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How Safe Is Our Clients' Money?

The recent bankruptcy of MF Global resulting in a reported $1.2 billion of missing client funds has caused many to question the safety of assets held in other brokerage firms. Just how safe is our clients' money?

Helen Modly, 01/12/2012

Prior to filing for bankruptcy on Oct. 31, 2011, MF Global was one of the largest commodities and listed derivatives broker-dealers. They were also a broker-dealer for fixed income, equities, and futures contracts. The actual cause of MF Global's implosion is still being explored by an army of investigators, regulators, and plaintiff's attorneys. It appears to have been a result of a combination of faults including overly aggressive proprietary trading, inadequate risk management, ineffective internal compliance controls, with enough poor timing and plain old bad luck to create a perfect storm for their clients.

The failure of brokerage firms has happened before, the most notable being the Lehman Brothers failure in 2008, but in most cases, a failure does not mean that the firm's customers necessarily lose money. For most brokerage firm clients, there are three levels of safeguards to prevent the loss of client funds.

Prevention: Custody & Capital
In 1972, Congress adopted Rule 15c3-3 to provide regulatory safeguards to clients of broker-dealers regarding the custody and use of client funds and securities. The rule requires broker-dealers to obtain and maintain possession or control of all fully paid (non-margined) client securities and all excess margin securities (securities with a market value in excess of 140% of the client's margin debt). Possession means the security is physically located at the broker-dealer, and control means the security is physically located at one of the approved control locations, such as the Depository Trust Company (DTC).

A second part of this rule also requires broker-dealers to fully segregate all client cash and money obtained from the use of customer property (securities lending) that has not been used to finance transactions of other customers. When clients margin securities, they are in effect borrowing money from the broker-dealer and putting up some or all the securities in their account as collateral.

The broker-dealer is allowed to loan or pledge these margined securities to third parties as a means of financing the margin loan to the client. When the cash proceeds from this activity exceed the amount of the margin loan, the excess must be placed in a segregated reserve account for the exclusive use of the broker-dealer's customers for financing securities purchases. In other words, the broker-dealer cannot use this cash as working capital for its operations. This calculation is done weekly, and the broker-dealer must deposit additional cash immediately if needed. This rule is designed to protect funds needed to repurchase client securities from creditors of the broker-dealer in a bankruptcy.

In 1975, Congress amended an existing securities law to set higher capital requirements for broker-dealers. This rule (15c3-1), focuses on liquidity and is designed to protect securities customers, counterparties, and creditors by requiring that broker-dealers have sufficient liquid resources on hand at all times to satisfy claims promptly, and to provide a cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks if they should be required to liquidate.

Insurance: SIPC
In 1970, Congress created the Securities Investor Protection Corporation (SIPC) to protect customers against the loss of cash and securities in the event of a broker-dealer failure. SIPC will replace missing customer securities up to $500,000 per customer. This figure includes a maximum of $250,000 for claims of missing cash. Note that money market funds are considered securities, not cash.

SIPC does not cover missing commodities futures contracts, precious metals, limited partnerships, or fixed annuity contracts.

Excess Insurance: Varies by Broker-Dealer
Most reputable broker-dealers carry an excess SIPC policy, which will cover additional claims for missing securities or cash in the event of a broker-dealer's insolvency. The primary insurer for this excess coverage is Lloyds of London, which will issue excess coverage of $145 million per customer including up to $900,000 in cash.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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