By Alistair Vigier, Guest Writer
Being an investor these days can undoubtedly be nerve-wracking with market uncertainty seemingly looming around every corner. Whether it’s global conflict, supply chain issues, record-high inflation, or fears of a recession, the investing public is surely right to be anxious and nervous about the long-term health of their portfolios and the short-term effects of world events on markets in which they hold positions.
Amid current market turmoil and fears of it continuing throughout the coming years in a post-pandemic world, many people likely find themselves full of questions about the health of their investments as they approach retirement age. They could ask, will my retirement savings carry me through my golden years? Will my pension keep up with housing costs and inflation? Meanwhile, some questions linger about the health of the market and those who administer investment funds, such as brokers and investment banks.
The global financial crisis of 2008 saw many brokerages and banks go belly up after the subprime mortgage fiasco. The global upheaval was particularly hard on individual investors in the United States, where mountains of bad mortgages were packaged as secure investments before the market for asset-backed commercial paper and securitized mortgage debt collapsed like a disastrous row of dominoes. With that in mind, many investors want to know: will I be protected if my investment broker goes bankrupt?
Protection for Investors in the United States
Investors in the United States thankfully enjoy a range of safeguards to their investment portfolios in case their brokerage firm goes belly up. Not only do regulators like the US Securities and Exchange Commission (SEC) enforce market regulations, but brokerage firms are also overseen by the industry-funded regulator known as the Financial Industry Regulatory Authority (FINRA). In most cases, should a brokerage firm go bust and stop business operations, the assets belonging to the firm’s customers are protected and moved along to another firm.
According to FINRA, there are “multiple layers of protection” enjoyed by investors and their assets in the US, including the requirement for registered brokerage firms to ensure that customers’ funds and securities are segregated from those owned by the firm. This requirement means that, should a brokerage firm go bankrupt and become insolvent, customers’ assets and funds on deposit are safeguarded and not in danger of being swallowed up by the firm’s creditors as it works with bankruptcy lawyers.
In addition, broker-dealers registered in the US are also compelled to adhere to a minimum net capital requirement to lessen the possibility of going bankrupt while also maintaining membership in the Securities Investor Protection Corporation. The SIPC, for its part, offers protections for customers of member brokerage firms, safeguarding up to $500,000 on deposit in “rare cases” where a brokerage house goes bankrupt and customers’ funds vanish into thin air due to fraudulent activity or outright theft.
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Securities and Exchange Commission Investor Protection
But should a brokerage firm become insolvent and can no longer sustain operations and handle customer accounts, it’s regulators like FINRA and the SEC that come into play. However, investors should also be aware of what’s expected of them if the firm they invest with goes out of business. For its part, FINRA touts multiple and “extensive” safeguards that exist to protect customers’ assets, though it points out that some investment products may not enjoy the same level of coverage as others.
Luckily for American investors, the country’s robust regulatory framework works to weave a strong safety net for brokerage firm customers’ assets. Firms that are members of FINRA and come under the oversight of the US SEC are under a strict rules-based regime that aims to “minimize the chances of financial failure.” These rules are meant to ensure that customer assets are safe in case the worst comes to pass and a firm is forced to close its doors. For instance, the SEC has a “net capital rule” that forces firms to keep a certain amount of cash on hand at all times—the amount of which is dependent upon how big the firm might be.
The SEC’s customer protection rule also prohibits brokerage firms from co-mingling firm-owned funds with those owned by customers. This rule acts to compartmentalize money controlled by the firm from securities and assets owned by customers. Keeping funds segregated means that brokerage firms can’t mix their own assets with those of their customers, meaning they can’t drag their clients down with them if they find themselves underwater and insolvent.
SEC’s Customer Protection
According to FINRA, it’s also important for customers of brokerage firms to know the distinction between firms that clear securities transactions and hold customers’ securities vs. so-called “introducing” firms that act as a sort of middleman between customers and carrying firms. The difference, the regulator says, depends on what kind of firm holds your account. A “clearing and carrying” brokerage firm both takes care of customers’ securities orders for buying and selling stocks and also holds the securities or “carries” them for their clients.
On the other hand, an “introducing” brokerage firm takes customer orders while having a deal with another firm to take custody of the securities when the order clears. Clearing and carrying firms are under greater obligations to hold more liquid capital, while also ensuring the separation of customer assets from those owned by the firm itself. Furthermore, brokerage firms that deal with everyday retail investors are also required to undergo audits every year and file documentation with the SEC, while publicly traded investment companies also have to file quarterly and yearly reports with the commission. Those filings are also publicly posted online in the SEC’s EDGAR database.
In cases where brokerage firms have gone bankrupt, a few different scenarios can play out. As FINRA points out, firms facing insolvency due to their inability to pay off debts or because of unexpected and massive losses can still find a buyer and use a merger deal to avoid becoming insolvent. The example the regulator uses for this situation is the buyout of Bear Stearns by investment banking behemoth J.P. Morgan in 2008, the peak of the great financial crisis caused by the collapse of the US subprime mortgage market.
