Understanding the Role of SIPC in Protecting Investors from Fraud
The Securities Investor Protection Corporation (SIPC) is not a Federal Deposit Insurance Corporation (FDIC) for the securities brokerage industry. The Madoff and Stanford cases have highlighted the differences. The purpose of this article is to examine when, why, and how SIPC funds are used to assist fraud victims.
The FDIC was established in 1933 during the Great Depression to maintain stability and public confidence in the nation’s financial system by insuring deposits and supervising financial institutions for safety and soundness. After thousands of bank failures in the 1920s and early 1930s, Congress decided that restoring confidence in the banking system required government action. As an independent agency of the federal government, the FDIC now insures approximately $9 trillion of deposits in U.S. banks and thrifts – almost every bank and thrift in the country. Since the agency began its coverage on January 1, 1934, no depositor has lost any money in a FDIC insured institution. If a bank is failing, the FDIC takes over at the close of business on a Friday and quickly restores depositors’ funds.
In contrast, SIPC is small, having slightly more than $1 billion in reserves. This is miniscule in comparison to stock fraud losses. Microcap stock fraud alone is estimated to range between $1 and $3 billion per year. It covers only eligible investments 1Among the investments that are ineligible for SIPC protection are commodity futures contracts (unless defined as customer property under the Securities Investor Protection Act) and currency, as well as investment contracts (such as limited partnerships) and fixed annuity contracts that are not registered with the U.S. Securities and Exchange Commission under the Securities Act of 1933. that meet certain criteria such as unauthorized trading of a failed broker-dealer. SIPC’s enabling statute impliedly excludes some “customers” of broker-dealer who are surprised by their exclusion. This exclusion was the key issue in the Stanford case described below.
SIPC is not a government agency or a regulatory authority like the FDIC. It is a nonprofit, membership corporation, funded by its member security broker-dealers. Investors of a failed broker-dealer have no right to force SIPC to cover or even consider their claims. Only the Securities and Exchange Commission (SEC) can sue SIPC.2§78ggg(b): “In the event of the refusal of SIPC to commit its funds or otherwise to act for the protection of customers of any member of SIPC, the Commission may apply to the district court of the United States in which the principal office of SIPC is located for an order requiring SIPC to discharge its obligations under this chapter and for such other relief as the court may deem appropriate to carry out the purposes of this chapter”. If the broker-dealer is small, investors must try to get someone in the SEC to take notice of the claim. If the failed broker-dealer is small or the closure is does not get much press coverage, the SEC often takes years before considering whether it will talk to SIPC regarding the investors’ claims. If the SEC refuses to respond to the investors’ claims, there is no recourse left for the investor.
Madoff: Although the litigation is ongoing, SIPC has refused to cover most of more than 16,000 Madoff-caused losses on the basis they invested through a feeder fund and the investors’ names were not on the accounts carried on Madoff’s books. Madoff aggregated the feeder fund investments in the names of the feeder funds. The SEC did not object to these exclusions from coverage by SIPC in the Madoff case. Even though SIPC does not cover losses caused by investment advisors, it made an exception for Madoff clients since Madoff did not establish a separate entity for his investment-advisory services.
Stanford: SIPC refused to cover victims of the Stanford Ponzi scheme arguing they were not “customers” as defined by its enabling statute. During negotiations with the SEC, SIPC offered up to $250,000 per investor in settlement. The SEC rejected the offer and for the first time in its history, sued SIPC. The district court agreed with SIPC’s interpretation of the statute.3SEC v. Sec. Investor Prot. Corp., 872 F. Supp. 2d 1 (D.D.C. 2012)
“Customer” is defined in the statute as including “any person who has deposited cash with the debtor [broker-dealer] for the purpose of purchasing securities”. Courts had required the broker-dealer to have actually “received, acquired or held the claimant’s property” or the person is not a “customer”.
If the broker did not take possession of the investors’ funds, the SIPC statute is interpreted to mean the investor is not a “customer” and therefore not protected. Most FINRA licensed broker-dealers retain an outside firm to perform “back office” functions. The outside firm is known as the “clearing broker-dealer” and the firm that deals with the customer is called the “introducing broker-dealer”. As a practical matter most broker-dealers must use a clearing broker-dealer because they cannot afford to have seats on the exchanges and therefore have limited ability to trade on their own. The clearing broker-dealer does the accounting work and the processing of customer orders including the purchasing and sale of securities. In order to provide these services, the outside firm holds the customer funds.4Also many small broker-dealers do not have sufficient “net capital” to hold client property under SEC regulations. Although the relationship is disclosed to the customer in the account forms, many investors think they are dealing only with their local broker-dealer.
