Securities Investor Protection: Steps Needed to Better Disclose
SIPC Policies to Investors (25-MAY-01, GAO-01-653).
The Securities Investor Protection Act of 1970 created the
Securities Investor Protection Corporation (SIPC) to help protect
customers against losses from the failure of a securities firm.
However, the large number of claims denied in several recent SIPC
liquidation proceedings has raised concerns that some SIPC
policies and practices may unduly limit the actual protection
afforded customers. This report discusses (1) the basis for SIPC
policies involving unauthorized trading and the extent that these
policies are disclosed to investors; (2) the basis for SIPC
policies involving the affiliates of SIPC member firms and the
extent that these policies are disclosed to investors; (3) SEC
oversight of SIPC; and (4) the disclosure rules for SIPC, the
Federal Deposit Insurance Corporation, and state insurance
guarantee associations, as well as the related implications for
consumers as the financial services industry consolidates.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-01-653
ACCNO: A01051
TITLE: Securities Investor Protection: Steps Needed to Better
Disclose SIPC Policies to Investors
DATE: 05/25/2001
SUBJECT: Bankruptcy
Brokerage industry
Disclosure law
Fraud
Information disclosure
Securities regulation
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GAO-01-653
Report to the Ranking Minority Member, Energy and Commerce Committee, House
of Representatives
United States General Accounting Office
GAO
May 2001 SECURITIES INVESTOR PROTECTION
Steps Needed to Better Disclose SIPC Policies to Investors
GAO- 01- 653
Page i GAO- 01- 653 Securities Investor Protection Letter 1
Executive Summary 3
Chapter 1 Introduction 14 SIPC?s Mission, Organization, Funding, and
Oversight 15 SIPC Protection Versus Federal Deposit Insurance 17 How SIPC
Liquidates a Member Firm and Protects Its Customers 18 SIPC Liquidation
Proceedings Are Relatively Infrequent 21 Objectives, Scope, and Methodology
22
Chapter 2 Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading 25
Unauthorized Trading Liquidations Accounted for Nearly TwoThirds of
Liquidations Initiated From 1996 Through 2000 25 The Establishment of an
Evidentiary Standard Is Authorized Under
SIPA 28 Bankruptcy Court Rejected the Stratton Oakmont Trustee?s
Procedure for Satisfying Certain Approved Unauthorized Trading Claims 31
SIPC and SEC Have Missed Opportunities to Disclose Information
About the Evidentiary Standard to Investors 32 Conclusions 38
Recommendations 39 Agency Comments and Our Evaluation 40
Chapter 3 Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved 43
SIPC and Trustees Denied Nonmember Affiliates Claims on Several Grounds 43
The Trustee and SIPC Concluded in the Most Recent Liquidation
That Customers of the Nonmember Affiliate Were Customers of the SIPC Member
48 Information Available to Investors About Avoiding Risks That Can
Be Associated With Nonmember Affiliates Is Limited 49 Conclusions 50
Contents
Page ii GAO- 01- 653 Securities Investor Protection
Recommendations 52 Agency Comments and Our Evaluation 52
Chapter 4 Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges 53
SEC?s SIPC Oversight Examination Program Has Some Limitations 53 SEC Has Not
Implemented SEC IG Recommendation on Sharing
Information About SIPC Issues 57 SEC OGC Has Established a Pilot Program to
Monitor Ongoing
SIPC Liquidations 58 Conclusions 58 Recommendations 59 Agency Comments and
Our Evaluation 59
Chapter 5 Investors May Confuse SIPC With Other Financial Guarantee Programs
as U. S. Financial Industries Restructure 60
Some Investors May Confuse SIPC and State Insurance Guarantee Associations
With FDIC 60 Investor Confusion May Increase as Financial Services Industy
Consolidate 67 Conclusions 69 Recommendation 69 Agency Comments and Our
Evaluation 69
Appendix I Comments From the Securities Investor Protection Corporation 72
Appendix II Comments From the Securities and Exchange Commission 83
Appendix III GAO Contacts and Acknowledgments 89
Page iii GAO- 01- 653 Securities Investor Protection Tables
Table 1: Selected SIPC Liquidations Involving Nonmember Affiliates. 45 Table
2: Protections and Disclosure Rules of SIPC, FDIC, and State
Life/ Health Insurance Guarantee Associations 62
Figures
Figure 1: Sample Back Page of Confirmation Statement 37 Figure 2: Official
Symbols of SIPC and FDIC 65
Abbreviations
FDIC Federal Deposit Insurance Corporation GLBA Gramm- Leach- Bliley Act of
1999 IG Inspector General NERO Northeast Regional Office NYSE New York Stock
Exchange OCIE Office of Compliance Inspections and Examinations OGC Office
of General Counsel SEC Securities and Exchange Commission SIPA Securities
Investor Protection Act of 1970 SIPC Securities Investor Protection
Corporation SRO Self- Regulatory Organization
Page 1 GAO- 01- 653 Securities Investor Protection
May 25, 2001 The Honorable John D. Dingell Ranking Minority Member Committee
on Energy and Commerce House of Representatives
Dear Mr. Dingell: This report responds to your November 16, 1999, and April
13, 2000, requests that we assess the operations of the Securities Investor
Protection Corporation (SIPC), which was established by the Securities
Investor Protection Act of 1970. As you requested, this report discusses (1)
the basis for SIPC policies involving unauthorized trading and the extent
that these policies are disclosed to investors; (2) the basis for SIPC
policies involving the affiliates of SIPC member firms and the extent that
these policies are disclosed to investors; (3) the Securities and Exchange
Commission?s (SEC) oversight of SIPC; and (4) the disclosure rules for SIPC,
the Federal Deposit Insurance Corporation, and state insurance guarantee
associations, as well as the related implications for consumers as the
financial services industry consolidates. This report includes
recommendations to the Chairman, SIPC, and the Chairman, SEC, regarding
disclosure of SIPC policies and SEC?s SIPC oversight.
As we agreed with your office, we plan no further distribution of this
report until 30 days from its issuance date unless you publicly release its
contents sooner. We will then send copies of this report to Senator Phil
Gramm, Chairman, Senate Committee on Banking, Housing and Urban Affairs;
Senator Paul Sarbanes, Ranking Member, Senate Committee on Banking, Housing
and Urban Affairs; Representative W. J. ?Billy? Tauzin, Chairman, House
Committee on Energy and Commerce; Representative Michael G. Oxley, Chairman,
House Committee on Financial Services; Representative John J. LaFalce,
Ranking Minority Member, House Committee on Financial Services; Debbie
Dudley Branson, Acting Chairman, SIPC; Michael Don, President, SIPC; the
Honorable Laura Unger, Acting Chairman, SEC; Mr. Robert R. Glauber,
President and CEO, National Association of Securities Dealers; Richard
Grasso, Chairman and CEO, New York Stock Exchange; and other interested
committees and organizations. Copies will be made available to others upon
request.
United States General Accounting Office Washington, DC 20548
Page 2 GAO- 01- 653 Securities Investor Protection
Major contributors to this report are acknowledged in appendix III. If you
or your staff have any questions, please call me or Orice M. Williams at
(202) 512- 8678.
Sincerely yours, Richard J. Hillman Director, Financial Markets
and Community Investment
Executive Summary Page 3 GAO- 01- 653 Securities Investor Protection
The Securities Investor Protection Act of 1970 (SIPA) created the Securities
Investor Protection Corporation (SIPC) to provide certain protections
against losses to customers from the failure of a securities firm. However,
the large number of claims denied in several recent SIPC liquidation
proceedings, has raised concerns that certain SIPC policies and practices
may unduly limit the actual protection afforded customers. Critics assert
that SIPC and court- appointed trustees, who carry out the liquidation
proceedings, interpret SIPA so rigidly that they act inconsistently with, if
not contrary to, the customer- protection purpose of the act. SIPC?s
handling of two types of claims has been most heavily criticized. The first
type involves claims of unauthorized trading, which is the buying or selling
of securities in an investor?s account without the investor?s prior
approval. The second type involves claims from investors who were doing
business with a nonmember affiliate but believed that they were dealing with
a SIPC- member firm and, therefore, covered by SIPC. 1 These two types of
claims were filed in 75 percent, or 28, of the 37 liquidation proceedings
initiated by SIPC between 1996 and 2000.
The enactment of the Gramm- Leach- Bliley Act of 1999 (GLBA) eliminated many
legal barriers to affiliation among banks, securities firms, and insurance
companies, and other financial service providers. As the financial services
industry consolidates to provide one- stop shopping mainly through
affiliates, concerns have been raised about whether consumers are adequately
informed about the respective coverage provided by SIPC, the Federal Deposit
Insurance Corporation (FDIC), and state insurance guarantee funds for
various financial products. In light of the concerns raised about SIPC?s
implementation of SIPA and the potential for increased investor confusion
surrounding coverage, the specific objectives of this report are to
review the basis for SIPC?s policies and practices for validating and
satisfying claims involving unauthorized trading and the extent that these
policies were disclosed to investors;
review the basis for SIPC?s policies and practices for determining claims
in liquidations of SIPC- member firms and their nonmember affiliates and the
extent that these policies were disclosed to investors;
evaluate the Securities and Exchange Commission?s (SEC) oversight of
SIPC?s operations and compliance with SIPA; and
1 Most registered securities firms automatically become members of SIPC.
However, affiliates of securities firms are not required to become members
of SIPC. Executive Summary
Executive Summary Page 4 GAO- 01- 653 Securities Investor Protection
compare the coverage provided by and disclosure rules for SIPC, FDIC, and
state insurance guarantee associations and the implications for consumers as
some banks, securities firms, and insurance companies consolidate their
operations.
GAO reviewed SIPA and its legislative history; reviewed legal briefs and
court decisions; and interviewed SIPC and SEC officials, SIPA trustees and
their attorneys, and claimants? attorneys. GAO focused its review on
liquidations initiated between 1996 and 2000 involving introducing firms 2
engaged in unauthorized trading and SIPC members with affiliates. GAO also
reviewed information relating to SEC?s oversight of SIPC and the differences
between SIPC and FDIC coverage and a summary of disclosure policies typical
of state insurance guarantee programs. A complete discussion of GAO?s scope
and methodology can be found in chapter 1.
SIPC?s policies and practices in liquidation proceedings involving certain
unauthorized trading claims have generated controversy because many claims
were denied or claimants received worthless securities instead of cash. 3
Two practices are central to the controversy. The first practice requires
that claimants provide some form of objective evidence that they complained
about an unauthorized trade within a reasonable time after the disputed
trade. SIPC?s practice of requiring objective evidence, usually a letter to
the broker, is based on the authority that SIPA provides SIPC and the
trustees to establish standards to determine the validity of customer
claims. Although challenged by some claimants and critics as unreasonable,
courts have upheld this policy. The second practice involves how SIPC and a
trustee satisfied certain unauthorized trading claims. Approved claims for
substantial amounts of cash were satisfied with worthless securities.
Claimants have successfully challenged this practice in a bankruptcy court,
but the appeals process is ongoing.
SIPC and SEC, which plays an important role in investor education, have not
adequately disclosed to investors information about the policy on
2 An introducing firm does not clear securities transactions or hold
customer cash or securities. 3 See ?Many Holes Weaken Safety Net for Victims
of Failed Brokerages,? The New York Times, Sept. 25, 2000; ?Group Assails
Insurer of Investors,? The Washington Post, July 21,
1999; and ?Many Unhappy Returns: Ex- Stratton customers still fighting to
recoup $130m,? Newsday, Dec. 20, 1998. Results in Brief
Executive Summary Page 5 GAO- 01- 653 Securities Investor Protection
providing objective evidence to prove unauthorized trading claims. For
example, SIPC?s informational brochure does not disclose information on this
policy to investors. For the claims we reviewed, investors seemed unaware of
the importance of documenting their complaints and were more than twice as
likely to telephone their broker to complain about an unauthorized trade as
to write a letter. GAO recommends that SIPC and SEC take actions to better
inform investors about this policy and the steps investors can take to
protect their interests.
SIPC?s position in liquidation proceedings involving SIPC members with
affiliates has also generated controversy because many claimants were
determined not to be customers of the failed member firm. SIPA authorizes
SIPC to liquidate only SIPC members. Therefore, only customers of the member
in liquidation are entitled to protection under SIPA. In general, for a
claim of a customer of the nonmember to be approved, SIPC requires that the
cash or securities involved has been entrusted to the SIPC member firm. 4
Several claimants, whose claims were denied because SIPC and the trustee
determined that they did not entrust funds with the SIPC member firm,
appealed the determination in Federal Court. In 2000, a Federal Court of
Appeals agreed, ruling that under the circumstances of that case, a
claimant?s reasonable belief that he or she was dealing with the member can
serve as the basis for a claim. However, in other cases, courts have upheld
SIPC?s position that a claimant?s belief does not constitute evidence that
funds in fact were entrusted to the member. Although SIPC has been involved
in several liquidation proceedings involving nonmember affiliates since
1996, there is limited information available to help investors avoid the
potential risks associated with the nonmember affiliates. GAO recommends
that SIPC and SEC take actions to increase the availability of this
information.
SEC, which is responsible for oversight of SIPC, faces important challenges
in its oversight of SIPC. Since 1971, SEC has initiated only three
examinations. The first two examinations focused on the adequacy of the SIPC
fund and administrative issues. The scope of the most recent examination
initiated in May 2000 was expanded to include many of the more controversial
issues raised in this report. To date, SEC examiners have focused on a
limited number of liquidations involving unauthorized trading and none of
the liquidation proceedings involving the affiliate
4 Claimants must also meet other requirements such as the products purchased
must be securities as defined by SIPA.
Executive Summary Page 6 GAO- 01- 653 Securities Investor Protection
issue. SEC officials agreed and said that they would expand the number of
liquidations reviewed. In addition, in March 2000, SEC?s Inspector General
(IG) issued a report 5 suggesting that SEC establish a formal mechanism to
share information about SIPC proceedings, but SEC has not implemented the
recommendation to date. A formal mechanism to share information could
enhance SEC?s ability to discuss staffs? varying opinions on issues relevant
to SIPC and ensure a comprehensive oversight program. GAO recommends that
SEC expand its oversight of SIPC operations to include a larger sample of
proceedings involving unauthorized trading and nonmember affiliates and
establish a formal coordination mechanism to share information about SIPC
liquidation proceedings within SEC.
Consolidation in the financial services industry has raised concerns about
whether consumers are adequately informed about the respective differences
in coverage provided by SIPC; FDIC; and, to a lesser degree, state insurance
guarantee funds as more companies offer banking, securities, and insurance
products from a single location or through an affiliated entity. Differences
in the coverage largely stem from the differences in the products offered
and the nature of the relationship between the financial institution (bank,
securities firm, or insurance company) and its customers. Many regulatory
and securities industry officials that GAO contacted said that consumers
already confuse SIPC with FDIC because of similarities in the amount of cash
coverage and misunderstandings about what that coverage entails. Without
improved investor education- especially that SIPC does not cover losses due
to changes in market prices- investor confusion is likely to increase as the
U. S. financial industry continues to consolidate and offer similar
financial products under a single corporate umbrella. GAO recommends that
SIPC improve the standard disclosure language it uses to describe its
coverage.
By law, securities firms are to keep customer accounts separate from the
firms? funds. For the firms that fail to do this and that are liquidated by
SIPC, SIPC?s statutory mission is to promptly replace missing cash and
securities in an investor?s account up to the statutory limits. Securities
firms registered with SEC automatically become members of SIPC and must pay
an annual assessment to the SIPC fund. The SIPC fund, valued at $1.2 billion
as of February 9, 2001, is used to replace the missing securities
5 Oversight of Securities Investor Protection Corporation. Securities and
Exchange Commission Office of Inspector General. Audit Report No. 301. Mar.
31, 2000. Background
Executive Summary Page 7 GAO- 01- 653 Securities Investor Protection
and cash and to pay administrative costs of the liquidation proceeding.
However, SIPC does not protect against losses from declines in the market
value of securities.
In typical proceedings under SIPA, SEC or the Self- Regulatory
Organizations- such as the NASDR 6 and the New York Stock Exchange- notify
SIPC when a SIPC member firm is in financial trouble. Upon receiving such
information, SIPC may file a petition in a federal district court to
liquidate the firm. 7 The district court appoints a trustee at SIPC?s
recommendation. SIPC serves as the trustee in some cases. The liquidation
proceeding is then removed to a U. S. bankruptcy court. The trustee notifies
the firm?s customers of the liquidation proceeding. Typically, the trustee
tries to sell or otherwise transfer customer accounts to another SIPC
member. Customers must file claims to recover missing funds or securities
from the member in liquidation. The trustee and SIPC staffs review submitted
claims and related information and notify individuals whether their claims
are approved or denied. To the extent that the SIPC member firm?s assets are
insufficient, SIPC advances funds for the payment of customer claims up to
the statutory limits. Claimants may seek review of the trustee?s decision on
their claims by the bankruptcy court. If the trustee?s fees and
administrative expenses cannot be recovered from the members? assets, SIPC
advances funds to cover them.
Pursuant to the authority provided under SIPA, SIPC and trustees generally
require claimants to provide objective evidence that they complained within
a reasonable time after the allegedly unauthorized trade or their claims
will be denied. However, SIPC and the trustees may consider other forms of
objective evidence, such as complaints to regulators. SIPC and the trustees
assert that objective evidence, such as reliable and timely documentation
showing a trade was unauthorized, is necessary to ensure claim accuracy and
to protect against fraudulent claims. Although courts have upheld this
policy, critics argue that the standard is unreasonable and places an undue
burden on claimants. For
6 NASDR, Inc., is the regulatory arm the National Association of Securities
Dealers. 7 In certain situations, SIPC may elect to use a direct payment
procedure in lieu of instituting a liquidation proceeding to pay customer
claims. Principal Findings
SIPC?s Policies and Practices Involving Unauthorized Trading Need Additional
Disclosure
Executive Summary Page 8 GAO- 01- 653 Securities Investor Protection
example, critics of the policy believe that it is unrealistic to expect
unsophisticated investors to complain about unauthorized trades in writing
within a specified period of time because securities orders and related
transactions routinely are conducted by telephone. Available evidence lends
support to the contention that investors are unaware of SIPC?s practice. For
example, GAO reviewed a random and representative sample of 152 unauthorized
trading claims from 2 of the larger liquidation proceedings and found that
about 87 percent of the claimants indicated that they telephoned to complain
about unauthorized trades compared with 38 percent of the claimants who
provided letters.
The second controversial practice in SIPC liquidations involving
unauthorized trading occurred in a case in which the trustee satisfied
certain claims for cash by unwinding all trades determined to be
unauthorized, including those not specified in the claims. As a consequence
of this process, the trustee treated the claims as claims for securities.
This practice resulted in some claimants receiving worthless securities,
rather than substantial amounts of cash for which they had filed claims. In
this case, claimants filed claims for cash that had been used to make
unauthorized purchases of securities. However, the trustee determined that
the securities had been purchased with proceeds from prior unauthorized
sales of securities. Therefore, SIPC and the trustee determined that the
claimants were entitled to the securities that were in the account before
the unauthorized sales, rather than the cash that was received from the
sales and placed in the account before the unauthorized purchase. Claimants
challenged the trustee?s practice, and a federal bankruptcy court rejected
the practice as not authorized by SIPA or any other law. SIPC and the
trustee maintained that SIPA requires the trustee?s approach. The court
determined that the claims for cash should be paid because the statute does
not authorize the trustee to consider trades not disputed in a claim form
and, therefore, treat a claim as if it were a claim for securities.
