Brahmins at the Gate
When Morgan Stanley choked on its own merger, the ugliest civil war in recent Wall Street history broke out. Now the old guard is on the march. A dispatch from behind the lines.

(FORTUNE Magazine) – At Morgan Stanley they have a nickname for the floor of the Midtown Manhattan skyscraper where investment bankers are given offices when they retire: Jurassic Park. It used to fit pretty well. This was a place where you could catch a glimpse of the dinosaurs who once stood atop the Wall Street food chain, men like S. Parker Gilbert, whose stepfather co-founded the firm in 1935, and Anson Beard Jr., who built its sales and trading operation into a legendary moneymaking machine.

Today, of course, the nickname fits even better. As in the novel and the movie, the dinosaurs have broken loose, they are making lots of noise, and they are out for blood. Dismayed by the firm's falling stock price and alarmed by an exodus of top talent, eight retired Morgan Stanley bankers are pressing a public campaign to oust CEO Philip Purcell. It's the kind of open warfare rarely seen on Wall Street--mainly a battle about alleged mismanagement, but clearly a personal fight too.

At its heart is one autocratic manager, Purcell, and two corporate cultures, those of Morgan Stanley and Dean Witter, which merged in 1997. Purcell came from Dean Witter, the prosaic retail brokerage. His opponents hail from Morgan Stanley, the white-shoe firm whose bankers regard themselves as Wall Street's elite.

The merger was supposed to produce a financial-services powerhouse with a wide spectrum of products, and during the bull market it seemed to be working (what didn't?). But beneath the surface the two sides didn't try very hard to conceal their mutual scorn. "We could always spot the Dean Witter guys," says a former Morgan banker. "All we had to do was go up to the gym. They were the ones who walked on the treadmills." Counters a recently departed Dean Witter executive: "They treated us like we were the Clampetts. We would have meetings with them, and they would ask to present first and then just leave. They wouldn't stay for us. Maybe they had somewhere to go."

It is a story that drips with irony: Here is a union engineered by some of the world's foremost experts in the art of mergers and acquisitions. They have made huge personal fortunes putting companies together, collecting their fees, and then walking away. But this time they must live with the combination they have created. And FORTUNE's conversations with current and former bankers--including an extended sit-down with six of the eight dissidents--combined with analyses of financial statements from both sides, reveal a merger that's nothing short of toxic.

Purcell, 61, declined to be interviewed. As this issue went to press, he still had his job as CEO. And who knows? He may keep it for a long time: His detractors say that he has packed the board (see chart) and that he picks key executives on the basis of loyalty rather than ability. On the other hand, top talent keeps departing the firm on a nearly daily basis--in mid-April the fabled investment banker Joe Perella walked away. The online trading site (the one that proved so much more accurate than polls in predicting the outcome of the presidential election) has a futures contract on the likelihood of Purcell's departure. Buyers of the contract are betting there's a 25% chance he'll be gone by June 30.

A senior investment banker at a rival firm puts the mess into context this way: "What do you really have here? A CEO who isn't terribly popular, who gets rid of any executive who isn't loyal to him. He packs the board with his pals, and the company's stock performance is mediocre. So what? That's like most companies on the S&P 500."

When that assessment is relayed to six of the Morgan Stanley dissidents gathered in a Park Avenue conference room, they grimace. "This used to be a first-class operation," says Robert Scott, 59, Morgan Stanley's former president and the group's choice to replace Purcell. "Now, what you have is congealed mediocrity. There is no such thing as equilibrium in our business. No one comes to work to be mediocre. That's why employees are leaving."

The dissidents--Wall Street has taken to calling them the G8--together own only 1% of Morgan Stanley's stock, but their power exceeds that small slice. They have some 200 years of collective experience at Morgan, many hundreds of millions of dollars of personal wealth, and overstuffed Rolodexes. Though retired from day-to-day operations, most if not all are advisory directors. "We aren't doing this for money," says Gilbert. "We simply won't stand idly by and watch our franchise be torn apart for reasons that are clear. It's a question of leadership."

