• / Free eNewsletters & Magazine
  • / My Account
Home>Practice Management>Practice Builder>How Safe Is Our Clients' Money?

Related Content

  1. Videos
  2. Articles
  1. What Does the Merger With NYSE Mean for ICE's Moat?

    Morningstar's Gaston Ceron addresses the short- and long-term prospects for and opportunities in ICE's takeover of NYSE Euronext.

  2. How Enticing Are Munis Today?

    As investors realize the impact of new tax increases, municipals are going to become more valuable--but research is key to finding value and avoiding trouble, says Fidelity's Kevin Ramundo.

  3. Will the Next Municipal Shoe Drop on Bondholders?

    Despite the scare of recent bankruptcies and downgrades, municipalities have the resources to continue making bond payments, while looming tax increases likely won't affect muni demand, says Morningstar's Jeff Westergaard.

  4. Steering Your Bond Portfolio in 2012

    Morningstar's Eric Jacobson comments on 2011's long-term Treasury rally, fund managers' current perspectives on government debt, PIMCO Total Return's current positioning, remaining opportunities in munis, and top considerations for fixed-income investors today.

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.

We contacted several broker-dealers commonly used by advisors and found that TD Ameritrade offers $145 million per customer, including up to $900,000 for missing cash with an aggregate limit of $250 million. Charles Schwab provides the same excess SIPC coverage but has an aggregate claim amount of $600 million. Fidelity Investments provides unlimited coverage for missing client securities with a limit for missing cash of $1.9 million per customer with an aggregate limit of $1 billion. This is the same limit provided by Pershing and Shareholder Services Group, which clears through Pershing.

So, What Happened at MF Global?
First and foremost, MF Global had two business objectives. One was to function as a broker-dealer for its clients. But more important to MF Global was its objective to make money by engaging in very risky proprietary trading strategies for its own accounts.

It appears that losses on their proprietary trading activities caused MF Global's executives to find themselves unable to meet the capital and liquidity requirements of the SEC rules described above, in addition to moneys owed to trading counterparties.

Remember that clients who have margined securities give permission to their broker-dealers to lend or pledge securities equal to 140% of their margin loan to third parties. Many customers of MF Global held margined securities as collateral for commodities futures contracts purchased as hedges for agricultural crop/livestock production. What actually happened to the securities in their accounts is still somewhat unclear, but it seems that some client securities were somehow “borrowed” to meet the trading obligations of MF Global.

Once the SEC became aware of the issues at MF Global, they audited the firm's reserve balances and determined that MF Global had apparently failed to maintain adequate segregated capital reserves to provide for the replacement of these loaned securities and/or failed to obtain and maintain possession or control of client securities. At this point, the brokerage firm was considered failed and filed for bankruptcy.

When these securities went missing, so did the collateral for those derivative contracts, which were then terminated. So while the missing covered securities will be returned due to SIPC protection, the losses on the prematurely terminated futures contracts as well as any missing non-covered securities such as precious metals, commodities, etc., will not be reimbursed. At present SIPC estimates that it will receive 75,000 covered claims from the failure of MF Global.

What's an Advisor to Do?
Choose your custodian carefully and be attentive to any discrepancies in client accounts that cannot be explained. Broker-dealers commonly used by advisors, such as Fidelity, Schwab, TD Ameritrade, and Shareholder Services Group, are different than MF Global in one very important aspect. None of them engages in proprietary trading for its own benefit, thus removing the risk of excessive losses to their capital reserves resulting from a faulty trading strategy or incurred by a rogue trader. Removing this risk removes the desperate incentive to "cover the losses" by any means possible.

While the problems at MF Global are extremely unlikely to be repeated by the types of firms that most advisors utilize, it is a good idea to continually educate clients to follow these best practices:

•    Make sure any brokerage firm they work with is a member of SIPC.
•    Encourage clients to avoid margin accounts unless absolutely necessary to meet their investment objectives.
•    Instruct clients to only make deposits and payments to firms that are registered with FINRA, never to an advisor or registered representative.
•    Tell clients to never use an abbreviated version of the brokerage firm's name; spell out the full name of the brokerage firm on any check.
•    Emphasize that clients must always check their monthly brokerage statements to verify that any transfers or deposits have been recorded accurately and that none of their securities is missing without an appropriate sell or transfer transaction. A cardinal warning sign of trouble is the failure of a brokerage firm to provide a routine client statement.

Susan Frederick, CTP, of Focus Wealth Management, and Karen Keatley, MBA, CFA, CFP, of Keatley Wealth Management, contributed to this article.

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.

©2017 Morningstar Advisor. All right reserved.