According to SIPC officials, SIPC and the trustee have filed notices of
appeal.
SIPC and SEC, which has an important role in investor education, have not
adequately disclosed information about the importance of documenting
unauthorized trading complaints. Although SIPC and SEC- through an
informational brochure and Web sites- provide much useful information, they
do not fully and consistently explain the need to complain in writing about
unauthorized trades within a reasonable time period of the unauthorized
trade. SEC?s Web site, for example, provided inconsistent advice about when
to telephone complaints and when to follow up in writing. Limited disclosure
may, in part, explain why many investors with
Executive Summary Page 9 GAO- 01- 653 Securities Investor Protection
unauthorized trading complaints appear to have been unaware of the
importance of documenting their complaints about trades that were not
authorized in a timely manner.
Under SIPA, only customers of a SIPC member firm qualify for SIPA protection
and only securities defined in the act and determined to be in the member?s
custody are covered. In three SIPC liquidations involving nonmember
affiliates that GAO reviewed, trustees or SIPC denied claims they determined
were not covered by SIPA because one or more of these requirements were not
satisfied, as well as for other reasons. SIPC and the trustees denied
certain claims in these proceedings, for example, on the grounds that
persons who dealt with the affiliates were not customers of the SIPC member
firms. They said that certain evidence, including checks made out to the
affiliates or fund transfers to accounts with the affiliates, demonstrated
that the claimants were not the customers of the SIPC members. In addition,
SIPC and the trustees determined that the investments purchased were not
securities as defined in the act.
In 2000, claimants in one liquidation involving a nonmember affiliate
successfully challenged the trustee?s and SIPC?s denials of their claims.
The claimants believed that they qualified as customers of the SIPC member
because the SIPC member and its affiliates were presented to them and
operated as a single enterprise and that the investments at issue were
securities. Moreover, the common owner used the member and nonmember in a
scheme to defraud customers. In August 2000, the Federal Court of Appeals
for the Eleventh Circuit found that the claimants reasonably believed that
they were dealing with the SIPC member and that the owner of both entities
used funds raised through the nonmember affiliate as if they were the funds
of the SIPC member. The court also found that the claimants deposited cash
to purchase securities covered under the act. However, other courts have
supported SIPC?s and the trustee?s position in similar cases.
Although disclosure alone would not resolve all of the issues surrounding
these types of liquidations, greater disclosure could help investors better
understand SIPC liquidation proceedings and what steps they could take to
protect their interests. SIPC?s informational brochure provides useful
information that tells investors that they should avoid writing checks to
anyone other than the firm, including affiliates. However, SEC does not
require SIPC member firms to routinely distribute the SIPC brochure to
investors. In addition, SEC?s Web site provides some information on dealings
with affiliates, but the information is generally limited. Information
Shared With
Investors About SIPC?s Policies Involving Nonmember Affiliates Is Not
Adequate
Executive Summary Page 10 GAO- 01- 653 Securities Investor Protection
SEC has taken steps to improve its oversight of SIPC. However, the oversight
program faces ongoing challenges. SEC?s Division of Market Regulation
(Market Regulation) has primary responsibility for ensuring SIPC?s
compliance with SIPA. Market Regulation has engaged in several important
oversight activities, such as monitoring the size of the SIPC customer-
protection fund and maintaining regular communication with SIPC. However,
Market Regulation initiated only two SIPC examinations between 1971 and
1999.
In 2000, SEC started a joint examination led by Market Regulation and the
Office of Compliance Inspections and Examinations (OCIE). Consistent with
observations made by SEC?s IG, the scope of this examination was expanded.
The examination guidelines include some of the issues raised by the more
recent controversial liquidations discussed in this report. As of March
2001, the sample of liquidations reviewed by SEC included 4 of the 28
liquidations involving the controversial policies and practices and none of
nonmember affiliate proceedings. In response to this observation, SEC staff
stated that they plan to review additional liquidations involving
unauthorized trading and the nonmember affiliate issue.
In September 2000, SEC also established a pilot program to monitor SIPC
liquidation proceedings. Although this program is a positive development, it
is too soon to determine its efficacy. The pilot program also highlights the
need for more formal information sharing among SEC units. The IG report on
SEC?s SIPC oversight found that communication among SEC units could be
improved and recommended that SEC units establish a formal method for
sharing information. GAO?s review found that SEC had not yet implemented the
IG recommendation. Given that different offices and divisions receive
different information about SIPC liquidations, more formal communication
among the groups that are involved in reviewing these liquidations- such as
Market Regulation, OCIE, and the Division of Enforcement (Enforcement)- is
important. Without a formal means to share information across organizational
lines, SEC?s ability to establish a comprehensive SIPC oversight strategy
could be hampered. SEC officials said that they plan to begin holding
quarterly meetings to share information about SIPC.
The type of financial protection that SIPC provides is similar to that
provided by FDIC and, to some extent, state life and health insurance
guarantee associations, but important differences exist. Consumers may
confuse the coverage offered by these programs. When a member firm fails, if
customer accounts are not transferred to another institution, both SIPC and
FDIC return up to $100,000 of missing customer or depositor SEC?s SIPC
Oversight Has
Improved but Faces Ongoing Challenges
Potential Exists for Increased Investor Confusion
Executive Summary Page 11 GAO- 01- 653 Securities Investor Protection
cash; however, SIPC also replaces missing securities. The total amount of
coverage under SIPA is up to $500,000, of which no more than $100, 000 can
be a claim for cash. Customer securities held by a securities firm are not
assets of the firm, but are held in custody by the firm for its customers.
SIPA protects the firm?s obligation to return these assets. Because
securities, unlike cash, are subject to price fluctuations, the securities
returned to a customer can be worth less than their purchase price. In
contrast, FDIC protects deposits, which are obligations of the accepting
firm, which includes banks and thrifts. FDIC protects depositors against the
risk that the institution that accepted the deposit will fail and not have
assets sufficient to return a customer?s deposit. Unlike securities
accounts, cash deposits do not fluctuate in value. Therefore, in order to
fulfill failed member depository obligations, FDIC returns the amount in the
account up to the statutory limit. The state life/ health insurance
guarantee associations also serve to preserve an insurance company?s
obligation to those insured. The state insurance associations guarantee that
owners of covered products will not lose their insurance coverage up to
certain limits and step in to fulfill the obligations of the policy when an
insured institution fails.
According to many regulatory and securities industry officials, some
consumers likely confuse SIPC with FDIC, given the similarities in coverage
amounts, misunderstandings between the nature of securities investing versus
making deposits, and the similarity in the SIPC and FDIC logos. Yet, neither
SIPC or SEC requires firms who are SIPC members to disclose in advertising
to the investing public a key fact that might help consumers distinguish
SIPC from FDIC: that SIPC does not protect against losses due to declines in
their securities? market value.
GLBA allows banks, securities firms, and insurance companies, primarily
through affiliates, to underwrite and sell each other?s traditional
financial products to a degree not previously allowed. To the extent that
financial companies consolidate and begin to offer a full range of banking,
securities, and insurance products to the public, individuals will be more
likely to purchase financial products from the same corporate family that
are covered by different guarantee organizations. Any public confusion that
already exists between SIPC and FDIC or the state insurance guarantee
associations may increase. Given the limitations of SIPC?s disclosure
requirements, unsophisticated investors who do not fully understand the
difference between investing in securities and depositing funds in a bank
may not realize that SIPC will not protect their securities investments from
certain losses, such as declines in market value.
Executive Summary Page 12 GAO- 01- 653 Securities Investor Protection
To improve investor awareness of SIPC?s policies, practices, and coverage,
GAO recommends that the Chairman, SIPC,
as part of SIPC?s ongoing effort to revise the informational brochure and
Web site, include a full explanation of the steps necessary to document an
unauthorized trading claim and
amend SIPC advertising bylaws to require that the official explanatory
statement about a firm?s membership in SIPC include a statement that SIPC
coverage does not protect investors against losses caused by changes in the
market value of their securities.
In addition, SEC can take steps to improve the information it provides to
investors and that investors receive about SIPC and about how to protect
investor interests. GAO recommends that the Chairman, SEC
require SIPC member firms to provide the SIPC brochure to their customers
when they open an account and encourage firms to distribute the brochure to
its existing customers more widely and
review the sections of SEC?s Web site and, where appropriate, advise
customers to complain promptly in writing when they believe trades in their
account were not authorized and update the SEC Web site to include a full
explanation of SIPC?s policies and practices in liquidations involving
nonmember affiliates.
In chapter 2 of this report, GAO makes additional recommendations to the SEC
Chairman to improve disclosure.
Finally, to improve oversight of SIPC operations, GAO recommends that the
Chairman, SEC
ensure that OCIE and Market Regulation include in their ongoing SIPC
examination a larger sample of liquidations involving unauthorized trading
and nonmember affiliates claims and
require Market Regulation, OCIE, General Counsel, and Enforcement to
establish a formal procedure to share information about SIPC issues.
GAO received written comments on a draft of this report from SIPC and SEC.
These comments are discussed in greater detail at the end of chapters 2
through 5. In addition, SIPC?s and SEC?s comments are printed in appendixes
I and II, respectively. SIPC and SEC also provided technical comments, which
have been incorporated into the report where appropriate. Officials from
SIPC and SEC agreed with most of the Recommendations
Agency Comments and Our Evaluation
Executive Summary Page 13 GAO- 01- 653 Securities Investor Protection
conclusions and recommendations in the draft report and both have begun to
take steps to implement several of GAO?s recommendations.
For example, SIPC officials said that they have begun to implement GAO?s
recommendation concerning improving disclosure of SIPC?s unauthorized
trading policies and practices. Specifically, SIPC officials said that
changes they are making to the informational brochure would urge investors
to complain about unauthorized trading in writing. In addition, SEC
officials said that they would consider the appropriateness of requiring
firms to distribute the SIPC brochure to new customers and existing
customers more widely. In addition, SEC officials said that they had already
reviewed SEC?s Web site and made changes in response to GAO?s
recommendations where appropriate. SEC officials also agreed with GAO?s
recommendations concerning its oversight effort. Specifically, SEC officials
agreed to review additional liquidation proceedings during its ongoing
examination, and SEC officials stated that they would hold quarterly
meetings to discuss various issues related to SIPC.
SIPC disagreed with GAO?s recommendation that it amend its bylaws to require
that any statement about a firm?s membership include a statement that SIPC
coverage does not protect investors against losses caused by changes in the
market value of their securities. First, SIPC officials believe SIPC lacks
the authority to implement such a change in SIPC?s bylaws. Second, they
believe such a statement would be misleading. GAO has revised the
recommendation to make clear that it applies to only SIPC?s
?official explanatory statement.? On the basis of GAO?s conversation with
SEC officials concerning SIPC?s authority to amend its bylaws and GAO?s
review of the statute and legislative histories, GAO continues to believe
that SIPC has authority, with SEC approval, to determine what should be
disclosed in its official explanatory statement. GAO also does not share
SIPC?s concern that simply stating that SIPC does not protect against losses
caused by changes in the market value of securities would be misleading.
Such disclosure would be similar to information disclosed in SIPC?s
informational brochure, as well as information contained on the Web sites of
SEC and NASDR describing SIPC coverage.
Chapter 1: Introduction Page 14 GAO- 01- 653 Securities Investor Protection
The Securities Investor Protection Act of 1970 (SIPA) established the
Securities Investor Protection Corporation (SIPC) to provide certain
financial protections to the customers of insolvent securities firms. As
required by SIPA, SIPC either liquidates a failed firm itself (in cases
where the liabilities are limited and there are less than 500 customers) or
a trustee selected by SIPC and appointed by the court liquidates the firm. 1
In either situation, SIPC is authorized to make advances from its customer
protection fund to promptly satisfy customer claims for missing cash and
securities up to amounts specified in SIPA. Between 1971 and 2000, SIPC
initiated a total of 287 liquidation proceedings and paid about $234 million
to satisfy such customer claims.
In the past 5 years, some SIPC liquidation proceedings have involved
controversial policies and practices because trustees denied large numbers
of investor claims. 2 One controversial practice involved the trustees?
denials of many claims because claimants did not satisfy the trustee?s
requirement that the claimants reliably demonstrate that trading in their
accounts was unauthorized (i. e., the firm had bought or sold securities for
a customer?s account without approval). Another controversial practice
involved denials of claims of individuals who said they believed that they
were customers of a firm covered under SIPA but actually had been dealing
with an affiliated entity not covered by SIPA. In these liquidations,
critics argue that SIPC?s main goal has been to protect its industry-
supplied fund rather than to protect customers as contemplated by SIPA. SIPC
maintains that its policies are consistent with SIPA. An additional issue
related to SIPC coverage has emerged from another source: consolidation in
the financial services industry. As securities firms, banks, and insurance
companies begin to merge and sell each others? traditional products through
affiliates, it raises important implications about the extent of disclosure
that SIPC should require its member firms to make concerning the program?s
coverage. In response to a request from the Ranking Member of the House
Energy and Commerce Committee, we reviewed SIPC?s policies and practices in
liquidations involving unauthorized trading and affiliate issues, Securities
and
1 SIPA authorizes an alternative to liquidation under certain circumstances
when all customer claims aggregate to less than $250, 000. 2 See ?Many Holes
Weaken Safety Net for Victims of Failed Brokerages,? The New York Times,
Sept. 25, 2000; ?Group Assails Insurer of Investors,? The Washington Post,
July 21,
1999; and ?Many Unhappy Returns: Ex- Stratton customers still fighting to
recoup $130m,? Newsday, Dec. 20, 1998. Chapter 1: Introduction
Chapter 1: Introduction Page 15 GAO- 01- 653 Securities Investor Protection
Exchange Commission (SEC) oversight of SIPC, and the potential for greater
investor confusion as banks, securities firms, and insurance companies offer
financial products from the same corporate family that are covered by
different guarantee organizations.
SIPC was established in response to a specific problem facing the securities
industry in the late 1960s: how to ensure that customers recover their cash
and securities from securities firms that fail or cease operations and
cannot meet their custodial obligations to customers. The problem peaked in
the late 1960s, when outdated methods of processing securities trades,
coupled with the lack of a centralized clearing system able to handle a
large surge in trading volume, led to widespread accounting and reporting
mistakes and abuses at securities firms. Before many firms could modernize
their trade processing operations, stock prices declined sharply, which
resulted in hundreds of securities firms merging, failing, or going out of
business. During that period, some firms used customer property for
proprietary activities, and procedures broke down for proper customer
account management, making it difficult to locate and deliver securities
belonging to customers. The breakdown resulted in customer losses exceeding
$100 million because failed firms did not have their customers? property on
hand. Congress became concerned that a repetition of these events could
undermine public confidence in the securities markets.
SIPC?s statutory mission is to promote confidence in securities markets by
allowing for the prompt return of missing customer cash and/ or securities
held at a failed firm. SIPC fulfills its mission by initiating liquidation
proceedings where appropriate and transferring customer accounts to another
securities firm or returning the cash or securities to the customer by
restoring to customer accounts the customer?s ?net equity.? SIPA defines net
equity as the value of cash or securities in a customer?s account as of the
filing date, less any money owed to the firm by the customer, plus any
indebtedness the customer has paid back with the trustee?s approval within
60 days after notice of the liquidation proceeding was published. The filing
date typically is the date that SIPC applies to a federal district court for
an order initiating proceedings. 3 SIPA sets
3 Under SIPA, the filing date is the date on which SIPC files an application
for a protective decree with a federal district court, except that the
filing date can be an earlier date under certain circumstances, such as the
date on which a Title 11 bankruptcy petition was filed. SIPC?s Mission,
Organization, Funding, and Oversight
Chapter 1: Introduction Page 16 GAO- 01- 653 Securities Investor Protection
coverage at a maximum of $500,000 per customer, of which no more than
$100,000 may be a claim for cash. SIPC is not intended to keep firms from
failing or to shield investors from losses caused by changes in the market
value of securities.
SIPC is a nonprofit corporation governed by a seven- member Board of
Directors that includes two U. S. government, three industry, and two public
representatives. SIPC has 29 staff located in a Washington, D. C., office.
Most securities firms that are registered as broker- dealers under Section
15( b) of the Securities Exchange Act of 1934 automatically become SIPC
members regardless of whether they hold customer property. As of December
31, 2000, SIPC had 7,033 members. SIPA excludes from membership securities
firms whose principal business, as determined by SIPC subject to SEC review,
is conducted outside of the United States, its territories, and possessions.
Also, a securities firm is not required to be a SIPC member if its business
consists solely of (1) distributing shares of mutual funds or unit
investment trusts, 4 (2) selling variable annuities, 5 (3) providing
insurance, or (4) rendering investment advisory services to one or more
registered investment companies or insurance company separate accounts.
SIPA, as recently amended, also exempts a certain class of firms that are
registered with SEC solely because they may affect transactions in single
stock futures.
SIPA covers most types of securities such as notes, stocks, bonds, and
certificates of deposit. 6 However, some investments are not covered. SIPA
does not cover any interest in gold, silver, or other commodity; commodity
contract; or commodity option. Also, SIPA does not cover investment
contracts that are not registered as securities with SEC under the
Securities Act of 1933. Shares of mutual funds are protected securities, but
securities firms that deal only in mutual funds are not SIPC members and
thus their customers are not protected by SIPC. In addition, SIPA does not
4 A unit investment trust is an SEC- registered investment company, which
purchases a fixed, unmanaged portfolio of income- producing securities and
then sells shares in the trust to investors.
5 An annuity is a contract that offers tax- deferred accumulation of
earnings and various distribution options. A variable annuity has a variety
of investment options available to the owner of the annuity, and the rate of
return the annuity earns depends on the performance of the investments
chosen.
6 Typically, bank certificates of deposit are not securities under the
Securities Exchange Act of 1934, however, they are defined as securities in
SIPA.
Chapter 1: Introduction Page 17 GAO- 01- 653 Securities Investor Protection
cover situations where an individual has a debtor- creditor relationship-
such as a lending arrangement- with a SIPC member firm.
SIPC has a fund valued at $1.2 billion as of February 9, 2001, that it uses
to make advances to trustees for customer claims and to cover the
administrative expenses of a liquidation proceeding. 7 Administrative
expenses in a SIPC liquidation include the expenses incurred by a trustee
and the trustee?s staff, legal counsel, and other advisors. The SIPC fund is
financed by annual assessments on all member firms- periodically set by
SIPC- and interest generated from its investments in U. S. Treasury notes. 8
If the SIPC fund becomes or appears to be insufficient to carry out the
purposes of SIPA, SIPC may borrow up to $1 billion from the U. S. Treasury
through SEC (i. e., SEC would borrow the funds from the U. S. Treasury and
then re- lend them to SIPC). In addition, SIPC has a $1 billion line of
credit with a consortium of banks.
