Bank customers have enjoyed the peace of mind of knowing their savings deposits are protected by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per account. However, those in search of higher returns who were willing to risk their money in the securities markets had virtually no protection of any kind for much of Wall Street's history, even from losses due to broker or dealer (or broker-dealer) bankruptcy. That changed in 1970 when Congress created an agency called the Securities Investor Protection Corporation (SIPC).
Are Investment Losses Insured?
Whenever you invest in a stock, bond, or mutual fund, there is no insurance against the possible loss of your initial investment. Even if you are investing in collectibles, the insurance that you can purchase protects only against unexpected occurrences such as fire or theft, not depreciation in value.
The element of risk is inherent to investing, which is why investments cannot be insured. For all types of investments, the return—whether in the form of interest, dividends, or capital gains—is a reflection of the type of risk you are taking on. The higher the risk, the higher the potential return.
Conversely, a reduction in risk means a reduction in potential return. For example, consider the investment products that guarantee your principal. Your money is guaranteed because you'll receive a relatively low rate of return. Remember, there is no such thing as a free lunch.
Insurance Against Broker and Dealer Bankruptcy
In 1970, Congress created a new agency known as the Securities Investor Protection Corporation (SIPC). This agency's only function is to cover the losses of investors' accounts incurred by the bankruptcy of their broker or dealer.
The SIPC does not cover any kind of loss incurred as a result of market activity, fraud, or any other cause of loss other than the bankruptcy of a broker or dealer. Regulatory agencies such as the Securities And Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) deal with issues related to fraud and other losses.
The SIPC either acts as a trustee or works with the client to recover assets in the event a broker or dealer becomes insolvent. The SIPC will also oversee the recovery process and ensure that all customer claims are paid in a timely and orderly fashion, and all recovered securities are distributed on an equitable, pro-rata basis.
The SIPC will reimburse investors for up to $500,000, of which up to $250,000 can be cash. Any securities that are already registered in the certificate form in the investor's name will be returned as well.
Example of SIPC Protection
Say an investor has $300,000 in cash and $150,000 in securities held in street name with a broker or dealer that becomes insolvent. They also deposit $450,000 worth of securities registered in their own name with the broker or dealer just before it declares bankruptcy.
The SIPC guidelines dictate that the investor will receive $250,000 of their cash and all of their securities that are held in street name, for a total of $400,000. Although the SIPC will reimburse for up to $500,000, the remaining $50,000 of cash will not be covered because it is over the $250,000 limit for cash. They will get back all of their stock certificates, provided they are still registered in their name.
When SIPC Protection May Not Apply
Not all types of securities are eligible for SIPC reimbursement. Securities that the SIPC will not reimburse for include commodities, futures, currency, fixed, and indexed annuity contracts, and limited partnerships (LP), which are covered separately by insurance carriers. In addition, any security that is not registered with the SEC will not be eligible for reimbursement.
Like the FDIC, the SIPC only covers member firms. This means you should make sure your brokerage is a member firm. If you are a customer at a large brokerage house, you're probably okay, but it's always a good idea to check. If your account is at a smaller firm, you should not only make sure that this firm is a member but also find out whether another company handles transactions on behalf of your brokerage.
If this is the case, you need to make sure this other company is also a member of the SIPC. The membership of the other company is necessary for your account to be insured.
The SEC has noted that a frequent problem for the SIPC is deciding how much of a person's account has suffered losses because of normal market risks and how much is lost because of unauthorized trading, which is a frequent cause of brokerage insolvency. If you need to claim losses that are a result of unauthorized trading, you may have to prove to the SIPC that unauthorized trading took place on your account.
Therefore, if you ever suspect that an unauthorized transaction on your account has taken place, make sure you send in a letter to the firm for documentation purposes. That way, if your firm ever becomes insolvent, the records can help the SIPC decide which portions of your accounts are covered and which portions are not.
In reality, few investors nationwide have ever lost any actual assets from insolvency when SIPC was involved. Between the pro-rata recovery distribution, the return of all registered securities certificates, and the insurance coverage limits, there is little chance that an investor will suffer a net loss as a result of broker or dealer insolvency.
In addition to protection by SIPC, many brokers and dealers also provide their customers with additional coverage through a private carrier. This type of coverage is known as "excess SIPC" insurance and coverage limits for this protection are often high, such as $100 million per account. As with the SIPC, this coverage will only reimburse investors for losses due to broker or dealer insolvency. Coverage limits for this type of insurance will vary from firm to firm.