When Brokers Fail

Phil Dawson

A RECENT ARTICLE by HumbleDollar’s fearless editor got me thinking about the potential risk of having most or all of my investments with a single brokerage firm or fund company. What happens if the company collapses? I was surprised at how little I knew about these matters after investing for nearly 30 years.

The Securities Investor Protection Act of 1970 was passed by Congress in response to some turbulence in the markets that caused a number of brokerage firms to fail. The law created the nonprofit Securities Investor Protection Corp., or SIPC. The SEC requires effectively all U.S. brokerage firms to be members. SIPC has the narrowly-defined task of assuring the return of investors’ securities and cash in the event of a member firm’s closure or bankruptcy. It does not protect against market losses.

If you invest with an SIPC member broker, and that broker is liquidated by SIPC, and some of your assets come up missing, SIPC will restore the missing assets from your account up to $500,000, unless it’s cash investments, in which case coverage is capped at $250,000. This coverage applies after any assets are recovered during the company’s liquidation, so potentially you’ll be made whole, even if you have far more than $500,000 at a brokerage firm that fails.

The liquidation process involves the appointment of a trustee for the broker, who tries to quickly determine the status of customer assets. If the assets are properly accounted for, the trustee may simply transfer the assets to another broker, after which customer control of the assets resumes.

SIPC coverage of multiple accounts with a single owner is determined by what is called “separate capacity,” so total coverage may exceed the $500,000 threshold. A detailed explanation of capacity can be found here.

In theory, the need for SIPC coverage is vanishingly small, because the SEC forbids the comingling of broker assets and investor assets. Thus, even if a broker goes—ahem—broke, investor assets should remain in trust. Only when the failing firm has caused a loss of investor assets is SIPC protection invoked. If your losses exceed the coverage offered by SIPC, there may be additional coverage through a private insurer, assuming the broker had elected to purchase it.

Historically, it’s very rare for losses to exceed the coverage limit. But in 2018, SIPC was still cleaning up the carnage involved with names like Lehman and Madoff. Still, most cases are settled within three months. You aren’t covered for market losses that occur while things are being sorted out.

How can you minimize the risk of loss stemming from your broker’s financial condition? Six action items come to mind:

  1. Determine your broker’s membership in SIPC here. Use caution, as some well-known investment firms hold assets in distinct business entities. For example, assets held with Vanguard Brokerage Services are protected by SIPC, but funds held by The Vanguard Group, Inc. are not.
  2. Make sure you’re receiving transaction confirmations and statements regularly. Review them for accuracy. The sooner you respond to a mistake, the easier it is to fix. This might seem like it hardly needs to be said. But I—for one—am guilty of throwing most correspondence into a pile or folder, without ever reviewing it.
  3. If you find a suspected error in any related correspondence, immediately notify your brokerage firm in writing. If you fail to do this, your SIPC protection may be limited.
  4. Similarly, notify your brokerage firm in writing if you do not receive an expected statement or confirmation.
  5. Keep copies of all correspondence with your brokerage firm. You’ll need to provide reasonable proof of your loss during liquidation.
  6. Pray to all that is holy that you never need any of the preceding information.

When not paddling, biking or shooting, Phil Dawson provides technical services for a global auto manufacturer. He, his sweetheart Donna and their four extraordinary daughters live in and around Jarrettsville, Maryland. His previous articles include Financially FitFighting for Peace and Taking Care. You can contact Phil via LinkedIn.

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