SIPA gives SEC oversight responsibility over SIPC. SEC may sue SIPC to
compel it to act to protect investors. SIPC must submit all proposed changes
to rules or bylaws to SEC for approval, and may require SIPC to adopt,
amend, or repeal any bylaw or rule. 9 In addition, SIPA authorizes SEC to
conduct inspections and examinations of SIPC and requires SIPC to furnish
SEC with reports and records that it believes are necessary or appropriate
in the public interest or to fulfill the purposes of SIPA.
SIPC and the Federal Deposit Insurance Corporation (FDIC) transfer or return
customer property in the event that a member fails; however, there are
important differences in the protection provided to investors. First, while
both protect cash left with the banks or securities firms, only SIPC
protects securities. Second, securities firms act as custodians for
customers? securities; this property does not become an asset of the firm.
SEC rules prohibit securities firms from using customer securities or cash
7 The SIPC board decided the fund balance should be raised to $1 billion to
meet the longterm financial demands of a very large liquidation. The SIPC
balance reached $1 billion in 1996.
8 As of February 2001, the annual assessment for SIPC members was $150. 9 A
proposed rule change becomes effective 30 days after it is filed with SEC,
unless the period is extended by SIPC or SEC takes certain actions. A
proposed rule change may take effect immediately if it is of a type that SEC
determines by rule does not require SEC approval. SIPC Protection
Versus Federal Deposit Insurance
Chapter 1: Introduction Page 18 GAO- 01- 653 Securities Investor Protection
to finance their own operations, and require firms to maintain minimum
levels of liquid assets to meet obligations to customers and other market
participants. However, if a firm fails and is unable to return all customer
securities or cash, SIPA provides limited protection, namely, the return of
the securities or cash in a given customer?s account up to the statutory
limits. SIPC generally returns the securities or cash that should have been
in the investor?s account on the liquidation filing date. Therefore, if the
price of the securities declines, SIPC does not protect investors from that
loss. However, investors benefit from continuing to hold the securities if
the price increases. Deposits held by a bank or thrift are different from
investments held by securities firms. Unlike securities, cash deposits do
not fluctuate in value. In addition, deposits are obligations of the
institution that accepts them. Banks are free to use these customer deposits
to finance their own operations (e. g., make loans or other investments). If
a bank makes bad investment decisions and fails with insufficient assets to
meet its liabilities to depositors, FDIC will provide coverage up to the
$100,000 limit.
When SEC or a self regulatory organization (SRO), such as NASDR, Inc., 10
informs SIPC that one of its member firms is in or is approaching financial
difficulty, SEC, the SROs, and SIPC take steps to determine whether the firm
might fail and whether and to what extent customers, as that term is defined
in SIPA, may be exposed. SIPC initiates liquidation proceedings if it
determines that the member firm has failed or is in danger of failing to
meet its obligations to customers, among other factor( s). 11 SIPC initiates
liquidation proceedings by applying for a protective order in a federal
district court or initiating a direct payment procedure. 12 The firm has an
opportunity to challenge the ruling. If the court issues the order, the
court appoints a disinterested trustee selected by SIPC, or, in certain
cases, SIPC
10 NASDR, Inc., is the regulatory arm of the National Association of
Securities Dealers, which was granted self- regulatory authority under the
Securities Exchange Act of 1933. 11 For SIPC to initiate a proceeding, at
least one of the following other factors must exist (1) the firm must be
insolvent under the Bankruptcy Code or unable to meet its obligations as
they become due; (2) the firm is subject to a court or agency proceeding in
which a receiver, liquidator, or trustee has been appointed for the member;
(3) the firm is not compliant with applicable financial responsibility rules
of the Commission or SROs; or (4) the firm is unable to show compliance with
such rules.
12 In the smallest proceedings (in which, among other factors, the claims of
all customers are less than $250, 000), SIPC directly pays customer claims
without filing an application for a protective order with a court and
without the appointment of a trustee. How SIPC Liquidates
a Member Firm and Protects Its Customers
Chapter 1: Introduction Page 19 GAO- 01- 653 Securities Investor Protection
itself, to liquidate the firm. 13 The district court orders removal of the
entire liquidation proceeding to the federal bankruptcy court for that
district. To the extent that it is consistent with SIPA, the proceeding is
conducted pursuant to pertinent provisions of the Bankruptcy Code. SIPA
requires that the trustee investigate facts and circumstances relating to
the liquidation; report to the court facts indicating fraud, misconduct,
mismanagement, or irregularities; and submit a final report to SIPC and
others designated by the court. Also, the trustee is to periodically report
to the court and SIPC on its progress in distributing cash and securities to
customers.
Promptly after being appointed, the trustee is to publish a notice of the
proceeding in one or more major newspapers, in a form and manner determined
by the court. The trustee also is to mail a copy of the notice to existing
and recent customers listed on the firm?s books and records, and is to
provide notice to creditors in the manner prescribed by the Bankruptcy Code.
Customers must file written statements of claims. The notice typically
informs customers how to file claims and explains the deadlines for filing
claims. Two deadlines apply. One is set by the bankruptcy court supervising
the proceeding and the other is set by SIPA. The deadline set by the
bankruptcy court for filing customer claims applies to customer claims for
net equity. Under SIPA, the deadline may not exceed 60 days after the date
that notice of the proceeding is published. Failure to satisfy the deadline
can affect what the customer may be able to recover. The second deadline
occurs 6 months after the publication date. SIPA mandates that no customer
or general creditor claim received after the 6- month deadline can be
allowed by the trustee, except for claims filed by the United States, any
state, infant, or certain incompetent persons.
The trustee and SIPC staffs review each claim that the trustee receives. In
some cases, the trustee?s staff, SIPC staff, or both may write a brief
analysis of the claim, which recommends whether the claim should be allowed
or denied. If the trustee and SIPC staff initially disagree over whether the
claim is valid, they hold a discussion. Typically, if the claim lacks
sufficient supporting evidence, the trustee will write to the claimant
requesting additional information. Once a final decision is made, the
13 SIPC may decide to serve as a trustee in any case where it determines
that the firm?s liabilities to unsecured general creditors and subordinated
lenders appear to aggregate to less than $750, 000 and it appears that there
are less than 500 customers.
Chapter 1: Introduction Page 20 GAO- 01- 653 Securities Investor Protection
trustee sends a determination letter to each claimant that informs him or
her of the decision and its basis. The letter also informs a claimant of his
or her right to object to the determination and how to do so. The bankruptcy
court judge overseeing the liquidation rules on customers? objections after
holding a hearing on the matter. Decisions of the bankruptcy court may be
appealed to the appropriate federal district court, and then upward through
the federal appellate process.
Under the typical SIPA property distribution process, SIPC customers are to
receive any securities that the firm holds that are registered in their name
or that are in the process of being registered in their name, subject to the
payment of any debt to the firm. Any other customer property in an account
is part of a customer?s net equity as calculated by the trustee. Net equity
claims are satisfied first by allowing customers to share on a pro rata
basis in the firm?s remaining customer property. The trustee may use up to
$500,000 advanced from the SIPC fund to satisfy a customer?s claim remaining
after the distribution; however, only $100,000 may be advanced to satisfy a
claim for cash. 14 SIPA specifies that a customer claim for securities must
be satisfied with securities whenever feasible. That is, if the firm being
liquidated does not possess the securities, then the trustee must purchase
them in the open market and return them to the customer if a fair and
orderly market for the securities exists.
Investors who attain SIPC customer status are a preferred class of creditors
compared with other individuals or companies that have claims against the
failed firm and are much more likely to get a part or all of their claims
satisfied. This is because SIPC customers share in any customer property
that the bankrupt firm possesses before any other creditors may do so.
Moreover, the trustee may use advances from the SIPC fund up to the
$500,000/$ 100,000 limits to satisfy claims that cannot be fully satisfied
by the estate of customer property. In fact, since many bankrupt securities
firms have no assets left at all, SIPC customers may be the only parties
with claims against the firm to have any of their claims satisfied.
SIPC liquidates clearing and introducing firms, which are distinct entities.
Introducing firms do not clear securities transactions or hold customer cash
or securities. Instead, introducing firms contract with clearing firms to
clear their customers? transactions and hold their customers? cash and
14 SIPC may advance funds to the trustee to satisfy claims prior to the
distribution of customer property.
Chapter 1: Introduction Page 21 GAO- 01- 653 Securities Investor Protection
securities. Introducing firms introduce their customers to a clearing firm
on a fully disclosed basis. This means that each introducing firm customer
has a securities account at the clearing firm in the customer?s name and in
which the customer?s securities transactions are cleared and securities and
cash are held. Under this scenario, the customers know their accounts are at
the clearing firm, and the clearing firm treats them as customers for
purposes of securities regulations governing custody of customer assets and
the financial responsibility of broker- dealers. In general, the clearing
firm, not the introducing firm, prepares and mails trade confirmations and
periodic account statements. 15 Some SIPC liquidations have involved
introducing firms that stole or misplaced customer property intended to go
to a clearing firm.
SIPC has initiated a fairly small number of liquidations each year compared
with the number of securities firms that go out of business annually.
Between its inception in 1971 and the end of 2000, SIPC commenced 287
liquidations of member securities firms. From 1996 through 2000, SIPC
initiated a total of 37 liquidations of member firms or about 7 per year. By
contrast, SIPC data indicate that hundreds of SIPC member firms go out of
business each year without ever becoming SIPC liquidations. 16 For example,
our 1992 report found that between 1971 and 1991, 20,344 SIPC members went
out of business, but only 228 (about 1 percent) became SIPC liquidations.
Similarly, in 1999, a total of 865 SIPC members went out of business but
SIPC initiated liquidation proceedings against a total of 9 firms.
Many of the thousands of SIPC members that have gone out of business without
SIPC involvement were firms that traded solely for their own accounts, did
not hold customer property, and did not introduce customer accounts to a
clearing firm. Accordingly, there were no customers in need of SIPC
protection. In addition, because introducing firms are not permitted to hold
customer cash or securities, most go out of business without any customer
securities or cash to return to customers. (These assets are at the clearing
firm.) However, if an introducing firm improperly holds, loses, or embezzles
customer securities or cash, there may be a need for a SIPA liquidation.
Furthermore, SEC?s financial responsibility
15 According to SEC, in some cases, the introducing firm sends the
confirmation or account statement rather than the clearing firm. 16 Although
some firms fail financially, others go out of business for nonfinancial
reasons, such as mergers. SIPC Liquidation
Proceedings Are Relatively Infrequent
Chapter 1: Introduction Page 22 GAO- 01- 653 Securities Investor Protection
and customer protection rules establish controls that securities firms must
follow, which promote firm solvency and the safekeeping of customer assets.
Regulators monitor compliance with these rules and intervene when problems
arise prior to a firm?s failure. SEC and SROs- such as NASDR and the New
York Stock Exchange (NYSE)- have primary responsibility for overseeing and
regulating SIPC member firms. SIPC does not have any authority under SIPA to
regulate or examine its membership. In some cases, securities regulators may
oversee the transfer of customer accounts from a troubled firm to a healthy
firm without the need for SIPC involvement.
Our objectives were to (1) review the basis for SIPC?s policies and
practices for validating and satisfying claims involving unauthorized
trading and the extent that these policies were disclosed to investors; (2)
review the basis for SIPC?s policies and practices for determining claims in
liquidations involving SIPC- member firms and their nonmember affiliates,
and the extent that these policies were disclosed to investors; (3) evaluate
SEC?s oversight of SIPC?s operations and compliance with SIPA; and (4)
compare the coverage provided by and disclosure rules for SIPC, FDIC, and
state insurance guarantee associations; and identify the implications for
greater confusion among consumers as some banks, securities firms, and
insurance companies consolidate their operations.
To meet the first two objectives, we reviewed SIPA and its legislative
history, court decisions, legal briefs, and other documents that were
relevant to understanding SIPC?s or its critics? views concerning the legal
aspects of SIPC positions. Consistent with our general policy, we have not
taken a position on issues involving ongoing litigation. To review the
implementation of SIPC?s policies and to assess investor awareness of these
policies, we also reviewed a total of 152 customer claim files from 2 recent
liquidations in which many claimants alleged unauthorized trading. For each
of the two liquidations, we randomly selected a sample of claim files and
reviewed documents from the files. These documents included affidavits and
other supporting evidence provided by the claimants, if any were supplied,
and the determination letter sent by the trustee to the claimant that
explained the reason for allowing or denying the claim. We interviewed
officials from SIPC and SEC, individuals who are or who have served as SIPC
trustees and their attorneys, and attorneys who have represented claimants
who have disputed trustee claim decisions concerning both the unauthorized
trading and affiliate issues. In addition, we reviewed SIPC and SEC
informational sources- such as brochures and Web sites- to determine what
SIPC disclosed to investors regarding its policies and practices.
Objectives, Scope,
and Methodology
Chapter 1: Introduction Page 23 GAO- 01- 653 Securities Investor Protection
To fulfill our third objective, to evaluate SEC oversight of SIPC, we
reviewed past SEC inspections of SIPC, the work plan and other documents
relating to SEC?s ongoing inspection of SIPC, a recent report by the SEC?s
Office of the Inspector General that reviewed SEC?s oversight of SIPC, 17
our 1992 report on SIPC, 18 and other SIPC and SEC documents. We also
interviewed officials in different organizational units of SEC, including
the divisions of Market Regulation (Market Regulation) and Enforcement
(Enforcement); the Office of General Counsel (OGC); the Office of
Compliance, Inspections, and Examinations (OCIE); and the Northeast Regional
Office (NERO) located in New York City.
To accomplish our fourth objective, to identify differences between SIPC and
other financial guarantee programs and the potential for increased investor
confusion as the financial services industry, we first compared general
characteristics of the coverage provided by SIPC, FDIC, and state insurance
guarantee associations. Then, we reviewed disclosure requirements regarding
firms? participation in these organizations? coverage. To compare SIPC to
FDIC, we reviewed pertinent statutes, regulations, and bylaws; and we
interviewed officials from both organizations. With respect to state
insurance guarantee associations, we focused on the 52 state life/ health
guarantee associations because the policies they sell, such as annuities,
more closely resemble investments than do many of the types of insurance
covered by property/ casualty insurance guarantee associations. For
information on the life/ health state associations, we relied solely on
information provided by the National Organization of Life and Health
Guarantee Associations, a group to which all of the state associations
belong. We did not verify the information this organization gave us with
individual state insurance laws.
17 Oversight of Securities Investor Protection Corporation. Securities and
Exchange Commission Office of Inspector General. Audit Report No. 301. Mar.
31, 2000. 18 Securities Investor Protection: The Regulatory Framework Has
Minimized SIPC?s Losses (GAO/ GGD- 92- 109, Sept. 22, 1992).
Chapter 1: Introduction Page 24 GAO- 01- 653 Securities Investor Protection
We obtained written comments on a draft of our report from SIPC and SEC,
which are provided in full in appendixes I and II. We did our work in
Jacksonville and Tampa, Florida; New York, New York; and Washington, D. C.,
between March 2000 and April 2001 in accordance with generally accepted
government auditing standards.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 25 GAO- 01- 653 Securities Investor Protection
SIPC liquidations involving unauthorized trading accounted for nearly
twothirds of all liquidations initiated from 1996 through 2000. SIPC?s
policies and practices in these liquidation proceedings have generated
controversy primarily because of the large numbers of claims that were
denied and the methods used to satisfy certain approved claims. The first
practice generally requires that investors with unauthorized trading claims
provide some form of objective evidence that they complained within a
reasonable time after the disputed trade. Although establishment of such a
practice is authorized under SIPA and has been upheld in court, this
practice has been criticized as unfair. The second controversial practice
occurred in one proceeding. The practice, which was rejected by a bankruptcy
court, resulted in SIPC and the trustee treating certain approved
unauthorized trading claims for cash as claims for securities. Consequently,
claims for cash were paid with worthless securities. Claimants successfully
challenged this practice in a bankruptcy court, but SIPC and the trustee
have filed notices of appeal. Another issue involving SIPC?s practices is
that they are often not transparent to investors. Specifically, SIPC and
SEC, which has an important role in educating investors, have missed
opportunities to disclose information about SIPC?s practices for determining
unauthorized trading claims and to educate investors about steps they can
take to protect their interests.
From 1996 through 2000, 24 of the 37 proceedings initiated by SIPC, or 65
percent, involved introducing firms that, according to SIPC, engaged in
unauthorized trading. 1 SIPA provides customer status and coverage to
claimants who can demonstrate that the securities or cash in their accounts
was unlawfully converted. Unauthorized trading is recognized as a form of
unlawful conversion in which the firm or its representative take control of
a customer?s property and use it for the firm?s purposes without the
customer?s permission. For example, a firm representative might buy or sell
a customer?s securities without authorization. In February 1996, SIPC, with
SEC?s concurrence, began initiating liquidation proceedings against failed
introducing firms that had engaged in unauthorized trading
1 SIPC officials listed an additional introducing firm- Old Naples
Securities- as having engaged in unauthorized trading. Old Naples also
raised issues that occur when SIPC liquidates member firms and their
nonmember affiliates. This issue and the Old Naples liquidation are
discussed in chapter 3. Chapter 2: Opportunities Exist to Improve
the Disclosure of SIPC?s Policies in Liquidations Involving Unauthorized
Trading
Unauthorized Trading Liquidations Accounted for Nearly Two- Thirds of
Liquidations Initiated From 1996 Through 2000
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 26 GAO- 01- 653 Securities Investor Protection
of customer accounts carried at clearing firms. 2 According to SIPC
officials, SIPC initiated the policy to liquidate these firms and provide
protection to their customers because of the increase in the number of
customers who dealt with introducing firms and the apparent increase in
unauthorized trading activity by them.
According to SIPC officials, many of these firms marketed microcap stocks 3
to their customers, which had become virtually worthless by the initiation
of liquidation proceedings. For example, a firm called Stratton Oakmont,
Inc. (Stratton Oakmont) committed the most serious violations and
manipulated the prices of numerous microcap stocks through various sales
practice abuses, including unauthorized trading. Of the approximately 3, 400
claimants in the Stratton Oakmont liquidation proceeding, the trustee either
directed approximately 2,600 claimants to pick up their generally worthless
microcap securities at the clearing firm or denied their claims because SIPA
does not protect against market losses. 4
The fact that these introducing firms engaged in unauthorized trading
presents significant challenges to SIPA trustees in determining the validity
of customer claims. These introducing firms contract with clearing firms to
hold customer accounts and maintain records and these account holders are
treated as customers of the clearing firm. However, in SIPC liquidation
proceedings involving introducing firms, claimants may argue that the
records of both the introducing firms and the clearing firms are incorrect
because they show positions that were the result of
2 Prior to 1996, SIPC did not initiate liquidation proceedings against
introducing firms that traded customer accounts without authorization by
transmitting unauthorized trade orders to clearing firms. SIPC took the
position that claimants were customers of the firms that cleared for the
introducing firms and that their securities and cash were generally
available at those firms. See e. g., 17 C. F. R. sect. 300.200 (2000) (SIPC rule
stating that persons having accounts cleared by a clearing firm on a fully
disclosed basis are customers of the clearing firm). See also Arford v.
Miller, 239 B. R. 698 (S. D. N. Y. 1999), aff?d Arford v. Miller, 210. F3d
420 (2dCir. 2000).
3 Microcap stocks are normally not listed on national stock exchanges, have
limited financial reporting requirements, and represent interests in
companies with speculative business prospects.