That may be, but at root this is a war of numbers--competing claims about Morgan Stanley's performance--and in the hands of rival investment bankers, numbers are always slippery. The starting point for the G8's complaint is that over the past five years, Morgan Stanley's stock price has sunk 28%, drastically underperforming its peers and the S&P 500. But use a different time frame and--surprise--you get a different picture. Purcell's camp at the firm notes that Morgan Stanley's stock has returned 248% since the merger, behind only Bear Stearns and Lehman Brothers. They also say that after the bust of 2000, Morgan had further to fall than rivals because it had climbed so high with technology deals: Its stock sold for almost seven times book value at the height of the bubble, nearly two multiples higher than Goldman Sachs's stock has ever achieved.

Even starker is the difference in how the two sides value the businesses that make up Morgan Stanley today. On an April 6 conference call that the G8 held for investors, the group complained that Dean Witter simply hadn't kept up. Scott noted that this was supposedly a merger of equals, meaning that Morgan Stanley and Dean Witter were worth roughly the same amount. He cited a recent analyst's report that said the old Morgan Stanley is worth $45 billion today. If Dean Witter had kept up, then the combined company should be worth $90 billion. It was worth only $60 billion on that day. "What happened to the $30 billion?" Scott asked. Add to that $45 billion valuation for the old Morgan Stanley the $14 billion that Scott says the Discover credit card business will fetch in a spinoff, and you get to $59 billion--just shy of the market capitalization of the combined company on the day of the call. That implies that the individual investor and asset-management businesses were worth next to nothing. Yet Purcell claimed recently that his Dean Witter business was worth $35 billion--which would mean that the old Morgan Stanley business was worth just $25 billion. Who's right?

Valuations are notoriously tricky, but other numbers leave little doubt that Morgan Stanley has failed to meet the promises made at the time of the merger and that its performance has been, to use the G8's word, mediocre. The merger was supposed to integrate Morgan Stanley's investment-banking franchise with Dean Witter's huge retail sales force to create a great white Wall Street shark. (This is a "lousy day for Merrill Lynch," Purcell reportedly said at the time of the merger.)

One of the promises of the merger was that the new firm could sell mutual funds and stock offerings, mostly from the old Morgan Stanley side, to retail-brokerage customers, mostly on the Dean Witter side. Sounds like a great idea, but making such a system work can entail some greasing of the wheels: The best way to encourage a broker to sell a specific mutual fund is to compensate him for selling it. That, however, is illegal, since it violates the fiduciary duty of the broker to put the financial interest of the client first in any transaction. After the wave of Wall Street scandals, the preferential selling of in-house funds by brokers is now being actively prosecuted.

Another promise was that Dean Witter's supposedly more predictable retail business could stabilize Morgan Stanley's volatile earnings during market cycles. It has not worked out that way. According to analyst Richard Bove of Punk Ziegel & Co., from 2000 to 2004, Morgan Stanley's revenues fell 9% while its peer group posted a gain, and its net income fell 18% vs. gains at Goldman Sachs, Bear Stearns, Lehman Brothers, and Merrill Lynch. Thought about another way, in 2000, Morgan Stanley, which posted net income of $5.5 billion, dwarfed rival Goldman Sachs, which had net income of $3.1 billion. In 2004, Goldman earned slightly more than Morgan Stanley.

You can see why when you dig into the details. The best thing Purcell's team can say about the individual-investor business is that it's No. 3 behind Merrill and Citi. Over the past five years total client assets, revenues, and pretax profits have all declined. Morgan Stanley's brokers are far less productive than their peers: According to a presentation by Greenhill, the banking firm for the G8, the average revenue per broker at Morgan was $431,000 in 2004, vs. $697,000 at Merrill.

The asset-management business has also been mediocre. The Purcell team points with pride to the fact that 48% of Morgan Stanley's mutual funds have four- or five-star rankings from Morningstar. The Greenhill team points with scorn to the same statistic, noting that it places Morgan in the bottom third of its peer group. Another Morgan Stanley critic, hedge-fund manager Scott Sipprelle, notes that inflows into Morgan's funds have lagged the industry for five of the past six years; revenues and pretax profits have also declined by an average of 1.2% and 7.1% per year, respectively, over the past five years. Morgan Stanley points out that both businesses have improved over the past 12 months.

