What Is SIPC Insurance? – Coverage for Your Brokerage AccountPosted on: November 14, 2018, by : promotiondept
What Is SIPC Insurance? – Coverage for Your Brokerage Account
If you have a deposit account at an FDIC member bank, you are probably aware that your funds are protected by FDIC insurance up to the statutory limit of $250,000 per bank. The best-known and most widely available form of deposit insurance available to U.S. consumers, FDIC insurance, provides dollar-for-dollar compensation for insured balances if a member bank fails.
Another type of deposit insurance provides some protection for investors holding cash and certain securities with brokerage firms registered in the United States. Backed by the Securities Investor Protection Corporation (SIPC) and known commonly as SIPC insurance, it serves as a backstop against losses incurred when member brokerages fail. The SIPC’s statutory protection limits are a minimum of $250,000 per brokerage for cash balances and a minimum of $500,000 per brokerage for securities.
The SIPC’s protections are not absolute. Most importantly, the SIPC provides no recourse for investment losses due to market volatility, making it unsuitable as a hedge against risk. The following sections outline what SIPC insurance does cover, along with its origins and limitations.
The SIPC’s roots lie in the changing securities market dynamics of post-World War II America. During this period, brokerage firms found it increasingly difficult to keep pace with demand as millions of new retail investors entered the market and trading volumes grew geometrically.
By the late 1960s, American financial markets were in the midst of what corporate law scholar Egon Guttman termed “the paperwork crunch.” The “crunch” caused record numbers of transaction recording errors. According to Guttman’s 1980 paper “Toward the Uncertificated Security: A Congressional Lead for States to Follow,” New York Stock Exchange member firms lost more than $9 billion as a result of failed equity transactions in December 1968 alone.
As a direct result of the paperwork crunch, “[b]rokers and dealers were finding it difficult, if not impossible, to ascertain their own financial condition,” writes Guttman. An economic downturn exacerbated the situation by depressing trading volumes (albeit from record levels) and pushing down equity prices, which in turn reduced brokers’ commission income. Meanwhile, a fragmented trading environment without a streamlined process for executing and clearing trades raised smaller brokerages’ execution costs to unsustainable levels. More than 100 brokerages failed during the crunch and its aftermath, wiping out thousands of investors in the process.
Many brokerages that went under during the paperwork crunch were already failing due to poor management and record-keeping practices. However, policymakers and industry leaders agreed that some central mechanism was required to coordinate and systematize the processing of securities trades.
This emerging consensus led the U.S. Congress to pass the Securities Exchange Act of 1976, which directed the Securities and Exchange Commission to establish a single trade processing system and end the practice of physically transferring paper certificates between counterparties. The Securities Exchange Act reduced the risk of processing errors and failed trades, paving the way for the vastly increased trading volumes we see today—not to mention automated investing, high-frequency trading, and other modern market innovations.
Congress also felt compelled to address the conditions that allowed untold thousands of individual investors to lose substantial assets held with failed brokerages. Its solution was the Securities Investor Protection Act of 1970 (SIPA), which established a first-of-its-kind investor protection scheme modeled loosely on FDIC deposit insurance.
SIPA established the Securities Investor Protection Corporation as a private, nonprofit corporation funded by assessments on member brokerages. The fund’s initial target balance was set at $150 million, reinforced when needed by a $1 billion line of credit with the U.S. Treasury. Protection was initially set at $50,000 per investor account.
In his signing statement, President Richard Nixon stressed that the SIPC’s constituency was small investors, not big brokerages. The “[SIPC] assures that the widow, the retired couple, the small investor who have invested their life savings in securities will not suffer loss because of an operating failure in the mechanisms of the marketplace,” he said.
In the years since President Nixon signed it into law, the SIPC has directly advanced $2.8 billion and assisted in the recovery or transfer of $138.7 billion in investment assets for more than 773,000 investors, according to the SIPC’s timeline. The SIPC claims that with their help, more than 99% of eligible investors recoup qualifying losses.
Now that we have some context for the SIPC’s genesis and mission, let’s take a closer look at what SIPC insurance does and does not cover.
