Financial Advice for Retirement, Social Security, IRAs and Estate Planning

What If Your Broker Goes Broke

Last update on: Nov 10 2017
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Investors suddenly are concerned about something they haven’t considered for years: That their securities broker might go out of business.

The credit and mortgage crises revealed that some brokers are more exposed to subprime mortgages than their customers realized. Merrill Lynch was a big player and took substantial write downs of its assets. E*Trade has a mortgage subsidiary that suffered significant losses. There were rumors that E*Trade’s existence was in doubt until it received a $2.5 billion investment from hedge fund Citadel Investments last Fall.

The question we have received from some readers is: What happens to a customer’s account when a broker fails?

Bank accounts have the Federal Deposit Insurance Corporation, a federal government entity that guarantees the safety of accounts up to a ceiling amount. For brokerage accounts there is the Securities Investor Protection Corporation (SIPC), a nonprofit group founded by financial services firms, not the government. Brokers technically own the assets in customer accounts; they are listed in the name of the broker not the customer. SIPC’s job is to help return the assets to investors.

Brokers are required to insure accounts with SIPC. If a broker fails, SIPC first attempts to return all stocks, bonds, and options to the customers for whose accounts they were purchased. The trustee put in charge of overseeing the broker’s assets is given cash from SIPC to buy these covered assets from the broker and give them to the customers. Then, the broker’s cash, futures, currencies, commodities and other noncovered assets are divided pro rata among customers who bought those assets.

Beyond that, SIPC covers losses up to $500,000 per customer with a $100,000 ceiling for cash. Many brokers purchase from private insurers coverage above these limits. Money markets funds are considered securities, not cash. Exchange-traded funds are securities, regardless of their underlying assets. Securities that are registered in a customer’s name are returned to the customer regardless of any coverage limits.

Time can be a factor. Assets and customer accounts are frozen until the trustee and SIPC can sort things out and return assets to customers. The process takes anywhere from weeks to years, depending on the condition of the broker’s and the customer’s records.

Customers who want to maximize protection should consider not holding more than $500,000 of assets at more than one broker. Alternatives are to check the excess insurance of a broker and who issues that insurance. Other goods steps are to check a broker’s rating from S&P and other rating agencies, and its capitalization and market cap. A review of the extent of a broker’s business for potential bombs such as subprime mortgages also is a good idea. Another concern is the firm that does trading for the broker, known as a clearing firm. This firm might be holding many of the securities in its name, and its failure would delay a customer’s access to the assets.

More information about the insurance and recovery process is available at www.sipc.org, including a brochure on brokerage firm liquidations.

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