The bulk of the firm's business, accounting for over 60% of pretax profits, is institutional securities--that is, the investment-banking and trading businesses that were the old Morgan Stanley. Here Morgan Stanley still has a strong market share in many businesses, but some see signs of deterioration. Take mergers and acquisitions, the heart of an investment-banking franchise. Back in 1997, Goldman's revenues from M&A were 30% higher than Morgan Stanley's. Today they are 50% higher. And morale is not good. "There was a greater sense that we were losing ground than the numbers would show," says a former Morgan Stanley banker.

Investment banks are always hothouses of intrigue, but in the eight years since the merger, the bad buzz emanating from the house of Morgan has been louder than the norm. A bitter and fractious war between Purcell and former COO John Mack (from the Morgan Stanley side) led to Mack's departure in 2001. As 2004 drew to a close and the stock still lagged the likes of Goldman Sachs, Merrill Lynch, Bear Stearns, and Lehman Brothers, discontent with management grew. On Dec. 9, Sipprelle, who heads hedge fund Copper Arch, a Morgan Stanley shareholder, fired off a letter to the board. In it he urged Morgan Stanley's directors to return the company to its investment-banking core by divesting the Discover credit card business, the investment-management business, and the brokerage business. He warned board members that if they didn't address his concerns, he would oppose their reelection. The board never responded, and on Jan. 5 Sipprelle went public with his letter.

And then Purcell began to do what some say he does best: maneuver on the corporate game board. Days after the directors received Sipprelle's letter, the CEO tapped an old acquaintance, Ed Brennan, the former CEO of Sears, to come out of retirement and rejoin Morgan Stanley's board--even though the company's age limit for directors is 70 and Brennan was about to hit 71. The two men were allies. Brennan had served on Dean Witter's board and then on the board of the merged company until 2003. Purcell had founded the Discover credit card business while working for Brennan at Sears, before Discover and Dean Witter were spun off in 1993. "When Ed Brennan came back onto the board, you knew Phil had to have some problems," says a Wall Street CEO.

Watching all this with dismay were Gilbert, Scott, and the other advisory directors. On March 3 they wrote the board seeking a private meeting and expressing the fear that Purcell would fire executives perceived as insufficiently loyal. Shortly after Easter Sunday, Vikram Pandit, head of institutional securities; John Havens, head of institutional equities; and president Stephan Newhouse--all highly regarded on Wall Street but not perceived as Purcell allies--were pushed aside. Their responsibilities were given to two other Morgan Stanley executives, Stephen Crawford and Zoe Cruz, who were made co-presidents and named to the company's board. Pandit, Havens, and Newhouse left the company.

Pandit's departure was especially shocking to Morgan Stanley veterans, as he had been seen as a candidate to run the company one day. It prompted Dan Strickler, a genteel former Morgan banker and owner of 3.8 million shares, to pen a scathing letter to the board. "Replace Purcell now," Strickler wrote. "He is a failed CEO."

The cultural gulf between Morgan Stanley and Dean Witter has been there from the start, if not visible to the public. In photos taken at the merger press conference, Morgan COO John Mack, Morgan CEO Dick Fisher, and Purcell are all holding Discover cards. But Fisher is holding his Discover card with his finger over the name. Why? Because it wasn't his card--he didn't have one. It was Mack's wife's card. After all, what use would the CEO of Morgan Stanley have for a downscale Discover card?

The businesses of the old Morgan Stanley--such as securities underwriting, mergers and acquisitions, and trading--are based to a great extent on key personal relationships. Lose a top banker or a big banking client and millions of dollars of revenue walk out the door. Though Dean Witter has thousands of brokers who have personal relationships with customers, both the broker and the customer are replaceable because they are much smaller pieces of the revenue pie. "The issue Phil has had with the securities business is that he thinks you can make a real business out of it," says an informed source, meaning that he's trying to make investment banking dependent not on individuals but on a brand. That's a little like thinking you can bring rational business practices to a Major League Baseball franchise. One former Morgan executive says he heard Purcell complain, "At Dean Witter, I tell people to turn left, and they turn left. At Morgan Stanley, they look at me and ask why."

