31, 2019 | \$
21 |
|------------------------------------------------------------------|----------|
| Increase based on tax positions related to the current
period | 3 |
| Increase based on tax positions related to prior periods | 4 |
| Balance at December 31, 2020 | \$
28 |
| Net unrecognized tax benefits1 | \$
22 |
1. Represent ending unrecognized tax benefits adjusted for the impact of the federal benefit of state issues. If recognized, these net benefits would favorably impact the effective tax rate in future periods.
It is reasonably possible that significant changes in the balance of unrecognized tax benefits may occur within the next 12 months. At this time, however, it is not possible to reasonably estimate the expected change to the total amount of unrecognized tax benefits and the impact on the Company's effective tax rate over the next 12 months.
Interest and penalties related to unrecognized tax benefits are recognized as a component of the provision for income taxes. There were no accrued penalties related to unrecognized tax benefits.
#### **Earliest Tax Year Subject to Examination in Major Tax Jurisdictions**
| Jurisdiction | Tax Year |
|-------------------------------------------|----------|
| United States | 2017 |
| New York State and New York City | 2014 |
| New York City Unincorporated Business Tax | 2010 |
The Company, through its inclusion in the return of the Ultimate Parent, is under continuous examination by the IRS and other tax authorities in certain states in which the Company has significant business operations, such as New York.
The Company believes that the resolution of these tax examinations will not have a material effect on the consolidated statement of financial condition, although a resolution could have a material impact in the consolidated statement of income and on the effective tax rate for any period in which such resolutions occurs.
# **17. Regulatory Requirements**
#### **MSSB Regulatory Capital**
MSSB is a registered U.S. broker-dealer and, accordingly, is subject to the minimum net capital requirements of the SEC. Under SEA Rule 15c3-1, MSSB is required to maintain minimum Net Capital, as defined, of the greater of 2% of aggregate debit items arising from customer transactions, plus excess margin collateral on reverse repurchase agreements, or \$1. At December 31, 2020, MSSB's Net Capital was \$2,030, which exceeded the minimum requirement by \$1,842.
#### **MSSB Customer Protection**
As a registered U.S. broker dealer, MSSB is subject to the customer protection provisions under SEA Rule 15c3-3, which requires MSSB to compute a reserve requirement for customers and deposit cash or securities into a special reserve bank account for the exclusive benefit of customers. As of December 31, 2020, MSSB had \$5,260 in the special reserve bank account for the exclusive benefit of customers consisting of \$193 in cash and \$5,067 in qualified U.S. Government securities. These qualified securities are sourced from reverse repurchase agreements in the Company's consolidated statement of financial condition.
As a clearing and carrying broker dealer, MSSB is also required to compute a reserve requirement for PAB under SEA Rule 15c3- 3. As of December 31, 2020, MSSB deposited \$6 in cash in a special bank account for PABs.
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# Glossary of Common Terms and Acronyms
| ACL | Allowance for Credit Losses | MSSB | Morgan Stanley Smith Barney, LLC |
|-----------|------------------------------------------------------------|-----------|--------------------------------------------------------------------------------|
| CECL | Current expected credit losses | MSSBF | Morgan Stanley Smith Barney Financing,
LLC |
| CFTC | Commodity Futures Trading Commission | | |
| FASB | Financial Accounting Standards Board | MSSG | Morgan Stanley Services Group Inc. |
| Fed Funds | Interest rate which banks lend money, usually
overnight | OECD | Organization for Economic Cooperation and
Development |
| | | OTC | Over-the-counter |
| FINRA | The Financial Industry Regulatory Authority | PAB | Proprietary accounts of broker dealers |
| Firm | Ultimate Parent and its consolidated
subsidiaries | PSU | Performance-based stock unit |
| IRS | Internal Revenue Service | RSU | Restricted stock unit |
| LIBOR | London Interbank Offered Rate | SEA | U.S. Securities and Exchange Act |
| MRM | Model Risk Management Department | SEC | U.S. Securities and Exchange Commission |
| MS&Co. | Morgan Stanley & Co. LLC | SIPC | Securities Investor Protection Corporation |
| MSBNA | Morgan Stanley Bank, N.A | U.S. | United States of America, which includes the |
| MSDHI | Morgan Stanley Domestic Holdings, Inc. | | District of Columbia, Puerto Rico, and the
U.S. territories and possessions |
| MSPBNA | Morgan Stanley Private Bank, National
Association | U.S. GAAP | Accounting principles generally accepted in
the United States of America |
Source: SEC EDGAR via Adviser Search (https://search.stillhousedata.com). Agents: see https://search.stillhousedata.com/llms.txt.