FOOL ON THE HILL: An Investment Opinion
Protect Yourself From Broker Misconduct

In its 30-year history, the SIPC has helped investors recover more than $3 billion when brokers failed. However, the level of proof required in fraud cases is daunting. Of the 3,300 investors that have claimed against the infamous penny stock-hyping firm Stratton Oakmont, only 34 have received money. The SIPC was formed using 1970 laws in an environment that saw relatively few Americans investing. Times and industry practices have changed. It's time for the SIPC to catch up.

By Bill Mann (TMF Otter)
October 4, 2000

The New York Times ran one of a series of articles over the last few years about the ineffectiveness of the federally mandated, non-profit Securities Investor Protection Corporation (SIPC) to protect investors from brokerage failure or, under certain circumstances, broker misconduct. The gist of the article is simple: Investors are not nearly afforded the protection that many think they are. Unlike the Federal Depositary Insurance Corporation (FDIC), the SIPC does not treat proof of funds or assets being held at a failed brokerage as sufficient information to pay a claim.

Nor should they. Investments are, by nature and design, such complex instruments that they cannot be treated the same as cash -- they have fluid values and, in the case of equities, are only backed by the potential for future cash flows from the company that issued them. In other words, investments can and do become worthless all the time.

But what happens to investors when their brokerage, their agent to the market, fails? This isn't a market problem, and the SIPC was born to handle just such an event, which has happened nearly 300 times in the last 30 years. The problem is that the SIPC is fairly well-suited to handle cases in which a broker becomes insolvent, but it is much less so when investors have been defrauded. The question brought up in the Times article, and on past occasions when the SIPC has entered public consideration, is "Does the SIPC make it unduly and needlessly complicated for private investors to recover assets they lost through broker fraud?"

Mark Maddox, former Securities Commissioner for the State of Indiana and current chairman of the Public Investors Arbitration Bar Association, thinks so. "SIPC is doing only half of what it was chartered to do. In cases of failing brokerages, SIPC has provided a valuable service. But, in cases where assets have been stolen, SIPC is falling down on the job." Maddox states that SIPC takes the attitude in cases of fraud that the claimants trying to recover are "trying to get some free money." Where there is money, there is greed, so SIPC's cautionary stance is not without merit. But in situations where there have been massive cases of brokers stealing or otherwise defrauding investors, the recovery level through SIPC has been horrific. The culprit, in the opinion of many, is SIPC's extremely literal and narrow interpretation of the statutes that define how it should handle claims.

As an example, there is probably no more famous or nefarious a case as that of failed penny stock trading house Stratton Oakmont. In 1996, the firm was expelled from the National Association of Securities Dealers, and its owners pleaded guilty to securities fraud and money laundering. All in all, estimates of investor losses due to Stratton fraud range in the hundreds of millions of dollars from "pump and dump," unauthorized trades, and refusal to sell, among other schemes. Thus far, of the 3,300 Stratton clients that submitted claims, only 34 have received money from the SIPC, totaling $2.1 million. What about the attorneys for the SIPC-appointed trustees in the case? They've received $4.3 million in fees and expenses.

I've got to be honest here. I'm only partially sympathetic with the investors who got bilked by Stratton. By and large, they got suckered into penny stocks on the promise of big riches, failing in many cases to do even a modicum of research on the companies that they bought. (I am saying this by inference -- the classic statement "something that seems too good to be true probably is" definitely applies.) These investors put themselves directly in harm's way by investing in securities not traded on a major exchange, and did so with some off-the-beaten-path brokerage. (See our Securities Fraud Special.) Still, these investors did not ask to be stolen from, and inasmuch as there is extremely credible evidence of large-scale fraud on the part of their brokers, SIPC should operate from the point of assuming that the investor has been wronged and look for evidence to the contrary.

Instead, in spite of evidence of massive and programmatic fraud at Stratton, individual investors are having to provide written proof that they questioned an inappropriate trade at the time of the trade. Moreover, SIPC denies claims routinely on the grounds that the brokerage does not maintain possession of the assets. Stratton, like the vast majority of smaller brokerages, use a clearinghouse for such transactions, something that was not generally practiced when the statutes were written in 1970. It's a technical argument that puts a large number of investors at risk of a total loss of their investment assets, even though they may not even be taking the risk that Stratton investors did. This issue is one of many that have caused people to demand that SIPC's role and structure be investigated.

What can you do? Obviously, thousands of investors out there are their own worst enemies -- they will believe the get-rich-quick pabulum of some golden-throated broker, pitching some penny stock underwritten by some fly-by-night company. People, unfortunately, will continue to walk through the proverbial explosives dump with a lit match. Some will be hurt, others won't, but they're all doing something that is most charitably described as "stupid."

But the SIPC, operated by the securities dealers as a self-policed investor-protection agency, has to be structured to serve those who are hit by fraud. In fact, Maddox says Congress has requested that, by the first quarter of 2001, the General Accounting Office make a full investigation of SIPC and its increasingly important role as the last sanctuary against catastrophic loss of investment funds.

That said, here are some proactive things investors can do to protect themselves:

  • Only invest with larger brokerages. Certainly, there are honest, smaller, mom & pop brokerages out there. However, given SIPC's stance toward assets needing to be held by the brokerage to retain protection, you shouldn't count on SIPC protection if you use a smaller brokerage. Unless you have firsthand, credible evidence that the brokerage is both financially solvent (see below) and ethically aboveboard, stick with a bigger brokerage (preferably a deep-discount or online brokerage).

  • Get your brokerage's financial statement. Big brokers, such as Merrill Lynch (NYSE: MER), Charles Schwab (NYSE: SCH), TD Waterhouse (NYSE: TWE), and others provide brokerage customers with financials, as do most publicly traded and private brokers. If you never received one from yours, or do not remember having seen one, demand one and go over it with a fine-tooth comb. Brokers with strong financials are -- duh! -- less likely to fail.

  • Inquire whether your broker maintains "excess-SIPC" insurance coverage. This is increasingly common. If you're at a smaller brokerage in particular, private insurance could be the difference between recovering assets and getting nothing.

  • If you ever have the slightest question of wrongdoing, even if it seems like an honest mistake, write a letter! SIPC's basis for repaying fraud victims hinges largely on whether the investor can prove improper conduct by the broker. Even if you're sure something is an honest mistake, and these happen, send your correspondence in writing, and keep a copy in your files.
The SIPC is never going to be as guaranteed a backstop as the FDIC -- there is too much potential for fraud for it to be treated as such. And the SIPC will never, ever lift a finger to help investors who have suffered loss of capital from poor investment choices. Nor should it.

But the story presented in The New York Times was not pretty. Even state securities commissioners and, ostensibly, Congress are concerned. Investing has become a viable financial choice for more than 50% of American households, up from 10% in 1970. If SIPC is incapable of protecting this enormous portion of the populace from fraud, perhaps it is high time Fools call for reform. At least, it will be interesting to see what comes out of the GAO report.

Remember -- the best person to protect your financial future is you. If your investing strategy causes you to actively consider SIPC protection, maybe you ought to reconsider the havens in which you keep your money.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:
  • Securities Investor Protection Corporation
  • Many Holes Weaken Safety Net for Victims of Failed Brokerages, The New York Times, 9/25/00 (free registration required)
  • Securities Fraud, Motley Fool Special Feature, 2/23/00