The Huge SIPC Risk Your Broker Isn't Disclosing
by Laurence Kotlikoff
July 16, 2014
Your broker has a duty to disclose all risks from investing with him and his company. He also has an obligation to tell the truth. If he misleads you, including failing to disclose a major risk to your investment, you can sue him personally.
There is one huge investment risk that your broker is surely not disclosing. It’s the risk arising from SIPC, the so-called Securities Investor Protection Corporation. And there is one extremely serious misrepresentation he surely is making, namely that your brokerage account is insured by SIPC. Falsely claiming that you are insured represents financial fraud.
Let’s start with three basic facts.
First, SIPC is a company mandated by Congress, but owned and operated by Wall Street firms, the largest of which have a well-deserved reputation for dishonesty. Citi’s $7 billion settlement with the Justice Department for marketing fraudulent securities, made just days ago, is the latest evidence in this regard.
Second, SIPC, i.e., Wall Street, is supposed to pay you up to $500,000 if your brokerage firm goes bust, including going bust due to fraud. There are multitudinous ways for brokerages to defraud their clients, get caught, and go under. But if SIPC chooses to define the fraud as a Ponzi scheme, it can a) avoid making good on its insurance pledge and b) accuse you of participating in the theft for up to 6 years and sue you to recover the funds you “stole!”
Third, as a front-page NY Times article just pointed out, Ponzi schemes are a dime a dozen. And since there is no clear definition of a Ponzi scheme, SIPC can call virtually any fraud it wants a Ponzi scheme.
I provided a simple example of the terrible risk arising from SIPC brokerage “insurance” in a recent Forbes column entitled, Close Your Brokerage Account and in a longer version published by PBS NEWSHOUR entitled Why No One Should Use Brokerage Accounts.
Today, I want to provide the “simple” math SIPC uses to a) renege on its insurance commitment and b) put you in truly terrible danger for doing what every investor expects and is entitled to do – spend the proceeds of his investment.
When you understand this math, you’ll understand why I’m advising you to a) close your brokerage account and b) avoid spending any withdrawals that SPIC can claw back arising from past or future fraud in your brokerage firm discovered in any of the next six years.
The “Simple” Math Underlying SIPC’S and Perforce, Your Broker’s Insurance Scam
I’ll start with the math and then illustrate it via an example. I assume your brokerage firm is headquartered in New York, whose 6-year claw-back, bankruptcy “law” is the basis of SIPC’s malfeasance.
Let’s call X the difference between withdrawals and contributions over the entire history of your account.
Note that we all invest on the basis of X being positive, i.e., on the basis of our being able to earn a return on our investments and, therefore, take out more than we put in.
But if X is positive when your brokerage goes under and SIPC calls it a Ponzi scheme, you not only lose every penny of your remaining account balance, which I’ll call Y. You also get no insurance protection from SIPC – not a penny, not a dime, not a quarter, and certainly not $500,000.
Y could be all the money you have left in the world. It could be far larger or far smaller than $500,000. But as long as X is a penny or more, SIPC will declare you a “net winner” and pay nothing whatsoever on your insurance claim.
In addition to not paying your insurance claim, SIPC will have its trustee sue you, up to the amount X, for every penny you withdrew from your account over the last six years with no credit whatsoever given for contributions you made to your account over the past six years.
Illustrating SIPC’s and Perforce, Your Broker’s Insurance Scam
Say you saved up $200,000 and invested it 40 years ago with your Kansas broker, whose brokerage company operates out of NY. Had the investment yielded the stock market’s historic 10 percent average return and had you let the money ride, your account balance would exceed $9 million. But it’s only $1.4 million because your return, as reported to you, wasn’t always great and because you a) took out $300,000 back in 2000 to pay for your mom’s nursing home and b) withdrew $100,000 per year for the past six years to help your daughter start a business, cover your medical bills, contribute to your church, and help finance your retirement. The $1.4 million would be only $1.35 million had you not reinvested $50,000 three weeks back at the strong suggestion of your broker.
Today you learn that your brokerage is broke. It borrowed heavily, pledging your securities and those of other customers as collateral, to place a huge bet that went south. You’re appalled, especially when you learn that the brokerage’s top management has been doing this for years while covering its losses with new investors’ funds.
SIPC rides to the rescue. But then it realizes, as it did in the Madoff case, that it doesn’t have the funds to cover its insurance obligations and it certainly doesn’t want to assess its members. So it declares the bankruptcy a Ponzi scheme.
You’ve just lost $1.4 million – virtually your entire remaining retirement savings. You’re devastated. You call up SIPC to request the $500,000 in insurance. Here’s what SIPC says:
“You are a net winner because you took out $900,000 over the last 40 years and contributed $250,000.”
“Your X is $900,000 less $250,000 or $650,00. And because your X is positive, we, SIPC, owe you nothing.”
“Because you stole $600,000 over the last six years and because $600,000 is less than X, you owe us $600,000.”
“We’ve hired the most expensive lawyers in the country to sue you for the $600,000. They are paid by the hour and have every incentive to work as long and as hard as it takes to make you pay.”
“Have a good day.”
Additional Insurance “Protection” Your Brokerage Advertises
Some brokerage companies claim to provide extra insurance holdings. Read the fine print. First the companies have ridiculously low limits on their total insurance coverage. Second, their insurance kicks in only after SIPC’s $500,000 payout limit is reached. But if SPIC is paying you $0 (not counting the $600,000 you need to pay it), its limit is never reached and you get no protection from the “additional protection.”
Here’s Charles Schwab & Co.’s statement: “This additional protection becomes available in the event SIPC limits are exhausted. “
Here’s Fidelity’s statement: “In addition to SIPC protection, Fidelity provides its brokerage customers with additional “excess of SIPC” coverage. The excess coverage would only be used when SIPC coverage is exhausted.”
Here’s Merrill Lynch’s statement: In addition to SIPC protection, MLPF&S has obtained excess-SIPC coverage through a Lloyd’s of London syndicate. This policy provides additional protection for shortfalls above the SIPC limits (including up to $1.9 million for cash), subject to an aggregate loss limit of $1 billion for all customer claims.
I could go on with these listings, but you get the point.
SIPC’s CEO Stephen Harbeck responded to my column in Your Brokerage Account Is Safe With the Securities Investor Protection Corporation. I responded to his column in Why Brokerage Account Insurance Is a Bigger Scam than Madoff.
As these columns indicate, I have relatives, friends, and colleagues who were twice victimized – first by Madoff and then by SIPC in its infamous, precedent-setting victimization of Madoff victims. But my personal interest in SIPC’s scam and its elimination doesn’t alter this basic fact:
SIPC has made all of us all Madoff victims. Thanks to its actions in the Madoff case, none of us can now safely use brokerage accounts.
Please have your broker read all the above-cited columns as well as this excellent exposé of SIPC “insurance” by nationally syndicated financial columnist, Scott Burns. Also ask your broker to push for immediate passage of H.R. 3482 and S. 1725, which would eliminate the SIPC risk to your brokerage account. Finally, tell him you’re closing your account pending passage of the bill.