4 The trustee determined these approximately 2, 600 claims in a variety of
ways. For example, the trustee directed about 1,210 claimants to contact the
clearing firm for their securities. The trustee also denied 448 claims for
market losses on securities and 342 claimed they were owed nothing. The
remaining approximately 600 claims were rejected for other reasons.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 27 GAO- 01- 653 Securities Investor Protection
unauthorized trades ordered by the introducing firm representatives. In
general, SIPC trustees do not have the ability to determine from the firms?
records whether the claimants? assertions are true. As discussed later in
this chapter, SIPC and its trustees require claimants to provide some form
of objective evidence to substantiate their claims, although many claimants
have been unable to provide such evidence. For example, the Stratton Oakmont
trustee denied 656 of a total of 728 unauthorized trading claims, or about
90 percent, largely for failing to provide objective evidence. 5 For other
unauthorized trading claims, the trustee approved the claims and returned
the microcap securities that he determined should have been in the
claimants? account.
SIPC?s liquidations of introducing firms that engaged in unauthorized
trading involve relatively higher administrative costs than other
liquidations because determining the validity of unauthorized trading claims
involves the acquisition and evaluation of information that is not usually
contained in firm records. On average, SIPC?s administrative expenses were
45 percent of the total funds advanced in liquidation proceedings involving
unauthorized trading initiated from 1996 through 1999. 6 By contrast,
administrative expenses averaged 10 percent of SIPC funds advanced for all
other SIPC liquidations. 7 The Stratton Oakmont liquidation provides a clear
example of the high administrative costs that may be associated with these
liquidations. As of year- end 2000, SIPC had advanced about $5.9 million for
administrative expenses of the Stratton Oakmont liquidation, as opposed to
about $2.1 million to satisfy customer claims. SIPC officials said that
administrative expenses in proceedings involving unauthorized trading tend
to be higher than other proceedings because, among other things, the
trustee?s staff must engage in lengthy investigations to determine the
merits of each unauthorized trading claim. In addition, many claimants whose
unauthorized trading claims have been
5 We reviewed a representative and random sample of about 98 approved and
denied claims in the Stratton Oakmont liquidation proceeding. The SIPA
trustee generally approved claims that met the standard and denied those
that did not.
6 The percentage is calculated based on financial information from
introducing firm liquidation proceedings that were closed or had satisfied
claims but had litigation pending as of December 31, 1999. Proceedings in
which the claims process was ongoing were excluded.
7 The percentage is calculated based on the liquidation proceedings that
where closed or had satisfied claims but litigation was pending, excluding
proceedings involving introducing brokers engaged in unauthorized trading.
Proceedings in which the claims process was ongoing were excluded.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 28 GAO- 01- 653 Securities Investor Protection
denied often file objections in bankruptcy court, which further increases
litigation and related costs. About two- thirds of the Stratton Oakmont
claimants whose unauthorized trading claims were denied have filed such
objections.
Pursuant to the authority provided under SIPA, SIPC and trustees have
established a standard that requires claimants to produce objective evidence
to substantiate their unauthorized trading claims. To satisfy this standard,
SIPC and trustees typically require claimants to provide some form of
objective evidence that they complained, usually in writing, to the SIPC
member firm or to regulators within a reasonable time after the disputed
transactions. According to SIPC officials, the evidentiary standard is
necessary to verify unauthorized trading claims and to protect against
fraudulent claims. SIPC?s critics have complained that the evidentiary
standard is unfair and that most unsophisticated investors call rather than
write their securities firm to allege unauthorized trades. However, the
court decisions that we reviewed have supported the evidentiary standard.
SIPA authorizes SIPC and trustees to establish the standards by which to
determine the failed firm?s obligations to its customers. Specifically, SIPA
directs the trustee to
?? discharge, in accordance with the provisions of this section, all
obligations of the debtor to a customer relating to, or net equity claims
based upon, securities or cash, by the delivery of securities or the making
of payments to or for the account of such customer? insofar as such
obligations are ascertainable from the books and records of the debtor or
are otherwise established to the satisfaction of the trustee?? (italics
added). 8
Claimants have a right to challenge the appropriateness of the trustees?
standards for verifying claims in bankruptcy court.
Pursuant to this statutory authority, SIPC officials said that they and
trustees generally require some form of objective evidence to determine the
legitimacy of unauthorized trading claims. Typically, to satisfy this
standard, claimants must provide reliable, objective evidence that they
complained in writing to the failed firm or to a regulatory agency within a
8 15 U. S. C. sect. 78fff- 2( b). The Establishment of
an Evidentiary Standard Is Authorized Under SIPA
SIPA Authorizes SIPC and Trustees to Establish Standards to Verify Claims
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 29 GAO- 01- 653 Securities Investor Protection
reasonable period after allegedly unauthorized trades. In general, SIPC
staff and trustees reject claims where the individual could not provide
documentation of the complaint made to the firm or regulators within 90 days
of the disputed transaction. However, we found that SIPC and the trustees
would consider alternative evidence or extenuating circumstances. For
example, one trustee used an NASDR investor complaint log as evidence that
claimants complained about allegedly unauthorized trades within a reasonable
time period. In another SIPC proceeding, a claimant proved that he had not
received any account statements within the 90- day time period and the
trustee approved his unauthorized trading claim.
According to SIPC officials, the evidentiary standard is necessary to
determine the validity of unauthorized trading claims and to protect against
fraudulent claims. The officials said that without such a standard, trustees
would generally have no way of verifying these claims- other than the
testimony of the claimants- because the failed firms? books and records
would not show that the trades were unauthorized. SIPC officials said that
one claimant in a SIPC liquidation proceeding had filed claims for 75
allegedly unauthorized trades totaling $10 million. The claimant did not
provide any evidence that the trades were unauthorized other than an
affidavit and trading records. After extensive investigation of the
claimant?s account history, SIPC officials said that staff determined that
the claimant had only identified trades that lost money as ?unauthorized?
while ignoring trades that made money. Without the evidentiary standard,
SIPC officials said that they would not be able to reasonably determine the
credibility of such claims.
According to SIPC officials, the requirement that customers provide evidence
of having complained in writing generally within 90 days is consistent with
the notifications that firms send to account holders, such as trade
confirmations and quarterly statements, showing the activities and positions
in their accounts. Typically, clearing firms send trade confirmations within
days of each security transaction. Clearing firms are also required to send
quarterly statements to account holders holding accounts carried on a fully
disclosed basis and often send monthly statements as well. These statements
provide a record of the transactions in each customer?s account. Provided
investors review these statements, SIPC officials said the statements would
give investors ample notice of any unauthorized trades within about 90 days
of the trade.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 30 GAO- 01- 653 Securities Investor Protection
Critics have questioned the fairness of SIPC?s evidentiary standard, but
courts have upheld its use in liquidation proceedings. 9 An attorney who
represents Stratton Oakmont claimants said that the evidentiary standard can
be unfair and is unsupported by law or SIPC regulations. He said that most
unsophisticated investors simply call their securities firms when they
identify a problem in their account, and that only sophisticated investors
can be expected to complain in writing within a specified period. The
attorney said that Stratton Oakmont claimants plan to contest in the
bankruptcy court the evidentiary standard as the basis for rejecting
unauthorized trading claims. Critics of the policy also said that the policy
ignores that SEC had taken enforcement actions against Stratton Oakmont for
pervasive unauthorized trading before the liquidation proceeding.
Our review identified information to support the contention that many
investors may not be aware of SIPC?s evidentiary standard for unauthorized
trade claims. We reviewed a representative and random sample of 152 claim
files from the Stratton Oakmont and Euro- Atlantic Securities, Inc.,
liquidation proceedings. We found that about 87 percent of the claimants
stated that they complained over the telephone about allegedly unauthorized
trades. By contrast, only about 38 percent complained in writing within the
90- day time period.
Although investors may generally not be aware of SIPC?s evidentiary
standard, recent court decisions have upheld its application in SIPC
liquidation proceedings. We identified bankruptcy court orders in 2 of the
24 introducing firm liquidations- Hanover Sterling & Co., Ltd. and
EuroAtlantic Securities, Inc.- relating to the evidentiary standard for
unauthorized trading claims in SIPC liquidations. In both cases, the
bankruptcy judges upheld the trustees? determinations to deny unauthorized
trading claims on the grounds that the claimants did not provide reliable,
objective evidence that they complained of allegedly unauthorized trades
within a reasonable period.
9 Also see ?Investor Protection - NOT: SIPC and the Securities Investor
Protection Act of 1970.? Securities Arbitration 2000, Practising Law
Institute, August 2000. Critics Question the
Fairness of SIPC?s Evidentiary Standard but Courts Have Upheld It
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 31 GAO- 01- 653 Securities Investor Protection
In a January 2001 decision, the bankruptcy court overseeing the Stratton
Oakmont liquidation concluded that the trustee?s procedure for satisfying
approved unauthorized trading claims was not authorized by SIPA or any other
law. Under the procedure, the trustee sometimes returned worthless
securities to claimants rather than the substantial amounts of cash that
they had sought. 10 SIPC officials supported the trustee?s procedure and
said it was based on SIPA.
The Stratton Oakmont trustee sometimes satisfied approved unauthorized
trading claims with securities rather than the cash for which customers had
filed their claims. Typically, these customers (claimants) filed claims with
the trustee for the cash that would have been in their accounts had Stratton
Oakmont representatives not purchased microcap securities without their
authorization. In deciding how to satisfy these claims, however, the trustee
considered evidence that suggested earlier transactions in the claimants?
accounts were also unauthorized. 11 These earlier transactions were
typically unauthorized sales of securities, the proceeds of which were used
to make the unauthorized purchases that were the basis for the claims for
cash. To satisfy the claims, the trustee reversed all transactions that he
determined to be unauthorized and returned the claimants to their positions
prior to the unauthorized trades. For some claimants, this procedure
resulted in the trustee returning securities that had become worthless, but
which had value when they were sold without authorization. As a result, the
trustee did not return the substantial amounts of cash that the claimants
had initially sought by unwinding only the unauthorized securities
purchases.
SIPC officials support the trustee?s procedure for satisfying approved
unauthorized trading claims as mandated by SIPA. According to SIPC
officials, in determining a claimant?s net equity under SIPA, a trustee has
the responsibility to determine what securities or cash should have been in
each claimant?s account as of the liquidation filing date in the absence of
any unauthorized trading. SIPC officials added that a claim seeking to
unwind only some of the unauthorized trades would not preclude the
10 The Stratton Oakmont trustee approved 72 unauthorized trading claims. A
total of 23 claimants filed objections to the trustees? determinations of
their claims, largely because the trustee offered to return worthless
microcap securities in satisfaction of their claims.
11 For example, the claimants may have filed copies of complaint letters
that they had sent to the securities firms, which identified particular
securities sales and purchases as unauthorized. Bankruptcy Court
Rejected the Stratton Oakmont Trustee?s Procedure for Satisfying Certain
Approved Unauthorized Trading Claims
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 32 GAO- 01- 653 Securities Investor Protection
trustee from determining whether other transactions in the account were also
unauthorized. The trustee would return to the claimant the cash and/ or
securities that should have been in the account had the unauthorized trades
not occurred.
In the January decision, the bankruptcy court in the Stratton Oakmont
proceeding stated that the trustee?s process, which in effect treated the
claims for cash as claims for securities, was not authorized by SIPA or any
other law. The court concluded that claims for the proceeds from the
unauthorized purchases were claims for cash and not, as the trustee and SIPC
argued, claims for securities. As stated by the court:
?{ T} he real question herein is whether the Trustee was correct when he
collapsed two distinct wrongs: in one wrong, Stratton Oakmont sold stock
without authority and turned the stock into cash, thereby cashing the
customer out; in the other wrong, the broker took the cash and invested it
in a stock whose purchase the customer did not authorize, thus tying up the
customer?s funds in an involuntary investment?
?Nothing in the (SIPA) definition of ?net equities? bears on the question of
whether the two wrongs here can be treated as if they were one? The statute
does not specifically authorize a trustee to search through earlier records
to satisfy a net equity claim for cash as if it were a net equity claim for
securities? In short, there is nothing in either bankruptcy or nonbankruptcy
law that would require that the two related but distinct wrongs can be
merged into one or that would prevent the complaining party from recovering
only in respect to the latter wrong.? 12
SIPC officials said that they disagreed with the bankruptcy court?s decision
and have filed a notice of appeal, as has the trustee.
Disclosure plays an important role in securities market regulation, and
given SIPC?s investor protection mission, we believe SIPC has a
responsibility to inform investors of actions that they can take to protect
their investments and help ensure that they are afforded the full
protections allowable under SIPA. Similarly, SEC plays a vital role in
ensuring that investors receive adequate disclosure about the securities
markets and programs, such as SIPC, that potentially affect their interests.
In our 1992 report on SIPC, we identified deficiencies in disclosure about
SIPC and recommended steps that SIPC and SEC could take to better
12 See SIPC v. Stratton Oakmont, No. 97- 40501 (ALG), slip op. at 20, 23
(Bankr. S. D. N. Y. filed Jan. 24, 2001). SIPC and SEC Have
Missed Opportunities to Disclose Information About the Evidentiary Standard
to Investors
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 33 GAO- 01- 653 Securities Investor Protection
educate investors about the SIPC coverage. In 1994, SIPC revised its
informational brochure to respond to our recommendations.
SIPC and SEC have missed opportunities to disclose information about the
evidentiary standard to investors. In particular, SIPC and SEC have not
updated informational resources, such as the SIPC brochure as well as the
SIPC and SEC Web sites, to provide information about the evidentiary
standard. We also identified additional and more proactive steps that could
also better serve to notify investors about the importance of documenting
unauthorized trading claims. These steps include (1) establishing uniform
disclosure statements on trade confirmations and other account holder
documents and (2) requiring firms that have engaged in pervasive
unauthorized trading to notify their customers about documenting complaints.
SIPC and SEC have established informational resources that provide a great
deal of useful information to investors. SIPC has developed an informational
brochure called How SIPC Protects You that provides useful information about
SIPC and its coverage. For example, the SIPC brochure provides the coverage
limits for securities and cash claims, defines the securities covered under
SIPA, and explains the claims review process. However, SIPC bylaws and SEC
rules do not require SIPC members to distribute the brochure to their
customers. Although SIPC officials said that a wider distribution of the
brochure would be beneficial, they do not believe SIPC has the authority to
require member firms to provide the brochure to their customers. This
authority resides directly with SEC or with the SROs. In addition, SIPC has
established a Web site at www. sipc. org that also provides useful
information to investors. SIPC?s Web site explains the SIPC program and
provides much of the information discussed in the informational brochure.
Although the SIPC brochure- which was last updated in October 1994- provides
useful information, it does not advise investors that SIPA covers
unauthorized trading and that they should promptly complain in writing about
allegedly unauthorized trades. In March 2000, the SEC IG issued a report on
SEC?s SIPC oversight, which found that the SIPC brochure did not give
information about notifying the securities firm in a timely manner about
improper account activity, such as unauthorized trading, and SEC and SIPC
Information
Resources Do Not Fully and Consistently Explain the Evidentiary Standard for
Unauthorized Trading Claims
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 34 GAO- 01- 653 Securities Investor Protection
documenting the notice. 13 The SEC IG report further recommended that SEC
review the current SIPC brochure for adequacy, and encourage SIPC to make
appropriate changes. As of March 2001, SIPC officials said that they had
hired an investor education firm to review the current brochure and to
recommend appropriate changes. SIPC officials anticipate that they will
revise the brochure in 2001.
In addition to the information that SIPC provides to investors, SEC has a
Web site at www. sec. gov, which includes useful investor information,
including information relevant to SIPC protection. 14 For example, the SEC
Web site contains a section called Microcap Stock: A Guide for Investors.
The section discusses the high risks associated with microcap stocks and the
fact that the prices of microcap stocks may be manipulated through
fraudulent schemes, as has been the case in some of the firms involved in
SIPC liquidations since 1996. SEC?s Web site also contains a section
entitled Cold Calling that provides tips to investors on how to avoid
highpressure telephone sales practices and advises investors to closely
review their statements for any unauthorized trading activity. Stratton
Oakmont used cold calling to attract investors. SEC?s Web site also includes
a brief discussion of SIPC and provides a link to the SIPC Web site.
However, we found that SEC?s Web site provides information to investors that
could be viewed as contradictory to the evidentiary standard. Specifically,
the SEC Web site section entitled Microcap Stock: A Guide for Investors
recommends that investors should first call their broker if they have any
problems in their accounts. 15 If the broker cannot resolve the problems,
SEC?s Web site recommends that investors talk to the branch manager.
Finally, SEC recommends that the investors (1) write to the firm?s
compliance department if the branch manager cannot solve the problem, (2)
ask that the compliance department respond to the problem within 30 days,
and (3) write to the state securities regulators or SEC if the problem is
not corrected.
13 Oversight of Securities Investor Protection Corporation. U. S. Securities
and Exchange Commission Office of Inspector General. Audit Report No. 301.
Mar. 31, 2000. 14 According to SEC, the Web site receives about 1 million
visitors daily.
15 An SEC- prescribed statement that it requires securities firms to send in
connection with penny stock advises customers to telephone SEC or NASDR with
concerns about the brokerage firm?s activities. It states that as an
alternative, customers can write to SEC. 17 C. F. R. sect. 240. 15g- 100.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 35 GAO- 01- 653 Securities Investor Protection
Although the telephone- based complaint approach SEC recommends appears
reasonable if the securities firm acts in good faith to resolve problem
trades, fraudulently operated firms such as Stratton Oakmont may not
promptly reverse unauthorized trades within a reasonable period. Moreover,
SIPC officials and the trustees? staffs told us that Stratton Oakmont
officials sometimes used high pressure and even fraudulent tactics to
convince persons who called to complain about potentially unauthorized
trades to ?ratify? these trades. According to these officials, persons who
agreed to ratify trades over the telephone- even due to highpressure tactics
and fraud- would generally not be able to sustain an unauthorized trading
claim in a SIPA proceeding. 16 Therefore, SEC?s recommendation that
investors call their securities firm to complain without simultaneously
writing a complaint letter potentially jeopardizes their ability to prove
claims in SIPC liquidation proceedings.
In contrast, we note that other sections of SEC?s Web site recommend that
investors complain in writing immediately if they encounter problems with
their broker. Specifically, the SEC Web site section entitled Invest Wisely:
Advice From Your Securities Industry Regulators warns investors that ?If
you have a problem with the sales representative on your account, promptly
talk to the sales representative?s manager or the compliance department.
Confirm your complaint to the firm in writing. Keep written records of all
your conversations. Ask for written explanations.? SEC?s Web site also
includes specific information on unauthorized trading in a section entitled
Fast Answers, which advises customers to send complaints to SEC via its on
line complaint system. SEC has since updated various areas on its Web site
to address many of the issues we raised.
We also reviewed NASDR?s Web site, which also plays an important role in
investor education, to determine what information it provides regarding
potentially illegal behavior by securities firms. NASDR?s Web site section
entitled Filing a Customer Complaint recommends that ?If you believe you
have been subject to unfair or improper business conduct by your broker, you
should complain to the brokerage firm promptly in writing.? The Web site
further recommends that investors should write to NASDR if the firm does not
resolve the problem. NASDR also provides an electronic form to file written
complaints about brokerage firms.