SIPC insurance protects investors holding eligible cash and securities in accounts at financially troubled member brokerages that are facing liquidation. Account holders can be individuals or corporate entities, and need not be U.S. citizens or permanent residents.
The SIPC keeps a detailed list of covered cash and equity instruments. Generally, the SIPC insures instruments defined as “securities” by the Securities Investor Protection Act. These include, but are not limited to:
SIPC protection applies only to cash and securities held in member brokerage accounts when the liquidation process begins. Cash and securities transferred out of the account before liquidation are not covered by SIPC insurance.
The SIPC’s aggregate insurance coverage limit is $500,000 per member brokerage firm. This figure includes a $250,000 limit on cash coverage.
However, in practice, investors with multiple types of securities accounts often qualify for far more coverage. This is because the SIPC resets its coverage limits for each “separate capacity” claimed by investors with member brokerages. Well-heeled individuals can plausibly claim several separate capacities, boosting aggregate SIPC coverage well into seven-figure territory.
Eligible separate capacities include:
Not all multi-account investors can claim separate capacities. For instance, if you have two individual taxable accounts with the same brokerage firm, the SIPC treats your entire portfolio as a single capacity.
Refer to the SIPC’s Series 100 Rules for more information about separate capacities and consult a financial advisor for advice about maximizing your SIPC coverage.
SIPC insurance does not cover certain financial instruments commonly held in brokerage accounts. These include, but are not necessarily limited to:
SIPC insurance certainly does not protect against losses due to market volatility. Other coverage exclusions include, but are not limited to:
The SIPC also does not intervene in broker-customer disputes outside the liquidation process, even if the dispute is related to financial troubles that subsequently lead to liquidation. Prior to liquidation, investors may lodge complaints with the appropriate regulatory authority—usually the SEC or FINRA.
The SIPC acts on referrals from securities regulators such as the Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA). A regulator may issue such a referral when cash, securities, or both go missing in the wake of a member brokerage firm’s failure, or when the regulator deems that such circumstances may be imminent.
After receiving a referral, the SIPC applies a three-part test to determine whether to intervene:
Having determined that these conditions are met, the SIPC then asks a federal court with jurisdiction over the failed brokerage to appoint a trustee to oversee the firm’s liquidation. The SIPC often serves as the trustee for small and midsize brokerage firms. When larger firms fail, the court generally appoints a seasoned bankruptcy lawyer with securities industry experience. In exceptional cases involving very small brokerage firms, the SIPC may elect not to request the appointment of a trustee and instead deal directly with investors in a direct payment procedure. Moreover, when no cash or securities are missing—and the SIPC is able to find another brokerage willing to assume the distressed firm’s accounts—a transfer may occur with little practical impact and without interrupting account holders’ access to funds.
Since court-supervised liquidation proceedings can take years to resolve, the SIPC advances funds and securities through the court-appointed trustee to cover affected investors’ losses. Such losses are covered up to the coverage limits when assets cannot simply be transferred to a receiving firm. This policy allows investors to recoup covered losses far sooner than would be possible under normal circumstances. As the liquidation process unfolds, the SIPC uses proceeds from the sale of the troubled brokerage’s assets to shore up the deficit produced by the advance.
If liquidation proceeds exceed the SIPC’s statutory obligations to covered investors, the corporation may return those proceeds on a proportional basis. However, investors should not expect to receive any cash or securities above the SIPC’s coverage limits.
SIPC insurance is often lumped together with FDIC insurance, but direct comparisons between these two essential consumer protections elide key details and context. Despite providing real protections to brokerage account customers, SIPC insurance is widely regarded as less comprehensive and secure than FDIC insurance. No one should mistake SIPC insurance’s limited protections for a blanket guarantee against investing risk.
Beyond those already outlined above—such as no protection against investment losses or for certain non-eligible instruments—SIPC insurance has some other limitations worth noting:
SIPC insurance may not apply to securities held in margin accounts. This is because brokers may lend out cash and securities held in margin accounts to third parties, effectively transferring responsibility for those assets to the borrowers, who may then lodge their own claims should the lender fail.