There is a broader cultural question too. Many of the Morgan Stanley people are Ivy Leaguers, and Purcell is a Notre Dame grad from Chicago. Yet Purcell, the stockbroker guy, has consistently outmaneuvered the boys from the Yale Club. A former Morgan banker puts it best: Morgan Stanley is a "bunch of white-shoe guys who, to my amazement, have completely gotten their pants pulled down by Phil Purcell."

But many investment bankers say that Purcell wins by playing unfairly. As an example, sources point to the case of Peter Karches, the outspoken former head of institutional securities at Morgan Stanley. In 2000, Purcell became disenchanted with Karches and wanted him out of the firm. At that point Karches was representing Morgan Stanley at meetings with other investment banks about a cooperative bond-trading system. Purcell told a senior Morgan Stanley executive that Karches had to go. The reason, Purcell said, was that he had received calls from then--Merrill Lynch CEO Dave Komansky and Goldman Sachs CEO Hank Paulson requesting that Karches no longer attend the bond meetings, as he was impeding the group's work. In August 2000, Karches left Morgan Stanley. Later, when Paulson and Komansky were asked if they had called Purcell to bar Karches from the meetings, both said they had no recollection of doing so.

Purcell's critics also blame him for the way Morgan Stanley's reputation has been tarnished during his tenure. In recent years the firm has suffered public rebukes from, among others, the SEC, the NASD, the EEOC, and the NYSE. Lately the damning headlines have been about financier Ron Perelman's lawsuit (see box). "This company is continually being fined, sued, and setting up reserves for problems," wrote analyst Richard Bove in a recent report. "This ... suggests sloppy management and a weak corporate culture." To many people, the blame lies with Morgan Stanley's legal department, which Sipprelle has called "a serial destroyer of shareholder value."

The headlines are taking a toll. "Phil needs to go because he's not making people feel proud to work at Morgan Stanley," says a former managing director. "People feel almost ashamed. When you work at Morgan Stanley, you expect to pick up the paper and read about an important transaction that Morgan was involved in. You don't expect to read about a steak-a-thon." (Morgan has just gotten slapped on the wrist by regulators for offering steaks to brokers who pushed in-house products.)

"This is like People magazine for Wall Street," says a senior executive at a rival firm, describing the Morgan Stanley story. "It's Peyton Place," says a hedge-fund manager. A former Morgan Stanley executive calls it "a holy war."

It is, without a doubt, a spectacle. But there's no guarantee that the dissidents will be able to make anything substantial happen. Their plans to find what Scott calls "the missing $30 billion" are uncomfortably vague. And Purcell backers note that Scott himself had a chance to fix some of the very problems to which he is now calling attention when he ran the individual-investor and Discover businesses between 2001 and 2003.

The biggest obstacle to change is Morgan Stanley's board. Many of the directors have ties to Purcell from McKinsey, Sears, Chicago, or even Augusta National. While Dean Witter executives who wrote a letter in support of Purcell described the board as a "model of corporate governance," the Corporate Library, a shareholder governance watchdog group, gives Morgan's board a D. To date, the directors are united in their support for their CEO. "We have full confidence in Phil Purcell," they wrote in an April 13 letter--in which they also accused the G8 of "ill-considered, professionally directed attacks on Morgan Stanley and our people," that "are damaging the firm and our shareholders." In that letter they did something many observers found shocking: They printed the home addresses of the G8 members.

The level of open vitriol between the board and the G8 is unprecedented at a firm that once prided itself on discretion. The G8 simply cannot believe that Morgan's board will not even deign to meet with them. They are stunned that in the face of growing criticism, three new directors--Brennan, Cruz, and Crawford--have been appointed, all of whom they call friends or associates of Purcell. In the call with institutional investors, Scott said that the "board's response has evolved from 'just say no' to 'over my dead body.'" Since ousting Purcell requires the approval of 75% of the directors, the bet is that it won't happen soon. And as the G8 members are well aware, time may prove to be their enemy because they will cease to make news. "We're grownups and we're sophisticated people," says Gilbert. "We know we can't keep this level of intensity up indefinitely."

But if the bitter fruits of this merger continue to spoil--if Morgan Stanley's legal situation gets worse, if the defections mount, if the stock continues to decline--things could change very quickly. As the dissidents' advisor Bob Greenhill told them, the board "will show complete solidarity until they don't."