16 Stratton Oakmont installed a taping system in 1995 to monitor telephone
calls between firm representatives and their customers. The trustee?s staff
listened to taped conversations between Stratton Oakmont representatives and
the firm?s customers to determine if trades were ratified.
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 36 GAO- 01- 653 Securities Investor Protection
SEC, NYSE, and NASDR have not established requirements that clearing firms
notify customers that they should immediately complain in writing about
allegedly unauthorized trades. We reviewed a judgmental sample of trade
confirmations and account statements and found that while many firms
voluntarily notify their customers to immediately complain if they
experience any problems with their trades, instructions about the next
course of action varied. Some firms notified their customers to ?complain
in writing within 10 days,? while other firms inform customers to ?notify
your broker immediately.? In the latter case, the firms did not inform
investors to complain in writing, which could result in the customer
telephoning rather than writing the securities firm.
Although standardizing the notices to investors about documenting
unauthorized trading claims would likely have some benefits, these benefits
may be limited. We note that questions can be raised about the extent of
investor awareness of the disclosures currently provided on trade
confirmations and other account statements. Clearing firms that provide
disclosures that investors immediately complain in writing typically do so
in small print on the back page of trade confirmations (see fig. 1). This
information is typically included with a substantial amount of information
in similar type that the clearing firms are required to provide to their
customers. For example, SEC Rule 10b- 10 requires firms to disclose, among
other things, information identifying and describing a securities
transaction and the capacity in which the firm acted (e. g., as an agent for
the customer or as a principal for its own account). Some regulatory
officials we contacted questioned whether investors take the time to read
these small disclosures on their trade confirmations and other account
statements. Nevertheless, SIPC officials said that standardizing the
disclosures to investors on account statements would be useful.
Market Regulation officials also told us that it would take a new rule or
possibly an amendment to Rule 10b- 10 to require firms to make a standard
disclosure on confirmations, which in turn would require SEC to consider
both the benefits and costs of such a rule. Although there would be some
costs associated with modifying the disclosure provided on the back of
account statements, the changes could be implemented in such a way as to
keep costs to a minimum. For example, in many cases the change would be as
simple as adding ?in writing? to their current statements warning people to
notify the firms of any problems with the statements. Clearing Firms Are Not
Required to Notify Customers to Complain in Writing About Unauthorized
Trades
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 37 GAO- 01- 653 Securities Investor Protection
Figure 1: Sample Back Page of Confirmation Statement
Source: A securities firm.
SEC may identify and impose sanctions on firms that have engaged in
pervasive unauthorized trading long before they ever become SIPC
liquidations, but it does not routinely require such firms to notify their
customers about documenting unauthorized trading claims. For example,
between 1992 and 1997, Stratton Oakmont operated under intensive SEC and
court supervision in connection with, among other violations, pervasive
unauthorized trading and stock price manipulation. However, in Opportunities
Exist to
Provide Disclosures to the Customers of Firms That Have Engaged in Pervasive
Unauthorized Trading
If you do not understand an entry on your statement or suspect an error, it
is essential that you immediately contact the manager of the office
servicing your account. We will consider your statement correct unless we
receive a written inquiry from you about the suspected error within 10
calendar days from the day on which you received your statement. It is your
responsibility to review your statement promptly and to seek immediate
clarification about entries that you do not understand.
Securities in [company name deleted] accounts are protected by the
Securities Investor Protection Corporation (? SIPC?), a non- profit
organization. The SIPC provides up to $500,000 in securities protection per
customer that includes protection for up to $100,000 in uninvested cash.
Through a third party insurance carrier, [company name deleted] provides
additional coverage for securities of customers up to their total net equity
balance as well as unlimited protection for uninvested cash.
Assets held by custodians, including those held in money market funds, are
not covered. If you would like more information, ask your Financial Advisor
for a detailed brochure.
All transaction dates on this statement are the transactions? settlement
dates. In the case of unsettled trades, we list the trade date instead of
settlement date with a notation that the trade is unsettled.
The prices of securities displayed on your statement are derived from
various sources and in some cases may be higher or lower than the price that
you would actually receive in the market. For securities listed on an
exchange or trading continually in an active marketplace, the price reflects
the market quotations at the close of your statement period. The prices of
securities not actively traded may not be available. These are indicated by
?N/ A? (not available).
For bonds trading less frequently, we rely on outside pricing services or a
computerized pricing model, which cannot always give us actual market
values. Similarly, some annuity values provided by outside sponsors are
estimates.
The amounts on this statement for limited partnerships are typically
obtained from a third party or from the investments? general partners unless
[company name deleted] has obtained other information such as an independent
appraisal. Since many partnership valuations are provided only annually,
they do not always represent current values.
Furthermore, limited partnerships and non- traded Real Estate Investment
Trusts (REITs) are illiquid and have no public markets, so the amounts shown
on this statement may not equal the amounts you would receive if you sold
your investment.
The value of mutual fund shares is determined by multiplying the Net Asset
Value (NAV) by the number of shares or units held as reported to [company
name deleted] by the correspondent custodian. If we cannot obtain a price or
estimate, ?N/ A? appears.
For more detailed current information on prices, speak to your Financial
Advisor. This figure represents the approximate value of your account on a
settlement date basis and is computed by adding (1) the market value of all
priced positions and (2) market values provided by pricing services and
correspondent custodians for other positions: and by adding any credit or
subtracting any debit to your closing cash or money market balance. Please
note, this valuation may be adjusted for the net change in priced asset
values for securities held or for the net change in money market balances in
your account during the statement period. Your closing cash and/ or money
market balance represents the cash and/ or money market funds available in
your account and reflects the net month end balance of all deposits, credits
and debits (including checking and MasterCard activity in Active Assets
accounts).
If you have applied for margin privileges and have been approved, you may
borrow money from [company name deleted] in exchange for pledging assets in
your account as collateral for any outstanding margin loan. The amount you
may borrow is based on the value of the eligible securities in your margin
account, which are identified by an asterisk (*) on your statement.
Errors & Inquiries Your [company name deleted] Account Statement
SIPC Protection Transaction Dates Pricing of Securities
Account Valuation Margin Privileges
(not available for IRAs or retirement accounts)
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 38 GAO- 01- 653 Securities Investor Protection
Stratton Oakmont, there was no requirement that the firm notify customers
that they should document their complaints in writing. In similar future
cases, requiring such firms to prominently notify their customers to
complain in writing about potentially unauthorized trades and to exercise
caution in ?ratifying? such trades in discussions with firm officials could
help investors protect their interests, including potential unauthorized
trading claims in a SIPC liquidation. Further, such prominent disclosures
could benefit unsophisticated investors who may not review the SIPC brochure
or review the disclosures on the back pages of trade confirmations and other
account statements.
We recognize that not all firms that engage in unauthorized trading become
SIPC liquidations, and that requiring firms to disclose the procedures for
documenting claims could result in a loss of customer confidence in those
firms. However, as discussed earlier, SIPC liquidations involving
unauthorized trading are increasing and represented nearly twothirds of all
SIPC liquidations from 1996 through 2000. Concerning customer confidence, an
SEC official who was responsible for overseeing Stratton Oakmont said that
requiring firms to notify their customers about documenting unauthorized
trades would not necessarily result in the immediate failure of the firms
and that it may be sensible to provide such disclosures.
SIPC?s evidentiary standard, although controversial, is based on authorities
afforded SIPC and the trustees under SIPA. Claimants may use evidence to
attempt to meet the burden of proof required to prove their claims, and it
is up to the trustee and ultimately the courts to decide whether the
evidence provided is sufficient. SIPC officials have concluded, and courts
have agreed, that an objective evidence standard is necessary to protect the
SIPC fund from fraudulent claims. However, some critics of SIPC?s
evidentiary standard believe the standard is unfair because many
unsophisticated investors call rather than write their securities firm, and
available evidence supports this argument. In the Stratton Oakmont
liquidation proceeding, for example, the trustee denied 90 percent of the
unauthorized trading claims, largely because claimants were not able to
provide objective evidence to support their claim. In the two liquidation
proceedings reviewed, we found that investors appeared unaware that failure
to provide objective evidence could jeopardize their claims. Claimants in
these liquidation proceedings were twice as likely to telephone complaints
about unauthorized trading activity than to write a letter to their broker.
Conclusions
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 39 GAO- 01- 653 Securities Investor Protection
Disclosure has an important role in securities market regulation, and SIPC
has a responsibility to inform investors of actions they can take to protect
their investments and help ensure that they are afforded the full
protections allowable under SIPA. SIPC and SEC, which plays a vital role in
investor education, have missed opportunities to disclose the evidentiary
standard to investors. Many investors appeared unaware of the steps they
should take to protect their interests. SIPC?s brochure provided no
information on handling unauthorized trading complaints, and there is no
requirement that securities firms provide customers with the SIPC brochure.
In addition, SEC?s Web site offers potentially contradictory guidance by,
sometimes telling investors to call first and write if the problem is not
resolved, and other times telling them to call and confirm the complaint in
writing. SEC guidance, such as steps for dealing with microcap fraud,
generally tells investors to first call their securities firms when they
have problems with their accounts. In certain instances, such advice could
result in unscrupulous brokers pressuring investors into increasing their
investments or ratifying the trades, which would compromise their SIPC
protection.
Moreover, we identified additional limitations in the information disclosed
to investors about the evidentiary standard. First, SEC, NYSE, and NASDR
have not required that clearing firms uniformly inform investors on the back
of trade confirmations and other statements to complain in writing if they
have complaints about trades that were not authorized. Second, SEC does not
routinely require firms that are subject to enforcement actions for
pervasive unauthorized trading to advise their customers that they should
document complaints about unauthorized trades in a timely manner.
In contrast to judicial acceptance of SIPC?s and the trustees? policy of
requiring objective evidence to support unauthorized trading claims, which
is based on SIPA, a bankruptcy court rejected the Stratton Oakmont trustee?s
procedure for satisfying approved unauthorized trading claims as not
authorized by SIPA or any other law. However, SIPC and the trustee have
filed notices of appeal.
To improve investor awareness of SIPC?s policies, practices, and coverage,
we recommend that the SIPC Chairman, as part of SIPC?s ongoing effort to
revise the informational brochure and Web site, include a full explanation
of the steps necessary to document an unauthorized trading claim. We also
recommend that SIPC revise the brochure to warn investors to exercise
Recommendations
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 40 GAO- 01- 653 Securities Investor Protection
caution in ?ratifying? potentially unauthorized trades in discussions with
firm officials.
In addition, SEC can take steps to improve the information it provides to
investors about SIPC and about how to protect investor interests. Moreover,
it can help ensure that more investors receive the SIPC brochure. To improve
investor awareness and education, we recommend that the SEC Chairman
require SIPC member firms to provide the SIPC brochure to their customers
when they open an account and encourage firms to distribute it to its
existing customers more widely;
review the sections of SEC?s Web site and, where appropriate, advise
customers to promptly complain in writing when they believe trades in their
account were not authorized, including an explanation of SIPC?s policies and
practices and warnings about how to avoid ratifying potentially unauthorized
trades during telephone conversations;
in conjunction with the SROs, establish a uniform disclosure rule to
require that clearing firms disclose on trade confirmations and/ or other
account statements that investors should complain in writing about
unauthorized trades in a timely manner; and
require firms that SEC determines to have engaged or are engaging in
systematic or pervasive unauthorized trading to prominently notify their
customers about the importance of documenting disputed transactions in
writing.
Overall, SIPC and SEC officials agreed with the report's conclusions and
recommendations regarding liquidations involving unauthorized trading.
However, SIPC?s written response clarified their positions on expanding SIPC
coverage to include customers of introducing firms, the establishment of an
evidentiary standard, and the 2001 bankruptcy court decision regarding
certain Stratton Oakmont claimants.
In response to our recommendation that SIPC revise its informational
brochure and Web site to explain the steps for documenting an unauthorized
trading claim, SIPC officials agreed ?wholeheartedly? with the
recommendation. SIPC officials stated that the planned changes will urge
customers to complain in writing and thus make oral ratification of
unauthorized trades less likely. SIPC officials stated that its revised Web
site and brochure would refer investors to other Web sites- such as those
maintained by SEC and NASDR- that warn investors against securities fraud.
Agency Comments
and Our Evaluation
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 41 GAO- 01- 653 Securities Investor Protection
SEC officials agreed that investors can best ensure that SIPC trustees will
recognize their claims resulting from unauthorized trades if they send
written complaints to their brokerage firm soon after the trade occurs. SEC
officials also agree that SEC should help educate investors about the need
to send written complaints. SEC officials stated that Commission staff have
reviewed SEC?s Web site and where appropriate added information advising
investors to complain promptly in writing when they believe they are victims
of unauthorized trading. However, SEC officials said that it would not be
appropriate to advise investors to put all complaints in writing because
most complaints can be resolved via telephone calls, and some investors may
abandon their complaints if advised to put them in writing. We agree that
all complaints do not have to be in writing, but in instances of
unauthorized trading SIPC and SEC should advise investors to document their
complaints in writing to ensure that their interests are protected. In
addition, we believe that SIPC and SEC should advise investors to exercise
caution in ratifying allegedly unauthorized trades in conversations with
firm representatives.
SEC officials stated that they supported improving disclosures to customers.
Moreover, they said that they would consider our recommendations that SEC
issue rules that would require (1) securities firms to distribute the SIPC
brochure to new customers and to encourage the distribution of the brochure
more widely to existing customers and (2) clearing firms to provide uniform
disclosures on account statements to complain in writing about allegedly
unauthorized trades. SEC staff asserted, however, that most firms distribute
the SIPC informational brochure when customers open an account and that most
statements have language telling customers to write or notify the firm at an
address if they believe the statement is in error. SIPC officials supported
the recommendation that SEC require securities firms to provide the SIPC
brochure to new customers and stated that it would assist in the
dissemination of this information to unsophisticated investors. Relating to
the second issue raised by SEC, the intent of our recommendation concerning
information disclosures on the back of account statements is to ensure that
all clearing firms provide uniform disclosures. For the account statements
we reviewed, we did not find that firms routinely provide an address when
they instruct customers to write or notify the firm.
SEC officials also said that they would consider our recommendation that
firms that have engaged in systematic unauthorized trading prominently
notify their customers to complain in writing about allegedly unauthorized
trades. Specifically, officials said that they would consider imposing the
Chapter 2: Opportunities Exist to Improve the Disclosure of SIPC?s Policies
in Liquidations Involving Unauthorized Trading
Page 42 GAO- 01- 653 Securities Investor Protection
requirement on a case- by- case basis as part of settlement proceedings with
firms found to have engaged in systematic unauthorized trading. However, SEC
officials said that many issues arise in settling cases and that the
requirement may not be the best way to address all unauthorized trading
cases.
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 43 GAO- 01- 653 Securities Investor Protection
SIPC?s policies and practices in liquidations of member firms that had
nonmember affiliates have also been controversial because SIPC and trustees
have denied many claims in such liquidation proceedings. In three such
liquidations, SIPC and the trustees denied claims by individuals who had
purchased financial products from the nonmember affiliates on several
grounds, including the determination that they were not customers of the
SIPC member firms. Although some courts had upheld the position taken by
SIPC and trustees that a claimant who places funds with an affiliate does
not qualify the claimant as a customer under SIPA, in August 2000, a federal
appellate court rejected SIPC and the trustee?s arguments on this point and
others. In the fourth and most recent liquidation that we reviewed, the
trustee requested, with SIPC?s endorsement, that the bankruptcy court
consolidate the estates of the SIPC member and its nonmember affiliate,
which potentially extended SIPA coverage to claimants who dealt with the
affiliate. SIPC maintains that the factual circumstances in the most recent
proceeding warranted consolidation, while similar circumstances were not
present to the same degree, if at all, in the other three proceedings.
SIPC and SEC have missed opportunities to educate investors about the
potential risks associated with certain nonmember affiliates. Although
SIPC?s informational brochure provides useful information, there is no SEC
requirement that SIPC members distribute the brochure to their customers.
Moreover, SEC?s Web site provides limited information about dealing with
nonmember affiliates. Given the limited information that is available,
investors may not be fully aware of the risks that can be associated with
certain nonmember affiliates.
Among other things, claimants seeking SIPA protection must be customers of
the SIPC member in liquidation, must purchase financial products that
qualify as securities under the Act, and the property they seek to have
returned must have been in the member?s custody. In three of the four SIPC
liquidations involving nonmember affiliates initiated from 1996 Chapter 3:
Disclosure of SIPC Policies in
Liquidations Involving Nonmember Affiliates Could Be Improved
SIPC and Trustees Denied Nonmember Affiliates Claims on Several Grounds
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 44 GAO- 01- 653 Securities Investor Protection
through 2000 (see table 1), 1 SIPC or trustees denied claims on one or more
of these grounds. 2 In determining whether a claimant qualified as a
customer of the SIPC member firm, for example, SIPC and the trustees
followed what has been referred to as the ?bright- line? rule. 3 Under the
bright- line rule, SIPC and the trustees deny claims unless the cash or
securities involved had been entrusted to the SIPC member firm because
entrustment creates the custodial relationship with the member that is
protected under SIPA. However, in an August 2000 decision regarding Old
Naples Securities, a federal appellate court rejected SIPC?s and the
trustee?s application of the rule in denying customer claims, as well as
their determination that the claimants had not purchased protected
securities.
1 In this chapter, we discuss four SIPC liquidations that involved affiliate
issues, including the New Times Securities. However, a fifth SIPC
liquidation, Primeline Securities, also raised affiliate issues. In the four
liquidation proceedings discussed in this chapter, customers were directly
or indirectly induced by the principal to deposit their funds with the
nonmember affiliates. The principal used the funds to operate a fraudulent
scheme. In Primeline, by contrast, a registered representative employed by
the SIPC member apparently acted on his own to defraud customers by
directing them to place their funds with bank accounts he maintained for
fraudulent purposes. Because of these differences, we decided to exclude the
Primeline liquidation from the discussion in this chapter.
2 SIPC and the trustees denied claims in the Old Naples and First
Interregional liquidations on one or more of the following grounds: (1)
claimants must be customers of the SIPC member in liquidation, (2) claimants
must purchase financial products that qualify as securities under the act,
and (3) the property claimants seek to have returned must have been in the
member?s custody. SIPC opposed initiating liquidation proceedings against
Churchill Securities, primarily on grounds that the investments at issue
were not securities under SIPA. However, SIPC did not concede its position
that persons who dealt with affiliates were not customers of the SIPC
member. Subsequently, SIPC initiated liquidation proceedings against
Churchill and as of January 2001, the trustee was reviewing claims.
3 See, for example , In re Stalvey & Associates, Inc., 750 F. 2d 464, 469
(5th Cir. 1985) (referring to ?the bright line rule that ?in the absence of
actual receipt, acquisition, or possession of the property of a claimant by
the brokerage firm under liquidation, ? a claimant (is) not entitled to the
protection of SIPA.? ( citing SEC v. Bove & Co., 378 F. Supp. 697, 699- 700
(S. D. N. Y. 1974)).
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 45 GAO- 01- 653 Securities Investor Protection Table 1: Selected SIPC
Liquidations Involving Nonmember Affiliates.