In a particularly egregious example reported by Barron’s in 2015, the president of a small California brokerage used the contents of an elderly client’s margin account to make unsecured loans to an unscrupulous businessperson. Ultimately, more than $4.4 million went missing from the client’s account. Following an investigation, FINRA and the SEC permanently revoked the broker’s license, shuttering the firm. Though the case had yet to be resolved when Barron’s went to press, it was not clear that the SIPC would step in to compensate the client for the missing assets.
In the past, the SIPC has limited compensation to victims of investment scams perpetrated by SIPC-registered broker-dealers.
For instance, per NYT Dealbook, several investors caught up in Bernie Madoff’s massive Ponzi scheme sued the SIPC in 2010 after the corporation ruled that they could claim only cash deposits minus withdrawals, rather than the full amounts reflected in the fraudulent account statements issued by Madoff just before the scheme’s collapse.
Prior to the scheme’s exposure, the plaintiffs withdrew more from Madoff’s fund than they deposited, pocketing the phantom gains manufactured by Madoff to maintain the deception. In an effort to claw back fraudulent gains to compensate later investors who suffered material losses, the SIPC initiated legal action against some of these more fortunate investors.
The Federal Deposit Insurance Corporation (FDIC) underwrites the best-known form of deposit insurance available to U.S. account holders. Deposits held in eligible accounts at FDIC member banks are insured up to a minimum of $250,000 per bank, with higher limits for joint accounts ($500,000) and trust accounts ($250,000 per unique beneficiary, of which there can be many). Account types covered by FDIC insurance include, but are not limited to:
The NCUA Share Insurance Fund is the credit union industry’s answer to FDIC insurance. Operating under the aegis of the National Credit Union Administration since 1970, NCUA Share Insurance Fund coverage is backed by the full faith and credit of the federal government.
Like FDIC insurance, the Share Insurance Fund guarantees qualifying deposits held in member credit union accounts up to $250,000 per individual account, per credit union. Separately, the fund guarantees joint account deposits up to $250,000 per joint account, per credit union. Note that the Share Insurance Fund’s joint account coverage is not as robust as the FDIC’s. Well-heeled depositors should proceed with caution when allocating funds among credit union accounts.
The Depositors Insurance Fund is a privately funded scheme that provides deposit insurance coverage to account holders with Massachusetts-chartered banks.
Popularly known as DIF insurance, the Depositors Insurance Fund effectively supplements FDIC insurance on deposits held in Massachusetts banks. All balances above the FDIC’s $250,000 minimum coverage threshold are guaranteed by DIF insurance, giving the high net worth depositors free reign to disregard the limit. Most accounts covered by FDIC insurance are also covered by DIF insurance.
DIF insurance is a significant factor in the surprising popularity of free checking accounts and other interest-bearing deposit accounts from Massachusetts-based online banks like Bank5 Connect and Salem Five Direct. Account holders are not required to live in Massachusetts to qualify for DIF coverage.
The Securities and Exchange Commission’s Rule 156 requires brokerages to tell investors that past performance is not adequate to predict future performance. In other words, investors must not assume recent changes in a financial instrument’s value will have any bearing on its value at any point in the future.
Investors would do well to apply Rule 156 logic to SIPC protection. That the SIPC has compensated investors for the overwhelming majority of qualifying losses over its half-century of existence is no guarantee that it will remain willing or able to do so in the future. Just as investors are obligated to perform thorough due diligence before investing in new financial instruments, they should carefully consider prospective brokerages’ relative strengths and weaknesses.
Do you have SIPC-protected funds in a brokerage account?
Updated: October 23, 2018
Brian Martucci writes about frugal living, entrepreneurship, and innovative ideas. When he’s not interviewing small business owners or investigating time- and money-saving strategies for Money Crashers readers, he’s probably out exploring a new trail or sampling a novel cuisine. Find him on Twitter @Brian_Martucci.
What Is SIPC Insurance? – Coverage for Your Brokerage Account
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