what happens when a broker fails

In short

A friend of mine once asked me what happens to her stock if her broker goes under, and she asked it in a whisper, as if the question itself might jinx something. It is a fair question, and the answer is calmer than the whisper suggests. In the United States, the law keeps your securities separate from the firm's own money, so they are not simply swallowed up in the failure. A nonprofit created by Congress, the Securities Investor Protection Corporation, steps in when a member firm fails and cannot return customer assets. It protects up to the current figure, which the official source publishes each year per customer, with a sub limit of the current figure, which the official source publishes each year for cash. It does not protect you from a drop in the market. Check that your firm is a SIPC member, and keep your statements.

The whole of it

What it is

I once watched a neighbor lose sleep over a bank rumor that turned out to be nothing at all. Worry like that usually grows from not knowing how a thing works, so let us look at the thing.

A broker is the firm that holds your account and carries out your trades. When you buy a share, the broker usually keeps it on your behalf in what is called street name. That means the firm is listed as the holder, but your account is the true owner on the firm's books. Your shares are your property. They are not the firm's property.

A broker failure means the firm cannot meet its duties to customers. It might be short on money, or something might have gone wrong with its records. That is rare, but it has happened. The law was built with that day in mind.

Two layers of protection matter here. The first is a rule that makes the firm keep customer assets apart from its own. The second is SIPC, which acts as a backstop when the first layer is not enough. SIPC is not a government agency, and it is not the same as the FDIC, which covers bank deposits. It is a nonprofit that members pay into. Its job is a narrow one, and it does that job well when called upon.

How it works

If you are holding an account at a brokerage, you have probably wondered who steps in when a firm falls apart. Here is the usual path.

First, SIPC asks a federal court to appoint a trustee. The trustee takes control of the failed firm's customer accounts and works to match each customer to the assets the firm's records show. Most of the time, the securities are still there, sitting where they should be, because the firm had to keep them apart from its own funds. The trustee then transfers those accounts to another healthy firm, or returns the assets directly to customers.

Sometimes the records do not match, or assets are missing. That is where the SIPC limits come in. SIPC can replace missing securities and cash up to the stated limits. The limit is set by law, and the current figure is the current figure, which the official source publishes each year per customer, including up to the current figure, which the official source publishes each year in cash. Those limits apply per customer, per separate capacity. A joint account and an individual account can be counted as different capacities, which can matter if you hold more than one kind.

Now for the part people miss. SIPC protects against the loss of assets when a firm fails. It does not protect against a loss in value. If you own a share that drops by half, SIPC will not make that right. It also does not cover fraud by an outside adviser who talked you into a bad deal. Think of it as a shield against a missing vault, not against a bad price.

Things move slowly. A trustee has to check the firm's records against each customer's account, and that work takes time, so trading may stay on hold while it goes on. Your assets are not gone in that stretch. They are on hold.

The numbers, and where to find yours

I like a number I can check for myself, so here is where to look.

The SIPC limit on securities is the current figure, which the official source publishes each year. The cash sub limit is the current figure, which the official source publishes each year. Both are set by law, and the site fills in the verified figure with its source and date. Do not rely on a figure you heard at a dinner table, because limits can change.

To find out whether your firm is a member, start at the SIPC website. It keeps a list of member firms you can search by name. Your brokerage should also show the SIPC logo or mention membership in its account documents. If you cannot find it, ask the firm in writing.

To find what you hold, look at your account statement. It lists each security, how many shares you own, and your cash balance. Add up the value of what you hold at that one firm, in each type of account, and compare that total with the limits above. If your total is well under the limit, you are covered in full for a missing asset. If it is over, only the amount up to the limit is protected by SIPC.

Some brokers also buy extra insurance from private companies. People call this excess coverage. It sits on top of SIPC, and it is the firm's own purchase, not a government promise. Read the details, since the terms differ from one firm to the next.

A worked example

Let me tell you about a woman named Maria, a school bus driver who started investing a little each payday. She opened an individual account at a brokerage. Over the years she built it up. Her account held $48,000 in stocks and $2,000 in cash.

Add her holdings together. $48,000 in stocks plus $2,000 in cash is $50,000 in total. For this story, we will call the securities limit the current figure, which the official source publishes each year and the cash sub limit the current figure, which the official source publishes each year, and the SIPC website carries the real figures. Maria's $50,000 sits well under the securities limit. Her $2,000 in cash sits well under the cash sub limit.

Now say her broker failed and a trustee found that $10,000 of her stock was missing from the firm's records. SIPC would replace that $10,000, because $10,000 is below her limit. She would end up whole on the missing assets.

Now suppose instead that the market fell and her $48,000 in stock dropped to $36,000. That is a loss of $12,000, since $48,000 minus $36,000 is $12,000. SIPC pays none of it. The firm was fine. The market simply moved. Maria bears that loss the way any investor would.

Same account. Two very different events. One is covered, and one is not.

Where it goes wrong

I have watched good people trip on small misunderstandings, so let us name a few.

The first mistake is mixing up SIPC with the FDIC. The FDIC covers deposits at banks. SIPC covers missing assets at brokers. Different jobs, different rules.

The second is thinking SIPC covers bad investments. It does not. A fall in price is the risk of owning anything that trades.

A third trouble is holding more than the limit at one firm. If a person holds well above the limit and the firm has a real shortfall, the extra may not be covered. Spreading holdings across separate firms is one way people handle that, and some firms carry the extra private insurance mentioned earlier.

Another trouble comes from firms that are not SIPC members. Not every financial company qualifies. Check the list first.

There is also the waiting. Even when your assets are safe, a freeze can last a while. Plan for the fact that you may not reach your money right away.

Last, keep your own records. Statements and trade confirmations help a trustee match your claim to the firm's books. A box of old statements has saved many a person a long afternoon of trouble.

Questions to answer before you leave this page

Is my broker a member of SIPC, and have I checked the official member list myself rather than trusting a logo? What is the total I hold at this one firm, counting each type of account, and how does it compare with the current limit? Do I hold anything that SIPC does not cover, such as certain contracts or assets outside the securities rules? Does my firm carry extra private insurance, and what do its terms say in plain words? Where do I keep my statements, and could I find the last twelve months in a few minutes? And if my account were frozen for a few weeks, would I still be able to pay my bills?