Securities Investor Protection: Update on Matters Related to the
Securities Investor Protection Corporation (11-JUL-03,
GAO-03-811).
As result of ongoing concerns about the adequacy of disclosures
provided to investors about the Securities Investor Protection
Corporation (SIPC) and investors' responsibilities to protect
their investments, GAO issued a report in 2001 entitled
Securities Investor Protection: Steps Needed to Better Disclose
SIPC Policies to Investors (GAO-01-653). GAO was asked to
determine the status of recommendations made to the Securities
and Exchange Commission (SEC) and SIPC in that report. GAO was
also asked to review a number of issues involving excess SIPC
insurance, private insurance securities firms purchase to cover
accounts that are in excess of SIPC's statutory limits.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-03-811
ACCNO: A07514
TITLE: Securities Investor Protection: Update on Matters Related
to the Securities Investor Protection Corporation
DATE: 07/11/2003
SUBJECT: Investment insurance
Investment planning
Strategic planning
Information disclosure
Securities regulation
Internal controls
******************************************************************
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GAO-03-811
A
Report to Congressional Requesters
July 2003 SECURITIES INVESTOR PROTECTION
Update on Matters Related to the Securities Investor Protection
Corporation
GAO- 03- 811
Contents Letter 1
Results in Brief 2 Background 5 SEC Has Taken Steps to Address Our
Recommendations 11 SIPC Has Taken Steps to Improve Investor Education 16
Terms of Existing Excess SIPC Policies Vary, and Most Insurers Have
Stopped Underwriting New Policies 20
Conclusions 28 Recommendations 29 Agency Comments 29 Objectives, Scope,
and Methodology 30
Appendixes
Appendix I: Comments from the U. S. Securities and Exchange Commission 32
Appendix II: Comments from the Securities Investor Protection Corporation
34
Appendix III: GAO Contacts and Staff Acknowledgments 36 GAO Contacts 36
Acknowledgments 36
Table Table 1: Examples of How SIPC Protects Investors 11
Abbreviations
FDIC Federal Deposit Insurance Corporation IG Inspector General NERO
Northeast Regional Office NYSE New York Stock Exchange OCIE Office of
Compliance Inspections and Examinations OGC Office of General Counsel PSA
public service announcement SEC Securities and Exchange Commission SIA
Securities Industry Association SIPA Securities Investor Protection Act of
1970 SIPC Securities Investor Protection Corporation SRO self- regulatory
organization
This is a work of the U. S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
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copyright holder may be necessary if you wish to reproduce this material
separately.
Letter
July 11, 2003 The Honorable John D. Dingell Ranking Minority Member
Committee on Energy and Commerce House of Representatives The Honorable
Barney Frank Ranking Minority Member Committee on Financial Services House
of Representatives The Honorable Paul E. Kanjorski Ranking Minority Member
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises Committee on Financial Services House of Representatives
Disclosure has an important role in securities market regulation, and the
Securities Investor Protection Corporation (SIPC) has a responsibility to
inform investors of actions they can take to protect their investments and
help ensure that investors are afforded the full protections allowable
under the Securities Investor Protection Act of 1970 (SIPA). In our 2001
report, we concluded that many investors were unaware of the steps they
should take to protect their investments. 1 We found that SIPC and the
Securities and Exchange Commission (SEC), which play vital roles in
investor education, had missed opportunities to disclose information on
SIPC*s policies, practices, and coverage to investors. Our report
contained 10
recommendations to SEC and SIPC about ways to improve the information
available to the public about SIPC and SEC*s oversight of SIPC.
This report responds to your August 16, 2001, and October 30, 2001,
requests that we followup on our 2001 report recommendations. As
requested, this report also includes information about *excess SIPC,*
which refers to private insurance that securities firms can purchase to
cover customer claims that are in excess of the $500, 000 (which includes
$100, 000 cash) limits established by SIPA. Excess SIPC policies typically
1 U. S. General Accounting Office, Securities Investor Protection: Steps
Needed to Better Disclose SIPC Policies to Investors, GAO- 01- 653
(Washington, D. C.: May 25, 2001).
cover cash and securities like SIPC, but the dollar amount of the coverage
can vary from net equity coverage to a specific dollar amount. Although
the policies are advertised as excess SIPC, not all policies may be
consistent with SIPA. In light of these concerns, you asked that we review
implications for investors and possible investor misunderstanding about
these policies.