SIPC member Nonmember affiliate( s) Filing date
Old Naples Securities Old Naples Financial Services Aug. 28, 1996 First
Interregional Equity Corporation First Interregional Advisors
Corporation Mar. 6, 1997 Churchill Securities CD Investment Group
Churchill Mortgage Investment Corporation
Nov. 30, 1999 Sources: SIPC and SEC. In each of the three cases identified
in table 1, the SIPC member firms and their nonmember affiliates were
involved in schemes to defraud investors. Claimants, victimized by these
schemes, asserted that in their dealings with the nonmember affiliate they
reasonably believed that either they were dealing with the SIPC member, or
that any distinctions between the firms were meaningless, and that both
firms were treated as a single entity by their common owners. 4 For example,
claimants maintained that representatives of the SIPC member firms solicited
investments in products offered by the affiliate, directed or guided them
toward dealing with the affiliate, or promoted the member and the affiliate
in such a way that the claimants reasonably believed both enterprises were
part of the same entity. In some cases, claimants also provided other
evidence indicating a close relationship between the two entities, such as
the use of similar names (e. g., First Interregional Equity Corporation and
First Interregional Advisors Corporation) and locations of the SIPC member
and its affiliate on the same premises. Claimants also pointed out that in
each case one person owned or controlled the SIPC member and its affiliate
and that funds and assets held by the nonmember were used in varying degrees
to benefit either the member or the common owner. Finally, claimants argued
that they purchased financial products- such as certificates of deposit-
that qualified as securities under SIPA.
However, SIPC and trustees concluded that this evidence did not establish
that the claimants were customers of the SIPC member firms. In applying the
bright- line rule, SIPC and the trustees relied on checks or wire transfers
the claimants paid directly to the nonmembers to show that the customers had
not entrusted their investments to the member as required
4 Typically, a trustee liquidates nonmember affiliates of SIPC members in
liquidation proceedings separate from the SIPC members. Moreover, the
affiliates typically have no assets to satisfy the claims of former
customers. SIPC?s Basis for Denying
Claims Associated With Nonmember Affiliates
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 46 GAO- 01- 653 Securities Investor Protection
under SIPA. SIPC and the trustees concluded that this evidence spoke for
itself, that is, the property the claimants sought to recover was placed in
accounts somewhere else and had not been entrusted to the member. SIPC and
the trustees did not accept claims by persons who presented evidence to show
that they reasonably believed they were dealing with the SIPC member. To the
extent that claimants produced evidence to show that the two entities
actually were one or that they were used by their common owners in such a
way that they were legally indistinct, SIPC and the trustees either
considered the evidence unpersuasive or determined for other reasons that
treating the two entities as one would not be appropriate.
In applying the bright- line rule, SIPC and the trustees focused exclusively
on whether the claimant?s property had been placed with the member.
Consequently, even if the claimant believed that he or she was dealing with
the member when placing funds with the affiliate, this belief would not
establish that the claimant was a customer of the member. 5 An example of
this position is set forth in a brief SIPC and the trustee filed with the
Federal Court of Appeals for the Eleventh Circuit in In re Old Naples
Securities, Inc. v. Heebner. 6 There, SIPC and the trustee contended that a
claimant was not a customer under SIPA if he or she wrote checks payable to
an entity other than the member regardless of what the claimant believed
concerning the recipient?s status as a registered brokerdealer. 7
SIPC and trustees also denied claims in these proceedings because, in their
view, the claimants did not purchase securities as defined under
5 SIPC refers to a decision by the United States Court of Appeals for the
Ninth Circuit, In re Brentwood Securities, Inc., 925 F. 2d 325 (9th Cir.
1991), as authority for the proposition that a claimant?s reasonable belief
that he or she was dealing with the member is not the proper basis for
determining whether the claimant is a customer. Stating that an investor is
entitled to compensation from SIPC only if he or she has ?entrusted? cash or
securities to the member, the court in Brentwood, rejected claims where the
claimants asserted that they had assumed or believed they had been dealing
with the member. The court observed that nothing in the record established
that the broker had any role in the disputed transactions. The claimants
effectively bypassed the broker to deal directly with the entities issuing
the securities; no brokerage service was performed by either Brentwood or an
affiliate in connection with making the investments.
6 223 F. 3d 1296 (11th Cir. 2000). 7 Joint Appellate Brief of SIPA and
Trustee at 20- 22, In re Old Naples Securities, Inc. v. Heebner 223 F. 3d
1296 (11 th Cir. 2000).
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 47 GAO- 01- 653 Securities Investor Protection
SIPA. 8 For example, in Old Naples, SIPC and the trustee determined that
claimants who allegedly purchased bonds from Old Naples Financial Services-
the affiliate of Old Naples Securities- actually made loans to Old Naples
Financial Services, which are not securities under SIPA. In a similar
situation, Churchill Securities, SIPC officials said that individuals who
allegedly purchased certificates of deposit from the nonmember affiliates
actually made loans to the affiliates or invested in unregistered investment
contracts, which also do not qualify for protection under SIPA. In addition,
SIPC and the trustees argued in some situations that claimants already had
their so- called securities in their possession, and therefore, SIPC had no
obligation to the claimants. For example, SIPC and the trustee argued that
claimants, who purchased ?lease assignments? from First Interregional Equity
Corporation, or its affiliate First Interregional Advisors Corporation, had
possession of the instruments at issue because they held the paper that
recorded the assignments.
In an August 2000 decision in the Old Naples litigation, the Eleventh
Circuit rejected SIPC?s application of the bright- line rule as well as the
determination that the instruments at issue were not SIPA securities. On the
issue of dealing with an affiliate, the court recognized that ?[ a] claimant
is only a ?customer? protected by SIPA in regard to a claim for cash
entrusted to a brokerage if he of she ?deposited [the] cash with the debtor
[or SIPC member firm]." The court further observed, however, that
determining customer status ?does . . . not depend simply on to whom the
claimant handed her cash or made her check payable, or even where the funds
were initially deposited.? 9 The court held that the claimants in that case
were customers of the SIPC member because (1) they reasonably believed that
they were dealing with the member through their dealings with the nonmember
affiliate and (2) the owner of both firms had acquired control over customer
funds held by the affiliate and used them as if they were funds of the
member firm. In addition, the court concluded that the claimants had
deposited cash that was intended to purchase bonds, which qualify as
securities under SIPA.
In November 2000, the trustee settled claims in the First Interregional
liquidation for $25 million out of a possible SIPC fund exposure of $100
8 The issue as to whether financial products qualify as securities is not
unique to cases involving nonmember affiliates. 9 Old Naples Lexis at *11.
The Eleventh Circuit Court
of Appeals Rejected SIPC?s and the Trustee?s Positions in the Old Naples
Liquidation
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 48 GAO- 01- 653 Securities Investor Protection
million. As of January 2001, the trustee for the SIPC liquidation of
Churchill Securities continued to review claims.
In May 2000, SIPC initiated liquidation proceedings against New Times
Securities Services (New Times), which had a nonmember affiliate called New
Age Securities (New Age). Similar to the previous three liquidations, the
New Times case involved an apparently fraudulent scheme by the controlling
principal of both New Times and New Age that involved both firms. However,
in November 2000, the trustee, with SIPC?s approval, requested that the
bankruptcy court consolidate the New Times and New Age estates for purposes
of the liquidation. According to the trustee, claimants who dealt with New
Age should be considered as customers of New Times and could qualify for
SIPA protection.
Among the many reasons the trustee discussed in support of the request, he
pointed out that although New Times and New Age in many respects operated
separately, generally did not commingle their assets, and distributed
account statements under their respective names, their owner had promoted
them to investors as being indistinguishable. Because the distinctions
between New Times and New Age were unclear, claimants either had believed
that they were dealing with the member or that any distinction between the
firms was meaningless. Accordingly, the trustee stated that the principal
benefit of consolidating the firms is to
?? ease the burden upon ponzi scheme victims (the claimants) who are
asserting claims for customer status in this proceeding so that they may, in
many cases, be eligible for SIPC advances. Under the proposed consolidation
order, those claims for ?customer? status (arising after the member became a
SIPC member in 1995) will be determined as if New Age and (New Times) were a
single broker- dealer.? 10
As the New Times proceeding demonstrates, SIPC recognizes that under certain
circumstances a member firm and its nonmember affiliate can be consolidated,
which may benefit claimants who dealt with the affiliate.
10 In a ponzi scheme, an individual raises investment funds under fraudulent
promises of above market and typically risk- free returns. The perpetrator
uses funds raised through the scheme to pay off the investments of early
participants in the scheme or for personal expenses. Such schemes depend
upon attracting an ever- increasing number of investors to continue paying
promised returns. Ultimately, ponzi schemes collapse when the perpetrator
can no longer raise funds to pay off the promised returns. The bankruptcy
court granted the trustee?s petition in November 2000. The Trustee and SIPC
Concluded in the Most Recent Liquidation That Customers of the Nonmember
Affiliate Were Customers of the SIPC Member
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 49 GAO- 01- 653 Securities Investor Protection
According to SIPC officials, the ?facts and circumstances? of the New Times
proceeding differed from the facts and circumstances in the three
liquidation proceedings discussed earlier in this chapter. Because of the
facts and circumstances analysis, SIPC officials said that standard criteria
could not be developed to determine whether claimants who dealt with an
affiliate qualified as customers of the member. SIPC officials explained
SIPC?s denials of claims in the first three proceedings as cases in which
they did not believe that consolidating the estates of the SIPC members and
their nonmember affiliates was warranted.
As discussed in chapter 2, SIPC and SEC have a responsibility to disclose
information about SIPC?s policies and procedures to investors. However, the
information that investors would need to avoid the type of problems that can
be associated with fraudulent schemes conducted by certain SIPC member firms
and their affiliates is limited. SIPC?s brochure does provide very useful
information, but as also discussed in chapter 2, the SIPC brochure is not
routinely distributed to investors. In addition, SEC?s Web site provides
useful information about affiliates; however, opportunities exist to educate
investors about the potential problems that can be associated with SIPC
members that have nonmember affiliates.
SIPC?s investor informational brochure advises investors to be sure that
they are customers of a SIPC member firm and contains helpful information
that could assist investors in avoiding fraud when dealing with certain
nonmember affiliates. The SIPC brochure has a section entitled How Can I Be
Sure I am Dealing With a SIPC Member, which explains that all SIPC members
are required to display the SIPC logo. The section also advises investors
that
?Some SIPC members have affiliated or related companies or persons who
conduct investment business but who are not members of SIPC. Some of these
affiliates may have names which are similar to the name of the SIPC member,
or which operate from the same offices or with the same employees. Be sure
that you receive written confirmation of each securities transaction in your
account and that each confirmation statement and each statement of account
is issued by the SIPC member and not by a SIPC member affiliate. Deposits
for credit for your securities account, by check or otherwise, should not be
made payable to your account executive, registered representative, or to any
other individual, but generally only to your SIPC member broker- dealer or,
if your account is carried at another SIPC member who provides clearing
services for your SIPC member broker- dealer, then to that other SIPC
member?? Information Available
to Investors About Avoiding Risks That Can Be Associated With Nonmember
Affiliates Is Limited
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 50 GAO- 01- 653 Securities Investor Protection
However, investor access to this information is uncertain because there is
no requirement that SIPC members distribute the informational brochure and
many unsophisticated investors may not access the SIPC Web site. 11 While
SEC officials agreed that wider distribution of the brochure would be
useful, they were concerned about the costs of distributing the brochure to
82 million account holders. Costs could be mitigated through a variety of
methods, from distributing it to only new account holders to creating
hyperlinks between SIPC and the firms? Web sites, which customers could
access.
SEC?s Web site contains sections that generally advise investors about risks
that can be involved with affiliated entities of broker- dealers. The SEC
Web site includes a section entitled Invest Wisely: Advice From Your
Securities Industry Regulators. The section warns investors to ?Never
make a check out to a sales representative? and to ?Never send checks to an
address different from the business address of the brokerage or a designated
address listed in the prospectus.? SEC?s Web site also contains a link to
the SIPC Web site, which advises customers on affiliate- related issues.
However, there are other prominent sections of the SEC Web site that
investors may access for advice that do not include specific information
about avoiding the frauds that may be associated with certain SIPC member
affiliates. Specifically, the SEC Web site has a section entitled SEC:
Protect Your Money that includes a subsection called Investor Alerts. The
purpose of the subsection is to advise investors on how to avoid frauds that
could result in substantial losses. The subsection contains links to other
Web sites as well as other sections of the SEC Web site that discuss common
frauds. These frauds include pump and dump schemes, promissory note fraud,
fraudulent telemarketers, and Internet securities fraud. However, the
subsection does not include any information the means by which broker-
dealers may set- up affiliates to perpetrate fraudulent schemes, and the
steps that investors could take to avoid these scams.
Although SIPC?s policies and practices in liquidation proceedings involving
SIPC members that had nonmember affiliates are based on SIPA and relevant
case law, it has had mixed success defending its position in court.
11 SIPC?s Web site contractor does not keep data on the number of ?hits?
that the Web site receives. Conclusions
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 51 GAO- 01- 653 Securities Investor Protection
The position taken by SIPC and the trustees regarding who is a customer and
whether they purchased securities depends largely on the facts of each
liquidation proceeding. In three of the four liquidations we reviewed
involving nonmember affiliates, SIPC and SIPA trustees denied SIPC coverage
to certain claimants, in part, on the grounds that they were not customers
as defined in SIPA. SIPC and the trustees generally determined that to
qualify for customer status, SIPC and the trustee must determine that the
SIPC member firm actually received cash or securities directly from the
claimant( s). In all three of these liquidations, SIPC also denied claims on
other grounds, including that the claimants did not purchase financial
products that qualify as securities under SIPA. In August 2000, a federal
appellate court rejected SIPC and the trustee?s positions in one of these
three liquidations. The court concluded that (1) customer status does not
depend simply upon to whom the claimant writes a check to purchase
securities, (2) the SIPC member firm acquired control of customer funds
deposited with the nonmember affiliate, and (3) claimants purchased products
that qualify as securities under SIPA. Although SIPC continues to believe
that its positions were correct in this case, this court decision
establishes a precedent that other claimants can consider, together with
cases in which SIPC?s positions have been upheld, in deciding whether to
file claims that involve dealings with affiliates.
In the fourth and most recent liquidation involving a nonmember affiliate,
SIPC supported the trustee?s decision to consolidate the estates of the
member and nonmember, which would extend customer protection to claimants,
who purchased financial products from a nonmember affiliate. Although the
trustee may still deny certain claims on other grounds, these claimants will
not have their claims denied because they had accounts or other dealings
with the nonmember.
As with SIPC?s evidentiary standard regarding unauthorized trading,
opportunities exist to improve disclosure to investors about the risks that
may be associated with certain SIPC member and their nonmember affiliates.
Although SIPC?s informational brochure provides useful information, such as
writing checks to the SIPC member rather than affiliates, there is no
requirement that SIPC members distribute the brochure to their customers. In
addition, SEC?s Web site does not prominently warn investors about how SIPC
members and their affiliates may conduct schemes to defraud their customers.
We recognize that investor education, although beneficial, has its
limitations and even with improved investor education, many investors may
continue to fall victim to fraudulent schemes perpetrated by certain SIPC
member firms and their nonmember affiliates.
Chapter 3: Disclosure of SIPC Policies in Liquidations Involving Nonmember
Affiliates Could Be Improved
Page 52 GAO- 01- 653 Securities Investor Protection
We recommend that the SEC Chairman, as discussed in chapter 2, require SIPC
member firms to provide the SIPC brochure to their customers when they open
an account and encourage firms to distribute it to its existing customers
more widely. We also recommend that SEC update its Web site to inform
investors about the frauds that may be associated with certain SIPC member
firms and their affiliates as well as the steps that can be taken to avoid
falling victim to such frauds.
SIPC and SEC officials generally agreed with our conclusions and
recommendation pertaining to liquidations involving nonmember affiliates. In
particular, SEC agreed to implement our recommendation by updating relevant
on- line publications about the danger of sending funds to affiliates. SIPC
officials commented that the draft report's recommendation that SEC require
securities firms to provide the SIPC brochure, which includes useful
cautionary information about dealing with nonmember affiliates, to new
customers should also assist in the dissemination of this information to
unsophisticated investors.
SIPC officials also provided additional explanatory remarks about their
positions concerning liquidations involving nonmember affiliates. First,
SIPC officials restated that several courts have upheld SIPC's positions in
liquidations involving nonmember affiliates. We acknowledge this fact in the
draft by discussing one of the federal appellate court cases and citing two
others. Second, SIPC officials provided background information on the origin
and significance of the rule SIPC and the trustees base their positions on
in cases involving nonmember affiliates. SIPC officials stated that ?SIPC
protection is not simply about getting money from SIPC.? They also stated
that it is a question of whether it is equitable and fair to allow persons
whom had not contributed to the assets of a firm in liquidation proceedings
to share in the assets of such firms. Finally, SIPC officials wanted to
clarify that the New Times liquidation proceeding was not the only case in
which SIPC supported the consolidation of a SIPC member and its affiliates.
SIPC stated that the New Times case is the fifth such circumstance where
SIPC supported consolidation. As we stated throughout the draft report, the
report addresses only four nonmember affiliate liquidations, which were
initiated in 1996, 1997, 1999, and 2000. Recommendations
Agency Comments and Our Evaluation
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 53 GAO- 01- 653 Securities Investor Protection
As provided in SIPA, SEC has the responsibility to oversee SIPC?s operations
and to ensure compliance with the act. During 2000, SEC initiated several
programs, which have the potential to strengthen its SIPC oversight as
provided for under SIPA. In particular, SEC initiated an examination of
SIPC, and OGC established a 1- year pilot program to monitor ongoing SIPC
liquidations and to assist investors who disagree with SIPC trustee claim
decisions. Our review found that SEC?s oversight program faces challenges in
meeting its potential goal of developing a comprehensive assessment of
SIPC?s operations. For example, to date the SIPC examination that SEC
initiated in 2000 has focused on a limited sample of SIPC liquidations that
involve unauthorized trading. Moreover, none of these proceedings involve
the affiliate issue. However, SEC officials said that they would expand the
sample to include more liquidations that involve unauthorized trading and
the affiliate issue. In addition, SEC has not established a formal procedure
to share information about SIPC issues as recommended by the IG report.
According to SEC officials, the various groups plan to begin holding
quarterly meetings to discuss SIPC.
Market Regulation is the SEC division responsible for reviewing SIPC?s day-
to- day operations, including the review and approval of SIPC rules, and
monitoring the size and adequacy of the SIPC customer protection fund.
Although these efforts are important, in the 28- year period between 1971
and 1999, Market Regulation completed only two SIPC examinations, the most
recent of which focused on four liquidations.
In May 2000, Market Regulation and OCIE initiated a joint SEC oversight
examination. Although the ongoing SEC examination will likely provide
important information about SIPC?s operations, as of March 2001, the SEC
examination sample included a limited sample of liquidations that involved
unauthorized trading and none of the SIPC liquidations that involve
nonmember affiliates, which were discussed in chapter 3. SEC staff said that
they would include additional liquidations involving unauthorized trading
and the affiliate issue as part of the ongoing inspection.
