A provision in a standard arbitration agreement signed by every

Morgan Stanley

(MWD)

customer is giving the Wall Street brokerage a big legal headache.

The provision, which requires all customer disputes to be decided under New York law, is under attack by regulators in two states. The regulators contend the provision is unenforceable because it denies Morgan Stanley customers the right to argue that a dispute should be decided under their own state's securities laws.

Morgan Stanley's arbitration agreement is under fire in New Hampshire and Idaho, states that often aren't seen as trailblazers on the securities regulatory front. But critics say the legal challenges could spark others to join the fray and open the door for Morgan Stanley customers to pursue their claims in state court rather than in arbitration.

Most brokerages insist that arbitration, in which a nongovernmental panel of experts decides disputes without the recourse of appeal, be the forum for settling customer complaints. While the panels are nominally impartial, observers say the arrangement can stack the deck in favor of the firms because disputes often end up being decided by former securities industry insiders.

Morgan Stanley takes things a step further, requiring that cases be arbitrated under New York law, which is seen as friendly to Wall Street.

The brokerages' problems began this summer when New Hampshire securities regulators issued an administrative order directing Morgan Stanley to remove the New York law provision from its arbitration agreement. The order said the provision "is not binding'' on the state's residents.

A New Hampshire spokesman says regulators and Morgan Stanley are trying to negotiate a resolution.

The controversy, however, moved west in November when Idaho officials got permission to file a so-called friend-of-the-court brief in a pending lawsuit involving a Morgan Stanley customer. Morgan Stanley contends the dispute should be resolved in arbitration, not in state court as is required by the terms of the customer's brokerage agreement.

But regulators in the Idaho Department of Finance are siding with the customer. The regulators argue that an Idaho court is the appropriate place to air the dispute since Morgan Stanley's arbitration clause is "illegal and unenforceable.''

Idaho officials say they aren't prepared to comment on the litigation, until they file their brief sometime in the next few weeks. William Batt, an attorney for the customer, says Idaho regulators strongly object to the provision that forces residents "to waive their Idaho statutory rights.''

It's not clear why the Morgan Stanley arbitration agreement has become such a hot-button issue now. The New York law provision has been part of Morgan Stanley's arbitration agreement for years.

In court papers in the Idaho case, Morgan Stanley argues the New York law provision is irrelevant, since the brokerage's lawyers rarely make an issue of it during arbitration proceedings. A Morgan Stanley spokesman made a similar point in commenting on the litigation.

"We have assured Idaho regulators that we will not seek to limit remedies in the arbitration that may be pursued under Idaho law in this case,'' says Morgan Stanley spokeswoman Andrea Slattery.

But critics point out that since arbitration is a private proceeding, it's difficult to document Morgan Stanley's claim that it rarely enforces the New York law provision. Arbitration panels also aren't required to put their decisions in writing and the courts are reluctant to overturn an arbitration ruling.

The regulatory dispute, however, could have ramifications for Morgan Stanley, especially if other states jump on the bandwagon. If more states find the arbitration clause is invalid, it could open the door for angry Morgan Stanley customers to take their claims to state court rather than arbitration.

"They have a potential legal loophole," says Jonathan Kord Lagemann, another attorney representing the Idaho customer. "And they have millions of customers."

One option is for Morgan Stanley to amend its arbitration agreement and remove the controversial provision. However, lawyers say such a move likely would not have any impact on existing customer claims against the brokerage.