What Happens When A Stock Broker Goes Bust?

Online stockbroker firms have opened up the world of investing to anyone with a relatively small amount of money, a computer and an Internet connection. These firms provide their clients with accounts and buy and sell investment products such as stocks, mutual funds, bonds, ETFs, futures and certificates of deposit (CDs) on their clients' behalf. Active investors who want to grow their money may have a large portion of their total liquid assets in the form of cash and securities in such an account. While a bank account is insured, what happens to cash and investments that are tied up with a stockbroker who goes bust? 

Although history does not contain too many examples of brokerage firms imploding, it does happen. This article explains the basic protections for investors and what to expect if a broker goes out of business. (Related reading: How To Choose The Right Online Trading Broker)

A multi-tier safeguard system is in place to protect investor assets. Protection is in the form of rules with which brokerage firms must comply. The rules help minimize the likelihood of a total brokerage collapse and help shield clients should a brokerage fail. Rule 15c3-1, "Net Capital Rule" of the U.S. Securities and Exchange Commission (SEC), makes it mandatory for brokerages to maintain a minimum amount of prescribed capital in liquid form. Rule 15c3-3, “Customer Protection Rule,” requires brokerage firms to keep client assets (both cash and securities) in a separate account from the firm’s own assets to avoid any confusion. In addition, the Securities Investor Protection Act of 1970 requires all broker-dealers already registered under the Securities Exchange Act of 1934 to be a member of the Securities Investor Protection Corporation (SIPC), a nonprofit, membership group that also functions as insurance for industry customers.

The U.S. stock markets were in a chaotic state toward the end of the 1960s due to the "paperwork crunch." After an unexpected increase in trading volume, broker firms were not equipped to handle trading activity because there was insufficient staff at every level from operations to management. Unable to keep up with proper record-keeping, broker operations became rife with incorrect transactions and recording errors. There was a breakdown in the processing mechanism, and the result was widespread chaos. At the time, there was no requirement for firms to segregate client funds and securities from the firm's own assets. When a firm went bankrupt, it could not return client funds or securities as records were inaccurate. Moreover, the firm may have spent client funds paying off firm debts. In the ensuing chaos, some firms were acquired, some firm merged to survive, and many went out of business. Investors were losing confidence in the securities markets because the firms were not honoring their obligations to their clients.

Congress decided to act to protect investors from failing brokerage firms and to bolster investor confidence in the securities markets. Congress passed the Securities Investors Protection Act that, in turn, created the Securities Investor Protection Corporation (SIPC)--a nonprofit industry membership organization that provides limited insurance for customers in cases where their brokerage firm defaults, becomes insolvent, or runs into a financial crisis. SIPC protection is limited up to $500,000 for securities and cash, or $250,000 for only cash. Prior to the inception of the SIPC, investors struggled to recover their assets and were forced to spend time and money on litigation.  

According to the SIPC, “although not every investor or transaction is protected by SIPC, no fewer than 99% of persons who are eligible get their investments back with the help of SIPC. From its creation by Congress in 1970 through December 2017, SIPC advanced $2.8 billion in order to make possible the recovery of $138.7 billion in assets for an estimated 773,000 investors. [1]” 

When a brokerage firm, which is a member of SIPC, is financially troubled, SIPC protects the customers against the loss of securities and cash. Securities here include stocks, notes, treasury stocks, bonds, debentures, certificates of deposit, voting trust certificates or any other instrument that fits the definition of a security according to Statue 78lll(14) of the Securities Investor Protection Act. However, securities do not include currency, warrants or commodities or related futures or contracts. In the case of cash, U.S. dollars or non-U.S. dollar currencies are both safeguarded provided the brokerage possessed them in connection with the sale and purchase of securities. An account holder at an SIPC-member brokerage firm is protected regardless of whether they are a U.S. citizen or non-U.S. citizen.

Investors must be clear about the protection provided by SIPC. There can be a misconception that the SIPC is to brokerage accounts what the Federal Deposit Insurance Cover (FDIC) is to bank accounts. But SIPC and FDIC differ. While FDIC protects the customer 's cash in an account at an insured bank, SIPC does not safeguard the absolute value of the securities the customer holds, only the number of shares. For example, if an investor is holding 200 shares of ABC Inc. originally purchased through a failed stock broker, SIPC will work to replace or restore the same number of shares to the investor. However, if the stock price plummets during the time the stock broker goes bust to the time that the SIPC steps in, the SIPC will not reimburse the money the investor lost.

Once the liquidation process begins, the court appoints a trustee for the broker-dealer. The firm’s office is closed while all documents, records and books are scrutinized by the trustee and staff. During the process, SIPC plays a supervisory role. In case the records of the failed brokerage firm are found to be accurate, provision is made to transfer the customer accounts to another brokerage firm by SIPC and the trustee. The customers are notified of the transfer of accounts, and that they can continue with the new assigned broker or further pick a broker of choice. The customer should file a claim with the trustee on receiving the initial notification of the transfer of the account. Remember, SIPC is not liable to protect customers who do not file a claim.

In certain cases, the SIPC may follow a direct payment procedure. This is an out-of-court process and usually happens when all customer claims fall within the SIPC protection limits (i.e., they do not exceed $250,000 in aggregate). In such cases, there is no court proceeding or appointment of a trustee.

Although relatively rare, stockbroker firms do go out of business. Investors should select a stockbroker after due diligence, which includes ensuring that the broker offers SIPC protection (see the full list of SIPC members). Once you begin trading or buying investment products, ensure your records are in order. Following best practices, which includes keeping either a hard copy or electronic record of holdings, account statements and trade confirmations will make filing an insurance claim with the SIPC much easier.

[1] https://www.sipc.org/media/brochures/HowSIPCProtectsYou-English-Web.pdf (see second para. ,page 2)