Meanwhile, other firms that have faced insolvency in the past can opt to “self-liquidate,” which involves working with regulators like FINRA and the SEC to ensure the orderly transfer of customer accounts and assets to another firm that is also a member of the Securities Investor Protection Corp. But should your brokerage firm fail, FINRA urges investors to “avoid panic” even though such an event is likely anxiety-inducing since many people stake their entire futures on their investment portfolios.
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Financial Gurus Who Have Gone Broke
The Securities Investor Protection Corporation
Should the unthinkable happen and your broker goes bust, the Securities Investor Protection Corporation is likely to step in and get your money back. The SIPC was formed as part of the Securities Investor Protection Act of 1970, a nonprofit entity set up as a measure to cover investors burned by a brokerage going bankrupt. However, the coverage it offers is limited, offering replacement costs of up to $500,000 in missing securities and up to $250,000 in cash holdings.
But that coverage is only in place if a firm goes bust and customer assets are found to be missing—whether through fraud and theft or unauthorized trading activity. The SIPC’s coverage does not extend to “ordinary market loss,” and it doesn't apply to futures contracts, foreign currency exchange activities, or other investments that aren’t regulated by the SEC. It doesn’t cover assets owned by the firm’s owners and directors. Moreover, people who hold multiple accounts at an insolvent firm are covered for each separate account as “legal customers”—such as individual accounts held by spouses along with a joint account.
When a firm goes bankrupt, which the SIPC calls an extremely rare event in the US, the organization begins the liquidation process and sends letters to the brokers’ customers. The SIPC has a guide brochure for investors in these situations, and it urges people to promptly put together all their account information statements and any communications they've had with their broker. Investors should also make sure their account statements are accurate and up to date and ensure that all their assets under the firm’s control are listed on the documentation provided.
Unauthorized Trading Activities
In addition, the SIPC’s guide strongly urges people to look out for any unauthorized trading activities on their accounts. After that, you can contact the SIPC and fill out any paperwork that is required to make a claim should you find your assets or cash missing when your firm went broke. It also strongly warns people to make sure they follow the procedures’ strict deadlines because US federal law doesn’t authorize insolvency trustees, courts, or the SIPC itself to pay out claims that are filed too late.
After the SIPC has stepped in and begun the liquidation process, customers of bankrupt brokerage firms typically get paid out in a few months. According to FINRA, the time it takes for the SIPC to pay out on claims is dependent upon several circumstances, such as “the accuracy of brokerage firm records.” During this period, investors are sort of forced to play a waiting game since they can’t trade on their accounts while liquidation proceedings wind their way through the courts. But while the SIPC’s coverage is universal, individual brokerage firms can also have their own insurance above and beyond what the SIPC offers.
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Brokerage Firm Failures in the 21st Century
While it may be a rare occurrence that a brokerage firm goes broke, there are some spectacular examples in recent history that still haunt markets today. The fall of Lehman Brothers in 2008 was one of the most shocking failures in the country’s history. Despite being regulated heavily by the SEC, the Commodities Futures Trading Commission, and FINRA, Lehman Brothers' failure sent what can only be described as an unexpected shockwave through global capital markets, dominating headlines for months as the investment bank sank like a financial Titanic, struck by a massive iceberg of instability when the subprime mortgage market fizzled out.
When its bankruptcy was revealed in September 2008, Lehman was a financial behemoth. It had tens of thousands of employees globally, far from its humble beginnings as a dry goods store in the 1840s. Started by a group of immigrant brothers in Alabama, Lehman grew to become one of the biggest players in the investment banking game in the US. It’s hard to imagine the sheer size of such an entity, which spectacularly failed under the crushing weight of more than $619 billion in debt against $639 billion in assets. With the failure of the massively risky subprime mortgage market, the firm was doomed having begun heavily investing in the space early—beginning shortly after the turn of the century—acquiring several small lending firms with bad debts on its books.
Despite the perceived strength of the US housing market, the market for securitized mortgages was never really safe since many firms were giving out loans to people with no income, no jobs, and no assets for collateral. The results, of course, were disastrous for the world economy, and it took many years for markets to rebound.
The mistakes of the past where investors have been burned by brokers going bust have fortunately given birth to important safeguards for people's assets. The Securities Investor Protection Corporation also has counterpart organizations and similar programs that protect investors in other countries, such as Canada, the U.K., New Zealand, Australia, and elsewhere. But as always, investors face certain elements of risk. Protection funds only go so far, and they are far from a be-all-end-all solution to market volatility and global unrest.
Do you find some comfort in the knowledge that your funds likely won't disappear if your brokerage firm goes bust? What else could you do to safeguard your money? Would this information make you more or less likely to use an investment broker? Comment below!
[Editor's Note: Alistair Vigier runs www.clearwaylaw.com, a website that is working hard at improving the access to justice problems. The goal is to get the public to leave reviews for their attorneys. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]