Close Your Brokerage Account!

by Laurence Kotlikoff

Source: Forbes

Every day brings fresh reports of gross misconduct in the financial sector. So it makes sense to worry about how well your money is protected from fraudsters. Your bank account is guaranteed for up to $250,000 by a government agency–the Federal Deposit Insurance Corp. (FDIC).

If you have an account at any of our nation’s 4,000 brokerage firms, however, your money is “protected” (for up to $500,000) by a Wall Street agency–the Securities Investor Protection Corp. (SIPC)–with no government guarantee. SIPC was established by an act of Congress in 1970, but Wall Street controls it, and asking Wall Street to protect investors from Wall Street is asking for trouble.

Its website boasts: “SIPC protects customers if their brokerage firm fails.” Nothing could be further from the truth. Investors with accounts at firms that fail as a result of fraud can, incredibly, be forced to pay an SIPC-appointed trustee money, rather than the other way round.

Here’s how the swindle can work (based largely on a real case): In 1992, when their daughter Sarah was born, Frank and Sally invested $40,000 in a brokerage account for her college tuition. Investing early and letting capital markets work for them was smart; by 2010 they had $160,000–just enough to cover four years of college tuition. Sarah graduated in May. The next day Frank and Sally learned that their brokerage firm had been shut down due to fraud, with not a penny left. They were shocked, but thanked God they hadn’t lost their investment.

Then Sam, their accountant, told Frank and Sally the awful truth: They owed the SIPC-appointed trustee for their broker $80,000 and would be sued if they didn’t pay!

How could that be? If a bankrupt brokerage firm was crooked, SIPC treats innocent customers as if they were complicit in the fraud, demanding they pay back any money they took out in the prior two years, up to the amount their cumulative withdrawals over the life of the account exceeded contributions. The notion that savers who withdraw the fruits of their investments–something every IRA brokerage-account holder over 70 is legally required to do–should be treated as criminals for spending those investment returns is as antithetical to capitalism as it gets.

What if Frank and Sally had taken out $80,000 three years ago and had $80,000 supposedly left in the account? They wouldn’t get sued, but according to the SIPC they wouldn’t be entitled to recover any of the $80,000 because their “net equity” in the account–the difference between their contributions and withdrawals–is negative. They aren’t entitled to appreciation on their investment, even though they paid taxes on that appreciation and could have earned similar returns in honest brokerages. When an SIPC-appointed trustee sues (or stiffs) innocent victims like Frank and Sally, every dollar he collects (or saves) is a dollar less Wall Street has to pay to support the SIPC. In effect, Wall Street uses the SIPC to further defraud people who have already been defrauded.

A bipartisan bill before Congress–H.R. 3482 and S. 1725–would base SIPC’s definition of “net equity” on the brokerage statement that Frank and Sally were sent before their broker went belly-up. Until that law is passed, the best way to avoid the SIPC threat is simply not to invest in brokerage accounts, period. Had Frank and Sally invested their original $40,000 directly in a mutual fund with a reputable third-party custodian they never would have faced this madness. If you already have money in a brokerage account that exceeds the amount contributed, move it today. Just don’t spend any of it for two years.