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What Happens When a Brokerage Fails

If securities or cash is missing from a brokerage account, investors have some protection.

When headlines were screaming about problems at E*Trade's (ETFC) - Get Free Report bank unit, depositors weren't the only ones unnerved. Word of the S&L's home-equity loan exposure and writedown of asset-backed securities also sparked a run on E*Trade's discount brokerage accounts. E*Trade stated that investors pulled a net $7 billion from both bank and brokerage accounts month to date, through Nov. 27.

Judging from reader questions, there's a lot of confusion about what the bank's problems mean for E*Trade's brokerage customers and the risks associated with the failure of a brokerage firm.

Bank Failures

If a broker-held bank were in danger of failing, its regulator would probably try to help avoid a failure by encouraging a sale to a larger, strongly capitalized institution. This would avoid a failure, so no depositors (insured or otherwise) would be hurt.

If the regulator were forced to close down the bank, the FDIC would then immediately pay off insured deposits, usually by transferring the balances to another bank overnight. Uninsured depositors would later be paid a "dividend" to recover a portion of their uninsured deposits.

For example, when

NetBank failed, depositors were immediately paid a dividend of 50 cents on the dollar for their uninsured balances, with the possibility of additional dividends as the FDIC sold off NetBank's remaining assets.

Brokerage Firm Failures and SIPC Coverage

If a brokerage firm fails and securities are missing from customer accounts, the Securities Investor Protection Corporation, or SIPC, will ask a federal judge to appoint a trustee to oversee the liquidation of the firm's assets and orderly transfer of customer accounts to other brokerage companies. The day of the SIPC's request is called the "filing date."

Investors may simply have their accounts transferred to another broker with no loss. In the event that securities or cash are missing from a brokerage account, investors have some protection from SIPC.

There are major differences between SIPC protection and FDIC protection. Unlike the FDIC, SIPC does not provide blanket protection for losses. The purpose of SIPC protection is to replace securities that are missing when a brokerage firm fails. It does not make up missing value for securities that may have lost market value while missing or for investments that the customer may feel he or she was ill-advised to make.

If you are missing 100 shares of IBM when your brokerage firm fails, SIPC will simply replace the 100 missing shares, regardless of whether they have gone up or down in value since they went missing.

Eligibility and Coverage Limits

It is important to make sure that your broker is a member of SIPC. The words "Member Securities Investor Protection Corporation," or "Member SIPC" will appear on signs at brokerage offices and on websites or advertisements for most brokers. If you are not sure, go to

SIPC's Web site to check.

Both cash and securities are covered, with a limit of $500,000 in value as of the filing date, including a $100,000 limit for missing cash. However,

some types

of investments are not covered, including commodity and currency futures contracts, unregistered investment contracts and annuity contracts.

Most investors are eligible for SIPC protection. Those that are ineligible include officers, general partners and directors of a failed brokerage firm, and brokers, dealers or banks acting on their own behalf, rather than for their customers. You should visit SIPC's Web site for a full list of the rules on eligibility and coverage.

SIPC Coverage for Money Market Funds

This is an area that can easily cause confusion. Many investors consider money market balances held at brokerage accounts as "cash." But a money market fund is actually a mutual fund that seeks to keep its share price fixed at $1.

The companies that manage these funds may or may not be affiliated with your brokerage. Money market funds hold short-term debt instruments, such as Treasury bills, commercial paper, certificates of deposit and other securities with maturities usually averaging about 90 days.

Because of the short maturities and generally liquid nature of these securities, it is very rare for a money market funds to "break the buck," or fall below $1 a share, which could lead to investor losses. When this has happened, fund managers have usually stepped in and supported the $1 price with their own money, but this has not always been the case.

So while investors often think of money market funds as safe alternatives to bank accounts, they are not insured by the FDIC or any other entity.

For SIPC purposes, shares in a money market fund are considered securities. SIPC protection may or may not apply to investments in money market mutual funds within your brokerage account. Whether or not your money market shares are covered depends on how your relationship with the money market fund is set up. There are two possibilities:

  • While the broker helped place your money in a money market fund, you have a separate relationship with the money market fund manager. This means you have your own money market fund account number and probably a checkbook and separate statement for the money fund. The company managing the money market fund "knows you." In this case, if your broker fails, SIPC coverage does not apply to your money market fund, and is not even necessary, as you can contact the money fund manager directly to access your shares.
  • The broker has placed your cash in the money market fund on your behalf. This means that the money market fund "does not know you," and that the broker is supposed to keep track of each of its customers' shares in the money fund. In this case, if any of your money market shares are missing from your account when the broker fails, SIPC covers the money market shares as part of your coverage for missing securities, up to $500,000.

Filing Claims

If your broker fails and securities are missing from customer accounts, the trustee will send you a claim form and instructions with a deadline for placing a claim, which is usually 30 to 60 days from the filing date. You will need to supply proof of what the broker owes you, which shows how important it is to save your statements. If you receive or have access to electronic statements, save the electronic files and maintain printed copies as well. Most customers receive their property back within one to three months.

Again, you should visit the SIPC Web site for further information. There's a much more detailed summary of how SIPC protection works. Among the other highlights is the

Investor Survival Quiz. Take it. You may be surprised at your score!

Philip W. van Doorn joined Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.