What Happens if My Broker Goes Bust?

Question: I know that the FDIC insures the funds in my bank account, but what about funds in my brokerage account? What would happen to them if my brokerage went bankrupt?

Answer: Although many people are familiar with the Federal Deposit Insurance Corporation, or FDIC, the government-established agency that insures bank deposits, far fewer are familiar with the Securities Investor Protection Corporation, or SIPC. SIPC is another government-created agency that helps ensure that investors aren't left out in the cold when a brokerage goes out of business and investor assets are missing.

These situations, while rare, do happen, as customers of MF Global are painfully aware. The New York-based brokerage declared bankruptcy last October after dipping into customer accounts to the tune of hundreds of millions of dollars in order to help cover its own bad bets on European sovereign debt. In cases such as this, SIPC steps in to try to make sure customers of the failed firm receive the assets they are owed.

Compensating Customers
When a brokerage fails and owes its customers cash and/or securities,  SIPC typically asks the court to appoint a trustee to liquidate the firm's assets and compensate customers. Customers might be asked to file claims on assets held with the company, which are matched against company records to determine payments. Customer accounts also may be transferred to other brokers.

If there is a shortfall in funds available to repay customers after liquidation, SIPC provides money to fill the gap. Each legally distinct investment account is covered up to $500,000, including up to $250,000 in cash. That means that if you have an individual taxable account, a joint account with your spouse, and a retirement account, each is eligible for half a million dollars in coverage, or up to $1.5 million total for those three accounts. Some brokerages also purchase supplemental coverage via private insurance companies such as Lloyd's of London. This allows these brokerages to offer coverage limits in excess of those available through SIPC. If you have an account worth more than $500,000, check with your brokerage to see what additional protections it offers. SIPC coverage applies to stocks, bonds, funds, and other investments but generally not to more exotic fare such as commodities futures contracts, currencies, and investments in hedge funds.

SIPC does not offer protection against investment fraud, such as a scam in which a broker invests assets in securities that are later found not to exist. SIPC also does not offer protection against market fluctuations. Only missing assets are covered.

In addition, only customers at brokerages that are SIPC members are eligible for protection, but according to Stephen Harbeck, president and CEO of SIPC, "virtually all" brokerages are members. At the end of 2010, the SIPC had more than 4,700 members, including some of the biggest investment firms, such as Vanguard, T. Rowe Price, and Fidelity. Member firms pay a small percentage (one fourth of 1%) of net operating revenue in annual dues.

According to its annual report, SIPC has paid out $1.08 billion to compensate customers with missing brokerage assets in the four decades since it was created-half of that in 2009 alone. The agency has helped 625,000 customers retrieve assets since its inception. At the end of 2010, the agency reported assets of $1.18 billion in its reserve fund.

No Protection Against Market Losses
Although many people think SIPC and the FDIC operate the same way, this is not the case. One important distinction pertains to the value of assets covered. While FDIC insurance preserves the value of assets in a bank account, SIPC offers no protection against market losses. If customer assets are missing when a brokerage goes under, SIPC will replace the number of shares in the account, regardless of whether they have increased or decreased in value.

Because customers of liquidated brokerages are often required to present evidence of their holdings, good record-keeping is essential and a good habit to develop. This means keeping copies of trade confirmations and your latest account statements, either in hard-copy or electronic format. You can find a checklist of steps to take to minimize your chances of being stuck with a financially troubled brokerage by clicking here.

To make sure your brokerage offers SIPC protection, check its website or search the SIPC member database here. Also, make sure the clearing firm--the company that processes trades for the broker--is a member, as well. (The name of the clearing firm should be on your brokerage statement.) Even if your brokerage remains solvent, if its clearing firm encounters financial difficulties, customer assets could be put at risk. Firms that are not members of SIPC are legally obligated to let you know this.

You might think twice about investing in a bank that was not FDIC-insured, yet few people take the time to make sure their investment holdings are covered in case their broker fails. Taking a few minutes to make sure it is a member of SIPC, and to learn what additional insurance it may carry, is one small way to provide long-term peace of mind.

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