Market Regulation has implemented its oversight responsibility for SIPC in
several ways. In particular, Market Regulation staff occasionally attend
SIPC board meetings and routinely monitor the size and adequacy of the SIPC
fund and discuss this issue with SIPC on an ongoing basis. In 1991, a Market
Regulation official served on a SIPC task force formed to make
recommendations regarding SIPC assessments on member firms. Market Chapter
4: Despite Positive Initiatives, SEC?s
SIPC Oversight Program Faces Some Challenges
SEC?s SIPC Oversight Examination Program Has Some Limitations
Market Regulation?s Ongoing Responsibility for SIPC Oversight
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 54 GAO- 01- 653 Securities Investor Protection
Regulation and SIPC officials also communicate frequently in person and via
telephone over relevant issues and ongoing liquidations. As provided by
SIPA, SIPC also submits any proposed rule changes to SEC for review and
comment, and Market Regulation has lead responsibility for reviewing and
approving the proposed rules. In addition, SIPC regularly submits its annual
reports and audited financial statements to SEC.
However, Market Regulation?s on- site SIPC examinations have been infrequent
and limited in scope. In general, on- site examinations are a crucial
component of an effective oversight program because they provide a
comprehensive, independent, and in- depth look into the operations and
practices of the regulated entity. To provide useful and meaningful
information, examination guidelines must address relevant issues and
examination staff must review a sufficient number of items to fully
understand the regulated entity?s operations. Although contacts between the
regulator and regulated entity are important oversight tools, they cannot
substitute for an effective on- site examination program.
Despite the need for a comprehensive examination program, our 1992 report 1
found that Market Regulation had only initiated one SIPC examination in the
21- year period between 1971 and 1992. Market Regulation?s limited scope
1985 examination found that SIPC was doing a good job in selecting trustees
and overseeing the liquidation process. However, our 1992 report also noted
that the examination identified actions that could speed the payment of
customer claims, such as the development of an automated liquidation system.
Our report also found that SEC did not follow- up on the 1985 examination
recommendations regarding SIPC?s automated systems. Consequently, our report
recommended that SEC periodically review SIPC?s operations and its efforts
to ensure timely and cost- effective liquidations. Market Regulation agreed
to implement this recommendation and subsequently established a program to
examine SIPC?s operations every 4 to 5 years.
In 1994, Market Regulation completed a 2- year SIPC examination that focused
on four liquidation proceedings. The examination assessed SIPC?s efforts to
maintain the size of the SIPC fund and reviewed the mechanics of the four
liquidations. In general, the SEC examination found that SIPC and its
trustees efficiently managed these four liquidations. However, the Market
Regulation examination also made several technical
1 GAO/ GGD- 92- 109.
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 55 GAO- 01- 653 Securities Investor Protection
recommendations to SIPC to improve liquidation proceedings and to better
serve individuals who file claims.
According to the SEC IG report on SEC?s SIPC oversight, 2 the 1994 SIPC
examination took 2 years to complete because Market Regulation assigned
staff to the project on a part- time basis. The SEC IG report stated that
the five staff assigned to the examination had other responsibilities, which
contributed to the length of time necessary to complete the project.
According to the IG report, SIPC staff said that, although the SEC
examination was not disruptive, they would have preferred a more timely
examination.
In May 2000, Market Regulation and OCIE initiated a joint examination of
SIPC. SEC created OCIE in 1995 to consolidate SEC?s inspection and
examination program. At that time, SEC transferred most of the examination
responsibilities of Market Regulation and the Division of Investment
Management to OCIE. Despite the transfer of most SEC examination functions
to OCIE in 1995, Market Regulation remained involved in SIPC examinations.
The IG report stated that Market Regulation retained expertise in SIPC
issues and has a constructive relationship with SIPC staff while OCIE has
valuable examination expertise. The IG report commended Market Regulation
and OCIE on agreeing to initiate a joint SIPC examination in 2000, and, upon
completion of that examination, recommended that both SEC units continue to
conduct joint examinations and to agree on a periodic examination schedule.
The SEC IG report identified several areas not addressed in the 1985 and
1994 inspections that could improve SEC?s oversight effectiveness. These
issues are as follows:
1. adequacy of SIPC policies, procedures, and/ or standards used to
determine whether a customer request to bring a liquidation proceeding has
merit under SIPA;
2. sufficiency of SIPC guidance given to trustees regarding (a) evidence
(such as type and amount) necessary to establish a valid customer
2 Oversight of Securities Investor Protection Corporation, Audit Report No.
301. SEC?s 2000 Examination
Is Ongoing
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 56 GAO- 01- 653 Securities Investor Protection
claim and (b) recognition of legal precedents in liquidation proceedings;
3. propriety of SIPC decisions made regarding claims submitted to the
trustee, during a proceeding, given SIPA?s requirements;
4. consistency of trustee actions in acting as a fiduciary to investors; 5.
comparison of the timeliness of each stage of claim processing during
a liquidation compared with results from past inspections; and 6.
reasonableness of SIPC administrative expenses, including a
comparison to amounts paid out in satisfaction of claims. SEC Market
Regulation and OCIE officials agreed that the 2000 inspection would cover
all the issues the IG report identified. The expanded scope would allow SEC
to address many of the controversies surrounding SIPC. For example, item 2-
SIPC guidance regarding evidence (type and amount)- addresses the issues
raised in SIPC?s liquidations of introducing firms engaged in unauthorized
trading. In particular, the guidance that SIPC provided to trustees who
implemented the documentation standard for unauthorized trading claims would
likely be a relevant issue for SEC?s ongoing SIPC examination. In addition,
item 6- cost of liquidation administrative expenses- has primarily been a
source of controversy in some SIPC liquidations involving unauthorized
trading claims. The examination is to also include other areas, such as
SIPC?s appointment of trustees in larger liquidations, the scope of SIPA?s
coverage, the public?s understanding of the type of coverage SIPA provides,
and the adequacy of the SIPC fund.
As of March 2001, SEC had included four SIPC liquidations involving
unauthorized trading in its examination sample but had not included any
liquidations involving nonmember affiliates. OCIE officials told us that as
of March 2001, SEC staff had reviewed 21 SIPC liquidation proceedings. 3 In
March 2001, the sample included 4 of the 24 liquidations that involved
unauthorized trading. However, Market Regulation and OCIE staff had not
included in the examination sample any of the four liquidations involving
3 The SEC sample of 21 liquidations includes 5 liquidations SIPC initiated
from 1996 through 1999. Four of these were introducing firms that engaged in
unauthorized trading. Of the remaining 16 liquidations in the SEC sample,
SIPC initiated 2 in 1995, 2 in 1994, 1 in 1993, 7 in 1992, 1 in 1991, 1 in
1989, and 2 in 1988.
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 57 GAO- 01- 653 Securities Investor Protection
nonmember affiliates. SEC officials told us that they were mindful of the
issues concerning unauthorized trading and nonmember affiliate claims. They
also said that the SIPC examination remained ongoing and that a final
determination on the number of liquidations to include in the final sample
had not yet been decided. However, they agreed that the sample should be
expanded to include additional liquidations involving unauthorized trading
and the nonmember affiliate issue. They said that they planned to expand the
sample of liquidations accordingly.
Given the controversies involving SIPC?s liquidations involving unauthorized
trading and nonmember affiliates, including a large number of liquidations
involving unauthorized trading and the affiliate issue, an expanded sample
size is warranted. As discussed in chapters 2 and 3, liquidations involving
unauthorized trading and affiliates comprise 75 percent of the SIPC
proceedings initiated since 1996. In three of the four SIPC liquidations
involving nonmember affiliates, SIPC or trustees denied large numbers of
claims where customers purchased financial products from the affiliates. In
the Old Naples Securities liquidation proceeding, a federal appellate court
rejected SIPC and the trustee?s basis for denying some of these customer
claims. SIPC officials and trustees also determined that consolidating the
estates of the SIPC member firms and their nonmember affiliates was not
warranted in these three cases because the members generally operated
independently from their affiliates. By contrast, SIPC and the trustee
concluded in the New Times/ New Age proceeding that consolidation of the
estates was warranted. Without a review of the issues involved in these
controversial SIPC liquidation proceedings, SEC?s ongoing examination will
not provide a complete basis for understanding SIPC?s operations.
In 2000, the SEC IG found that communication among SEC?s internal units
regarding SIPC could be improved. To achieve this objective, the IG
recommended that Market Regulation, Enforcement, NERO, and OCIE conduct
periodic briefings to share information related to SIPC. Although the SEC IG
report found that SEC officials tried to keep each other informed about
relevant SIPC issues, there was no formal procedure for doing so. According
to SEC officials that we contacted, they have not yet established a regular
procedure to ensure the dissemination of information about SIPC.
Subsequently, SEC officials stated that they will begin holding quarterly
meetings to discuss SIPC.
As the IG report found, periodic briefings among SEC units would help ensure
that information about issues such as investor complaints, the SEC Has Not
Implemented SEC IG Recommendation on Sharing Information About SIPC Issues
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 58 GAO- 01- 653 Securities Investor Protection
status of current liquidations, and securities firms that may be candidates
for SIPC liquidations are discussed in a timely manner. Moreover, the SEC IG
report also found that SEC staff in offices responsible for SIPC oversight
have expressed differing opinions on issues relevant to SIPC. By
establishing periodic briefings, SEC staff would have the opportunity to
discuss such differing opinions over SIPC and ensure a comprehensive
oversight program. SEC officials stated that they plan to begin holding
quarterly meetings.
In September 2000, SEC, at the request of OGC, Market Regulation, and
Enforcement, authorized a 1- year pilot program to monitor ongoing SIPC
liquidations. OGC requested authorization of the program after SEC received
numerous inquiries from investors and their attorneys regarding SIPC
liquidations. Under the pilot program, SEC will enter notices of appearance
in all SIPC liquidation proceedings. This will enable staff in OGC and in
SEC regional offices, which include about a dozen attorneys specializing in
bankruptcy, to monitor ongoing SIPC liquidations. The bankruptcy staff
already monitors corporate bankruptcy reorganizations affecting public
investors, pursuant to authority in the Bankruptcy Code to take positions in
reorganization proceedings. SIPA likewise authorizes SEC to file notices of
appearance and to participate as a party in liquidations initiated under the
act.
OGC staff said that the primary objective of the pilot program is to provide
oversight of claims determinations in SIPC liquidation proceedings in order
to make certain that the determinations are consistent with SIPA. OGC staff
will not be involved in evaluating investor claims until after the trustee
has made the initial determination because SEC does not want to circumvent
the claims determination process as established by SIPA. By entering notices
of appearances, SEC will receive investor objections to adverse claims
determinations and can seek authorization from SEC to take positions in
court if the staff disagrees with the determinations.
Despite SEC?s initiatives to strengthen its SIPC oversight efforts such as
the OGC pilot program, SEC faces several important challenges. The joint
Market Regulation and OCIE examination initiated in 2000 will likely provide
important information about SIPC?s operations and was expanded to include a
much larger sample of cases than the 1994 examination. However, the sample
of liquidations selected as of March 2001 included a limited number of
liquidations involving unauthorized trading claims and did not include any
SIPC liquidations that involved nonmember affiliates. These liquidations are
among the most controversial that SIPC has SEC OGC Has
Established a Pilot Program to Monitor Ongoing SIPC Liquidations
Conclusions
Chapter 4: Despite Positive Initiatives, SEC?s SIPC Oversight Program Faces
Some Challenges
Page 59 GAO- 01- 653 Securities Investor Protection
initiated over the past 5 years. SEC?s plan to expand the sample of
liquidations involving unauthorized trading and nonmember affiliates should
strengthen its ongoing review.
Given the number of units involved in SIPC?s oversight, it is essential that
these units communicate across organizational lines, share information, and
take coordinated steps to resolve any critical issues that are identified.
Although SEC units share information on an informal basis, the lack of a
formal means of communication could hinder SEC?s overall SIPC oversight
efforts. In addition, the pilot program implemented in September 2000 could
enhance SEC?s oversight of SIPC and provide useful timely information about
ongoing proceedings, but it is too soon to assess its efficacy.
To improve SEC?s oversight of SIPC operations, we recommend that the
Chairman, SEC
ensure that OCIE and Market Regulation include in their ongoing SIPC
examination a larger sample of liquidations involving unauthorized trading
and nonmember affiliate claims and
require that Market Regulation, OCIE, OGC, and Enforcement establish a
formal procedure to share information about SIPC issues.
In general, SEC officials agreed with our conclusions and recommendations
dealing with its SIPC oversight program. Specifically, regarding our
recommendation that SEC sample a larger number of liquidations in its
ongoing SIPC inspection, SEC officials stated that they will include
additional liquidations involving unauthorized trading and nonmember
affiliates as we recommended. Regarding our second recommendation on the
need for a formal mechanism to share information about SIPC issues, SEC
officials stated that they plan to hold quarterly meetings to discuss issues
regarding SIPC. SEC said that the primary purpose of the formal meetings
will be to ensure that factual information about investor complaints, the
status of current liquidations, and other similar matters are shared with
all interested persons. Recommendations
Agency Comments and Our Evaluation
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 60 GAO- 01- 653 Securities Investor Protection
Investors that do not fully appreciate the differences in how banks and
securities firms operate may confuse SIPC with FDIC and, to a lessor extent,
state insurance guarantee associations. Although SIPC and FDIC offer similar
coverage for cash, only SIPC protects securities, whose market value
fluctuates. The market losses generated from such fluctuations in the price
of securities are not covered by SIPC. However, securities firms are not
required to disclose this information when referring to SIPC in advertising
statements. Conversely, FDIC insures deposits, which do not fluctuate in
value, and state guarantee associations guarantee that owners of covered
policies and contracts will not lose their coverage if their insurer fails.
According to industry officials, investor confusion may increase as banking,
securities, and insurance industries consolidate.
Like FDIC, SIPC and state government life and health 1 insurance guarantee
associations protect owners of financial products when, respectively, their
securities firm or insurer fails. However, there are important differences
that customers may not fully understand and SIPC rules do not require its
members to disclose in advertising an important detail of coverage that
might help investors distinguish SIPC from the other programs.
SIPC, FDIC, and the life/ health state insurance guarantee associations are
broadly similar in the main functions they perform but with important
differences. Each organization protects the owners of certain financial
products when their securities firm, bank, thrift, or insurer becomes
insolvent, subject to various statutory limitations. In a SIPC liquidation,
SIPC pays customer claims against the failed firm to the extent they cannot
be satisfied by customer cash and securities still in the firm?s possession,
and also pays the administrative expenses of a courtappointed trustee. FDIC
liquidates failed members itself, as does SIPC in
1 According to the National Organization of Life and Health Guarantee
Associations, each state has at least two guarantee associations to protect
policyholders of financially troubled insurers: one for life and health
insurance and another for property and casualty insurance. We focused on the
52 state life/ health guarantee associations because the policies their
member firms sell, such as annuities, more closely resemble investments than
do many of the types of insurance sold by property/ casualty insurers. The
life/ health associations exist in every state, the District of Columbia,
and Puerto Rico. Chapter 5: Investors May Confuse SIPC With
Other Financial Guarantee Programs as U. S. Financial Industries Restructure
Some Investors May Confuse SIPC and State Insurance Guarantee Associations
With FDIC
SIPC?s Protection Is Similar to FDIC and State Life/ Health Association
Guarantees, but Also Differs in Some Important Respects
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 61 GAO- 01- 653 Securities Investor Protection
some cases, and FDIC pays depositors if the firm cannot do so and pays
administrative expenses. State life/ health insurance guarantee associations
assist the state insurance commissioners in liquidating failed insurers and
assume responsibility for covered policies that cannot be transferred to
another insurer. Each organization covers a broad range of their members?
traditional business. SIPC protects most types of securities and cash
deposited at the firm. FDIC insures all deposits made in the normal course
of an insured bank?s business. A state association typically covers most
types of life and health insurance sold in the state.
Despite these basic similarities, public confusion over the programs-
particularly between SIPC and FDIC- may lead to misconceptions about
coverage. Table 2 shows the different products the organizations cover and
the types of protection they offer. One key distinction is that FDIC insures
only cash deposits and SIPC protects cash and securities. Banks can use
deposits to make loans or other investments. FDIC protects depositors
against the possibility that their bank will not be able to repay the
deposit amount because it has insufficient assets. When an FDICinsured
institution fails, depositors receive back all of the funds that they
deposited in (and had not withdrawn from) the institution, plus interest
that accrued prior to the insolvency, up to a statutory limit of $100,000
per depositor. 2 Unlike deposits at a bank, securities left with a
securities firm do not become assets of the firm. Instead, the firm holds
this property as a custodian. In the event of a failure, SIPC returns
missing customer property: securities, the value of which is based on market
pricing and not the firm?s financial health, and cash held in customer
accounts for the purpose of buying securities. SIPC?s per- customer limit is
$500,000, of which no more than $100,000 may be for cash. SIPC?s statute
requires it to value securities as of the filing date. This requirement
protects the filing date value of securities in that, if the securities
claimed by customers cannot be purchased by the SIPC trustee in a fair and
orderly market, the claimant would receive their value as of the filing
date. Losses caused by a decline in the price of the securities due to
market fluctuations between the filing date and the date the investor
originally purchased them would not be covered.
2 Multiple accounts held in different capacities (such as an individual and
a corporate account) are covered separately by both FDIC and SIPC.
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 62 GAO- 01- 653 Securities Investor Protection Table 2: Protections and
Disclosure Rules of SIPC, FDIC, and State Life/ Health
Insurance Guarantee Associations Guarantee organization Nature of guarantee
Disclosure rules
SIPC Returns missing securities valued as of the filing date and investment
cash. The securities? filing date value may be more or less than their
original purchase price, and the cash must have been intended to purchase
securities or result from the sale of securities.
$500,000 per customer b limit, of which no more than $100, 000 may be a
claim for cash.
Official symbol must be displayed in member firms? offices. Providing more
information in advertising through use of SIPC official advertising
statement, or an official explanatory statement, is optional. b
FDIC Returns deposits unconditionally credited to deposit accounts as of the
date of default, plus interest accrued as if the deposit had matured on that
date.
$100,000 per depositor a limit. Display and advertising rules are
similar to SIPC?s rules. Insured institutions must disclose that uninsured
products are neither FDIC- insured nor obligations of the bank, and carry
market risk (if appropriate). State Life and Health Insurance Guarantee
Associations
Continuous coverage is guaranteed if the association covers the product.
Another insurer or the association takes over all policies of the failed
insurer.
$300,000 per policy limit in most states. c
Twenty- four states and Washington, D. C., require insurers to explain the
association?s coverage and limits to new policyholders. However, 48 states,
Washington, D. C., and Puerto Rico prohibit insurers from advertising
membership in the association to induce the sale of insurance. a Multiple
accounts held in different capacities (such as an individual and a corporate
account) are
covered separately by both SIPC and FDIC. b The SIPC official advertising
statement is ?Member of the Securities Investor Protection Corporation? or
an abbreviated variant, such as ?Member SIPC.? The official explanatory
statement may either be (1) ?Member of SIPC. Securities in your account
protected up to $500, 000;? or (2) ?Member of SIPC, which protects customers
of its members up to $500, 000 (including up to $100, 000 for claims for
cash). Explanatory brochure available on request.? c The state associations
also have sub- limits on certain types of insurance, such as a typical $100,
000 limit on health insurance benefits. Sources: SIPA and SIPC rules, FDIC
regulations, and National Organization of Life and Health Guaranty
Association documents.
