Saturday, January 05, 2008

If Your Broker Goes Belly Up: Part II

TWO WEEKS BACK WE TRIED to work out what would happen to readers’ money if their favorite electronic brokerage bit the dust. The issue apparently hit a nerve as our e-mail soon was stuffed with more than 150 entries, some posing more questions about the process and others advising on how to protect against losses—particularly in light of the recent problems with subprime mortgages. Given the interest, we’ve decided to offer more information on the topic.

First, a little context. No brokerages failed in 2007, so readers can take some comfort in the fact that these are pretty rare occurrences.

But when something does happen, the Securities Investor Protection Corp., or SIPC, a nonprofit group funded by the financial-services industry, steps in to help investors get their assets back from failed brokers. This usually happens at small broker-dealers who engage in less-than-legal trading practices and have been caught stealing from their customers. You can view the current list of cases at the SIPC Website’s “Cases” tab,

As we noted ("Are You Covered if Your Broker Fails?” Dec. 17), brokers must carry SIPC-backed insurance. SIPC will attempt to return all of a customer’s stocks, bonds and options. The failed broker’s other assets (including cash or assets like futures, currencies and commodities not covered by SIPC) are then divvied up among clients in proportion to their claims. If that doesn’t cover their losses, SIPC reserve funds are used, up to a $500,000-per-customer ceiling, including as much as $100,000 for claims of cash. Many brokerages also have added coverage.

A key question for a couple-dozen readers was whether money-market funds are considered cash or securities. These funds, which have had a number of problems recently because of their investments in mortgage-related assets, are treated as securities; thus they’re covered by SIPC insurance and any excess SIPC insurance a broker carries should there be a problem.

One investor asked how exchange-traded funds that have underlying investments in commodities such as gold or currencies are treated. SIPC says they’re treated as securities regardless of the underlying investments.

Several Barron’s readers wondered about SIPC coverage that states that “customers of a failed brokerage firm get back all securities (such as stocks and bonds) that are registered in their name.” Their concern was whether the insurance protects securities held in street name; that is, registered to their broker’s name but held on the customer’s behalf.

Josephine Wang, general counsel at SIPC, says that you don’t need to worry about whether your securities are legally held in your name or street name unless you have more than $500,000 at a particular broker. Few investors in today’s rapid trading world go to the trouble of having a certificate generated on their behalf; instead, they allow their brokers to hold securities in their accounts, which are technically the property of the broker or the clearing corporation. Should the broker fail, however, a trustee is named who then uses money advanced by SIPC to purchase the lost securities on a customer’s behalf, regardless of whose name they are in. The securities are then restored to the customer’s account.

If you have a security in your name, you have a negotiable stock certificate with your legal name on it. According to Wang, any certificates registered in the investor’s name are automatically returned to the client, even if they exceed the $500,000 SIPC-coverage limit.

A big reader worry was how long this process takes. Unfortunately, there’s no set answer. Wang says that SIPC’s priority is to take care of customers as quickly as possible. But the timing depends on how quickly the customer files a claim, how well she documents that claim, and the shape of the broker’s books and records. “If the firm’s books are in bad shape, it can take awhile to figure out what belongs to whom, but our priority is to take care of the customers,” says Wang. A perusal of closed cases suggests it can be as little as a few weeks or as much as two or three years.

SIPC, which emphasizes that it is not a federal entity like the Federal Deposit Insurance Corp., which protects bank accounts, publishes a brochure on the subject, entitled “The Investor’s Guide to Brokerage Firm Liquidations: What You Need To Know...And Do.” The brochure is at BD_Liquidations.pdf.

According to SIPC’s Website, it advanced $505 million between 1970 and the end of 2006 to enable the recovery of $15.7 billion in assets for roughly 626,000 investors. SIPC figures that it has replaced the assets of 99% of eligible investors in the failed brokerage-firm cases.

Cautious investors with large accounts say that they split their assets into $500,000 chunks at different brokers. One reader even makes sure that his assets are held by different clearing firms, just to spread his risk.

In order to entice larger accounts to their firms, many brokers offer excess SIPC coverage, which provides additional protection above and beyond the $500,000 SIPC limit. From the early 1970s through about 2004, several insurers such as Travelers provided unlimited supplemental SIPC insurance. Industry insiders assured us that no company ever had to file against these policies. But after watching the dot-com meltdown in 2001, the insurers stopped issuing unlimited policies.

Currently, excess SIPC coverage comes from two sources: Lloyd’s of London policies with caps on total coverage, and Capco, a consortium of brokers who each contribute $5.4 million and fund a reinsurance policy of $240 million for all firms.

Says Interactive Brokers’ Executive Vice President Steve Sanders: “Given this limited supplemental protection, I would highly suggest that all customers look at the [broker’s] S&P rating, years in business, capitalization and the market cap of the firm doing the clearing for their account. There is just no substitute for doing this homework.”

When Barron’s publishes its next survey rating online brokers, we’ll gather some of this information for you.

Published in Barron’s, December 31, 2007. 

Posted by twcarey on 01/05 at 10:36 AM
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