In a typical situation, the investor deals with a local stock broker and receives statements in the name of the local broker’s firm. The statements are prepared by the clearing broker-dealer but the logo of the local broker-dealer is placed on the statements. The local broker-dealer proudly displays the SIPC sign on the statements and in his office. He touts to his customer that his funds are protected by SIPC even though this is misleading. Neither the SEC or FINRA object to these practices. The investor must carefully study the account documents to understand his money is held by a firm other than his local broker-dealer. The investor does not know that the introducing broker-dealer is not covered by SIPC if someone at the firm embezzles the investor’s funds.
In the Sanford Ponzi-scheme case, the SEC sued SIPC and argued that the definition of “customer” should not be limited to the entity that holds customer funds. The court, although claiming to be “truly sympathetic” to the defrauded customers, held that the SEC did not prove that SIPC refused “to commit its funds or otherwise to act for the protection of customers of any member of SIPC” because customers of introducing broker-dealers are not “customers” under the SIPC statute.5SEC v. Sec. Investor Prot. Corp., 872 F. Supp. 2d 1, 12 (D.D.C. 2012).
To make matters worse, the courts and FINRA arbitrators have usually held that clearing broker -dealers have no duty to the customers of the introducing broker-dealer. They reach this conclusion even though the clearing broker-dealer executes all the orders and owns all the account records that reveal the fraud by the introducing broker-dealer. For example, if a stock broker is writing checks to himself from his client’s account, the money is taken from the money held by the clearing broker-dealer and the check is honored by the clearing broker-dealer. Lawyers for clearing broker-dealers argue that the clearing broker dealer has no duty to inquire or even look at the records of the customers.
There is a fairly new legal theory, called “conscious avoidance” or “conscious disregard” that may help investors who have accounts at introducing broker-dealers. The theory was used to reach officers of Enron and other companies who claimed not to know of the fraud in the companies they managed. If “conscious avoidance” is proved, the avoider is considered to have actual knowledge of the fraud. The idea is one cannot simply ignore what is going on around him and have no liability. So far, we have found no cases applying the conscious disregard theory to clearing broker-dealers but we are trying to do so for several investors who were defrauded.
Since SIPC is not legally responsibility for investment fraud by most broker-dealers (the introducing broker-dealers), one would expect that the smaller introducing broker-dealers would be required to post a high bond and have high net capital to protect investors. In a strange twist of logic, the SEC and FINRA require much smaller bonds and net capital for the introducing broker-dealer than for clearing broker-dealers. The bond can be a little as $5,000, less than the amount a general contractor is required to post. Net capital can be as little as $7,500.
Because customers of the smaller broker-dealers are not “customers” under the SIPC statute, they are not protected from fraud and theft by the introducing broker-dealer by SIPC. The introducing broker-dealer usually has minimal funds to pay defrauded investors and the clearing broker-dealer claims to have no duty to the clients of the introducing broker-dealer. Until there is a change, investors should avoid doing business with any broker-dealer that uses a clearing broker-dealer.
On November 21, 2013 a bipartisan bill, Restoring Main Street Investor Protection and Confidence Act, was introduced to force SIPC to cover the losses of introducing broker-dealer customers. Any bets on whether Congress will opt to protect main street investors?
Footnotes [ + ]
|1.||↑||Among the investments that are ineligible for SIPC protection are commodity futures contracts (unless defined as customer property under the Securities Investor Protection Act) and currency, as well as investment contracts (such as limited partnerships) and fixed annuity contracts that are not registered with the U.S. Securities and Exchange Commission under the Securities Act of 1933.|
|2.||↑||§78ggg(b): “In the event of the refusal of SIPC to commit its funds or otherwise to act for the protection of customers of any member of SIPC, the Commission may apply to the district court of the United States in which the principal office of SIPC is located for an order requiring SIPC to discharge its obligations under this chapter and for such other relief as the court may deem appropriate to carry out the purposes of this chapter”.|
|3.||↑||SEC v. Sec. Investor Prot. Corp., 872 F. Supp. 2d 1 (D.D.C. 2012)|
|4.||↑||Also many small broker-dealers do not have sufficient “net capital” to hold client property under SEC regulations.|
|5.||↑||SEC v. Sec. Investor Prot. Corp., 872 F. Supp. 2d 1, 12 (D.D.C. 2012).|