Some investors in securities who erroneously believe that SIPC protects
against market losses may not fully understand the difference between SIPC
and FDIC coverage. The data on the extent that investors already confuse
SIPC with FDIC or any other organization are anecdotal. We are
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 63 GAO- 01- 653 Securities Investor Protection
not aware of any recent nationwide survey of investors that explored their
understanding of FDIC, SIPC, and the state insurance guarantee associations
or the differences between them. Bank regulator guidance on investment
products emphasizes the differences between the two programs. 3 However, a
recent SEC IG report 4 and many securities industry and regulatory officials
we spoke with said that some customers probably confuse SIPC and FDIC
coverage. For example, FDIC officials said that some investors do not
understand the differences between FDIC and SIPC. The main reason they cited
was that both organizations have similar logos. Another reason might be that
both SIPC and FDIC protect cash up to $100,000 per customer (SIPC) or per
depositor (FDIC). The officials also cited similarities in coverage and
advertising as reasons for any confusion. Our review of claim files in one
recent SIPC liquidation suggested that many claimants did not understand
that SIPC returns securities that should have been in the account or their
value as of the date the liquidation began, rather than the securities?
value at the time they were purchased. The trustee in the Stratton Oakmont
liquidation denied almost 450 claims for redemption of market losses.
The coverage provided by the state life/ health insurance guarantee
associations resembles that of FDIC and SIPC in some ways, but they offer
another degree of protection that neither of the other two organizations
provide. Like SIPC and FDIC, the state associations may transfer customer
policies to another, healthy firm. However, the state associations guarantee
that holders of covered policies or contracts will not lose all of their
policy coverage if the company fails. An association directly takes over
policies that cannot be transferred to another insurer, as long as the
policyholders continue to pay their premiums and the policies do not
terminate on their own terms. SIPC and FDIC both may transfer customer
accounts to other firms, but when that does not occur, positions in customer
accounts are distributed subject to statutory coverage limitations. The
protection that state life/ health insurance guarantee associations provide
differ from that of SIPC and FDIC in other ways, as well. For example, most
of the associations limit protection to $300,000 per policy, unlike FDIC?s
$100,000 cap or SIPC?s $500,000 limit.
3 Interagency Statement on Sales of Nondeposit Investment Products, Fed. 15,
1994. See e. g., FDIC Interpretive Letter FIL- 9- 94 at 13. 4 Oversight of
Securities Investor Protection Corporation. Securities and Exchange
Commission Office of Inspector General. Audit Report No. 301. Mar. 31, 2000.
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 64 GAO- 01- 653 Securities Investor Protection
Table 2 also compares the extent to which FDIC, SIPC, and life/ health state
insurance guarantee associations require their members to inform customers
of the coverage provided by these organizations. The disclosure
requirements, or the lack thereof, may contribute to any confusion between
SIPC and FDIC, and perhaps with the state associations.
SIPC and FDIC disclosure requirements are minimal. SIPC only requires that
members display the official SIPC symbol prominently in their offices.
Advertisements, unless exempted, must include the SIPC symbol, the official
advertising statement, or the official explanatory statement, which are
discussed below. SIPC does not require that its members disclose that SIPC
does not protect against losses from changes in market value. When asked
about disclosing this information, SIPC expressed concern about their
authority to require additional disclosure in advertisements. Specifically,
officials stated that they thought the SIPA provision authorizing SIPC to
establish advertising bylaws restricted their authority to require
additional disclosure. The provision states as follows:
?SIPC shall by bylaw prescribe the manner in which a member of SIPC may
display any sign or signs (or include in any advertisement a statement)
relating to the protection to customers and their accounts, or any other
protections, afforded under this chapter. No member may display any such
sign, or include in any advertisement any such statement, except in
accordance with such bylaws. SIPC may also by bylaw prescribe such minimal
requirements as it considers necessary and appropriate to require a member
of SIPC to provide public notice of its membership in SIPC.? 5
We spoke with SEC staff about SIPC?s concern regarding its statutory
authority and they do not appear to share this concern. From the face of the
statute, we also believe that the SIPA provision does not bar SIPC from
requiring the additional disclosure in the optional disclosure statement.
FDIC generally requires insured institutions to display the appropriate
official seal (FDIC has two seals, one for thrifts and one for banks) at
each station or window where deposits are normally taken. Advertisements
must include either the appropriate seal or the advertising statement, which
says only that an institution is an FDIC member. Certain advertisements may
be exempt from this requirement.
As figure 2 shows, SIPC?s official symbol resembles FDIC?s official seal. 5
15 U. S. C. sect. 78kkk( d). SIPC Does Not Require
Members to Disclose Important Coverage Issues
SIPC and FDIC Disclosure
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 65 GAO- 01- 653 Securities Investor Protection
Figure 2: Official Symbols of SIPC and FDIC
Both SIPC and FDIC allow but do not require member firms to disclose more
information than can be gleaned from these logos. SIPC?s Advertising Bylaw
permits members to advertise their membership using a
?SIPC official explanatory statement.? The explanatory statement, which has
two variants, discloses somewhat more information about SIPC coverage. The
statement may either be (1)
?Member of SIPC, which protects customers of its members up to $500,000
(including up to $100,000 for claims for cash). Explanatory brochure
available on request;? or (2) ?Member of SIPC. Securities in your account
protected up to $500,000.? As we discussed in chapter 3, SIPC?s brochure
describes SIPA coverage in more detail. However, SIPC does not allow member
firms to use any other language to describe its coverage in advertisements,
out of concern that they might mischaracterize SIPC protections. For
example, some firms have described the coverage as
?insurance.?
SIPC also allows members to use an official advertising statement. Yet, this
statement (? This firm is a member of the Securities Investor Protection
Corporation? or an abbreviated version such as ?member
SIPC?) provides no more information to investors than the official symbol
does. FDIC also requires insured institutions to use an official advertising
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 66 GAO- 01- 653 Securities Investor Protection
statement in most advertising. The statement (Member of the Federal Deposit
Insurance Corporation? or an abbreviated version), like SIPC?s official
advertising statement, discloses few details about the organization?s
coverage.
Although FDIC only mandates use of its official seals or the official
advertisement statement in advertising, there may be no need for additional
disclosure. Arguably, FDIC protection is easier for consumers to understand,
because it generally guarantees deposits placed in a failed insured
institution. Unlike securities prices, cash deposits do not fluctuate in
value. As explained above, SIPC protects the filing date value of
securities, but not their original purchase price. Also, FDIC- insured
institutions must disclose to their retail customers which of their products
are not FDIC insured. As table 2 shows, they must inform customers, in
writing and orally at the time of sale, that the uninsured product they are
selling is not FDIC insured nor an obligation of the bank, and that the
product carries market risk if that is appropriate. Further, according to
FDIC officials, FDIC encourages insured institutions to disclose as much
information as possible about the organization?s insurance. In contrast,
SIPC member firms are not required to disclose which products they sell are
not protected by SIPC (such as commodity- based investments), although they
are prohibited from displaying or advertising SIPC membership if doing so
would mislead the public into believing that products they sell that do not
meet SIPA?s definition of a security are protected.
SIPC?s disclosure rules differ from many states? requirements that members
of a life/ health insurance guarantee association must prominently disclose
the limitations to the association?s protections. Most of the associations
are based on a ?model act? drafted by the National Association of Insurance
Commissioners (NAIC). The NAIC model act reflects the consensus of state
insurance commissioners on how states should write their insurance laws. The
model act for life/ health insurance guarantee associations recommends that
states prohibit any insurer, agent, or affiliate of an insurer from
publishing, disseminating, or advertising membership in a life/ health state
insurance guarantee association ?for the purpose of sales, solicitation, or
inducement to purchase any form of insurance covered by the guarantee
association.? The purpose of prohibiting advertising of membership is to
help prevent people from making insurance decisions out of a belief that
they are protected from financial loss. State Insurance Guarantee
Association Disclosure
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Programs as U. S. Financial Industries Restructure
Page 67 GAO- 01- 653 Securities Investor Protection
However, the advertising prohibition does not mean that policyholders do not
know of the existence of their state?s life/ health insurance guarantee
association. The model act also recommends that states require insurers to
provide a document that summarizes the general purposes and current
limitations of their state?s life/ health guarantee association whenever the
insurer delivers a policy or contract to a policy or contract owner. The
model act recommends that this document state clearly and conspicuously,
among other things, (1) that the guarantee association may not cover the
policy or, if it does, that coverage will be subject to substantial
limitations and exclusions and (2) the types of policies for which the
association will provide coverage. An example of a substantial limitation or
exclusion is that most of the life/ health associations do not cover
nonindemnity policies, such as health maintenance organizations.
Table 2 also shows the number of states whose laws conform to the model
act?s recommendation on life/ health insurance guarantee association
disclosure and advertising. As the table indicates, 48 states, Washington,
D. C., and Puerto Rico prohibit insurers from using the existence of their
association to sell any insurance product; and 24 states and Washington, D.
C., require insurers, insurance agents, and affiliates of insurers to
provide a written explanation of their association?s coverage and coverage
limits to all new policyholders.
As banks, securities firms, and insurance companies consolidate and offer
similar products to the public, some people may increasingly confuse SIPC,
FDIC, and state life/ health insurance guarantee organizations.
GLBA makes major changes to the laws that govern how the U. S. financial
services industry is structured and regulated. Before GLBA passage, federal
and state laws limited the extent to which banking, securities, and
insurance companies could affiliate. For example, banking and insurance
companies were not allowed to affiliate nor were securities companies
permitted to own banks. National banks could underwrite and deal in only
certain types of securities known as bank- eligible securities. These
included U. S. government securities and general obligation bonds of states
and municipalities. Also, banks could engage in any mutual fund activity,
except for underwriting the mutual fund. Securities firms that were Investor
Confusion
May Increase as Financial Services Industy Consolidates
GLBA Eliminates Barriers to Affiliation Among Banks, Securities Firms and
Insurance Companies
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 68 GAO- 01- 653 Securities Investor Protection
affiliates of banks that were members of the Federal Reserve System were
allowed to underwrite and deal in securities to a limited extent.
GLBA repeals or overrides sections of federal and state laws that restricted
the affiliation of banks, securities firms, and insurance companies and
agents. It permits traditional bank holding companies and foreign banks to
expand into new insurance and securities activities and insurance and
securities firms to enter commercial banking. Under GLBA, banking
institutions can participate in the securities and insurance businesses by
becoming Financial Holding Companies (FHC), a new kind of bank holding
company authorized by the act. An FHC may directly engage in, or affiliate
with companies that engage in, a wide array of financially related
activities. These activities include securities underwriting and dealing,
insurance underwriting and agency activities, and any other activity that
the Federal Reserve Board (usually in conjunction with the Secretary of the
Treasury) determines to be financial in nature or incidental or
complementary to financial activities.
GLBA also expands the range of financial activities that banks that are not
FHCs may engage in. The act does this by allowing national banks to form or
purchase subsidiaries that may engage in some, but not all, of the
activities that FHCs may engage in. For example, the national bank
subsidiaries are prohibited from engaging as principle in underwriting
insurance (other than credit- related insurance) or providing or issuing
certain types of annuities.
Regarding insurance, GLBA reaffirms the traditional authority of the states
to regulate the insurance industry. However, the act uses broad preemptive
language intended to override any state law restricting the establishment of
bank- insurance affiliations or placing burdens on sales and cross-
marketing of insurance by banking institutions and their affiliates. The
preemption provisions apply to any type of affiliation permitted by GLBA,
not just to the FHCs that the law creates. GLBA does maintain some
restrictions on banks? insurance activities. Still, many state laws that
prohibit insurers from merging or affiliating with banks or securities firms
will be superseded.
Ultimately, GLBA may lead to creation of financial conglomerates that
contain under one corporate umbrella underwriters and distributors of
banking, securities, insurance, and other financial and complementary
products and services. Such consolidation already has occurred in some
institutions. Whether or not financial one- stop shops become the norm in
this country, as the U. S. financial services industry consolidates to take
Greater Disclosure May
Help Address Investor Confusion
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 69 GAO- 01- 653 Securities Investor Protection
advantage of GLBA?s opportunities, it will be more common in the future for
individuals to purchase financial products from the same institution that
are covered by the three different financial guarantee organizations that we
have been discussing. An individual who buys securities from a securities
firm affiliate of an FHC may be protected by SIPC should the firm fail. That
same person may be covered by a state insurance guarantee fund if he or she
buys certain types of insurance from the same or another affiliate. And,
funds deposited with a banking affiliate of one of these entities may be
insured by FDIC.
In chapters 2 and 3, we highlighted the need to improve disclosure of SIPC?s
policies and practices. SIPC has engaged a private firm to survey investors
to discover how well they understand SIPC coverage. The firm is also charged
with devising ways in which SIPC coverage could be better advertised.
SIPC and FDIC perform similar functions: they return customer property when
a member firm fails if the firm cannot do so. Moreover, SIPC and FDIC share
similar logos and coverage amounts. As financial companies continue to
consolidate, investor confusion concerning SIPC protections could grow more
widespread. In a consolidated entity, it?s possible for a single customer to
have various accounts with various affiliates that are afforded different
types of protection.
Although SIPC?s mission is to return the securities or cash that should have
been in a customer?s account when liquidation proceedings start, we found
some evidence that investors are unaware that SIPC does not protect against
decreases in the price of their securities. This type of misperception has
led some investors to file claims for market losses in SIPA liquidation
proceedings that were denied. The official explanatory statement that SIPC
members can opt to use does not state that SIPC does not protect against
losses from changes in the market value of securities.
We recommend that the Chairman, SIPC, amend SIPC advertising bylaws to
require that the official explanatory statement about a firm?s membership in
SIPC include a statement that SIPC coverage does not protect investors
against losses caused by changes in the market value of their securities.
SIPC agreed with our conclusion that there is ample anecdotal evidence that
some investors believe that SIPC protection is akin to FDIC protection and
that some investors believe that SIPC will protect them from market losses.
Furthermore, they agreed that the industry has an Conclusions
Recommendation Agency Comments and Our Evaluation
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 70 GAO- 01- 653 Securities Investor Protection
obligation to correct these misperceptions. However, they disagreed with our
recommendation that SIPC require any statement about SIPC membership to
include information about the fact that SIPC does not protect investors from
market losses. According to SIPC officials, the statute does not give SIPC
the power to adopt such a bylaw and such a statement, without elaboration,
would be misleading.
Regarding SIPC?s concern about its statutory authority, SIPC stated that in
the early 1970s it proposed a bylaw that would have required members to give
public notice of their SIPC membership. According to SIPC, SEC rejected the
proposal ?on the ground that SIPC did not have authority to require its
members to identify themselves as such.? Consequently, in 1978, Congress
amended 15 U. S. C. sect. 78kkk( e) and added the following sentence: ?SIPC may
also by bylaw prescribe such minimum requirements as it considers necessary
and appropriate to require a member of SIPC to provide public notice of its
membership.? Even though the sentence appears to grant SIPC discretion to
determine what such ?minimum
requirements? should be, SIPC maintains that, on the basis of the
legislative history, Congress strictly limited that discretion to allow only
for a requirement that a SIPC member must identify its status as a member.
Although we recognize SIPC?s discretion to interpret its enabling
legislation, we do not believe that the provision in question precludes SIPC
from adding our recommended statement to an official explanatory statement
already authorized in its bylaws. Further, SEC staff does not share SIPC?s
statutory concern. The legislative history cited by SIPC in its comments
clearly shows that Congress intended SIPC to have discretion to impose
?minimal notice? of SIPC membership. As shown below, SIPC?s bylaw permitting
use of an official explanatory statement allows a member?s statement about
its membership to include a statement about SIPC coverage. We believe that
SIPC has discretion to require members to disclose in prescribed language
the fundamental consequence of SIPC membership when a firm chooses to use
SIPC?s official explanatory statement.
We have reworded our recommendation to make it clear that it contemplates
SIPC amending SIPC?s bylaw allowing members to disclose more information
than can be gleaned from the SIPC logo by using a SIPC
?official explanatory statement.? The statement has two variants (1)
?Member of SIPC, which protects customers of its members up to $500,000
(including up to $100,000 for claims for cash). Explanatory brochure
available upon request;? or (2) ?Member of SIPC. Securities in your account
protected up to $500, 000.? As SIPC states, ?SIPC can, by bylaw, give its
members the option of making a statement about SIPC coverage.?
Chapter 5: Investors May Confuse SIPC With Other Financial Guarantee
Programs as U. S. Financial Industries Restructure
Page 71 GAO- 01- 653 Securities Investor Protection
Our recommendation involves amending SIPC?s official explanatory statements
to include information about losses from changes in market values not being
protected.
SIPC also raised an additional concern that the recommended language that
SIPC does not protect against market losses would be misleading. We do not
share SIPC?s concern that amending SIPC?s official statement, without
elaboration, would be misleading. In its comments, SIPC sets forth three
reasons why it believes the statement would be incomplete and misleading.
These reasons relate to steps SIPC might take in liquidating a member should
certain circumstances exist, that is; (1) providing the actual securities,
(2) purchasing replacement securities, and (3) providing the cash value of
the securities as of the filing date. Regardless of what steps SIPC might
take in a particular proceeding, SIPC?s actions would not change the
fundamental fact that a firm?s SIPC membership does not protect investors
against market losses.
Rather than being misleading, we believe that our recommended language about
market losses not being covered is consistent with current disclosures about
SIPC coverage that SIPC and securities regulators already make to investors.
For example, the first page of SIPC's informational brochure contains the
following statement:
"Of course, SIPC does not protect against changes in the market value of
your investment. It does, however, provide important protections against
certain losses if a SIPC member fails financially and is unable to meet
obligations to its securities customers.?
Moreover, our recommended language, which was based on SIPC?s information
brochure, is similar to language used by SEC and NASDR on their Web sites to
discuss SIPC coverage. For example, the SEC Web site states that ? SIPC does
not protect you against losses caused by a decline in the market value of
your securities.?
Appendix I: Comments From the Securities Investor Protection Corporation
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Appendix I: Comments From the Securities Investor Protection Corporation
Appendix I: Comments From the Securities Investor Protection Corporation
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Appendix I: Comments From the Securities Investor Protection Corporation
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Appendix II: Comments From the Securities and Exchange Commission
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Appendix II: Comments From the Securities and Exchange Commission
Appendix II: Comments From the Securities and Exchange Commission
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Appendix II: Comments From the Securities and Exchange Commission
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Appendix II: Comments From the Securities and Exchange Commission
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Appendix II: Comments From the Securities and Exchange Commission
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Appendix II: Comments From the Securities and Exchange Commission
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Appendix III: GAO Contacts and Acknowledgments Page 89 GAO- 01- 653
Securities Investor Protection
Richard J. Hillman (202) 512- 8678 Orice M. Williams (202) 512- 8678
In addition to the persons named above, David Genser, Rosemary Healy, Wesley
M. Phillips, and Paul G. Thompson made key contributions to this report.
Appendix III: GAO Contacts and
Acknowledgments GAO Contacts Acknowledgments
(233640)
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