To determine the status of our 2001 report recommendations to SEC and
SIPC, we interviewed relevant officials from SEC and SIPC to determine
what steps they had taken to implement our recommendations since May 2001.
We verified changes to SEC and SIPC Web sites and SIPC*s brochure to
determine what SEC and SIPC disclosed to investors regarding SIPC*s
policies and practices regarding unauthorized trading 2 and nonmember
affiliate issues. 3 We also spoke with self- regulatory organization (SRO)
officials about related disclosure issues. 4 To address issues surrounding
excess SIPC coverage, we interviewed SEC, SIPC, and SRO staff;
representatives from underwriters and insurance brokers; securities firms
(policy holders); SIPC trustees; and attorneys knowledgeable about excess
SIPC. We also reviewed a sample of excess SIPC policies, including one
policy from each of the four major underwriters that provided coverage in
2002. We conducted our work from October 2002 through July 2003 in
accordance with generally accepted government auditing standards.
Results in Brief SEC has completed or is in the process of implementing
each of the seven recommendations made in our May 2001 report. Three
recommendations
were aimed at improving the information SEC provides to investors about
SIPC*s policies and practices, particularly with regard to unauthorized
trading and nonmember affiliate claims. In response to our
recommendations, SEC updated the investor education section of its Web
site to include more consistent information about documenting
2 Unauthorized trading occurs when a firm buys or sells securities for a
customer*s accounts without the customer*s approval. 3 Most registered
firms automatically become members of SIPC. However, affiliates (firms
that are formally tied within the same financial holding company) of
securities firms are not
required to become members of SIPC. 4 SROs have an extensive role in
regulating the U. S. securities markets, including ensuring that members
comply with federal securities laws and SRO rules. SROs include all the
registered U. S. securities exchanges and clearing houses, the NASD
(formerly known as National Association of Securities Dealers) and the New
York Stock Exchange (NYSE).
unauthorized trading claims and updated a Web page dedicated to providing
information about SIPC policies and practices. SEC has also implemented
two recommendations intended to improve its oversight of SIPC operations.
As recommended, SEC adjusted the sample of liquidations it examined in its
recently completed review of SIPC to include a larger number of
liquidations involving unauthorized trading or nonmember affiliate issues.
In response to the SEC Inspector General (IG)
and our recommendation that SEC establish a formal procedure to share
information about SIPC among its various divisions and offices, SEC began
holding quarterly meetings. SEC has subsequently determined that more
frequent, informal meetings were more effective. If this format continues
to allow SEC to share information with all the relevant parties, it would
be an effective response to our recommendation. Finally, SEC is still in
the process of implementing our recommendations to require firms to
distribute the SIPC brochure to customers and to require clearing firms to
include information about documenting unauthorized trades in writing on
account statements. SEC officials have sent letters to the New York Stock
Exchange (NYSE) and NASD asking them to explore how these recommendations
could be implemented through SRO rulemaking or notices to members, and the
SROs are evaluating possible approaches to implement these
recommendations.
SIPC has taken steps to implement each of our three recommendations, but
needs to complete additional work on one. We made recommendations to SIPC
aimed at improving the information it provides to investors about its
policies and practices, particularly regarding unauthorized trading and
nonmember affiliate claims. First, we recommended that SIPC revise its
informational brochure and Web site to include a full explanation of the
steps necessary to document an unauthorized trading claim. In response to
our recommendation, SIPC has updated its brochure and Web site to clarify
that investors should complain in writing to their securities firms about
suspected unauthorized trades. Second, we recommended that SIPC amend its
advertising bylaws to include a statement that SIPC does not protect
against losses due to market fluctuations. According to SIPC officials,
such a statement would be misleading unless additional explanations were
added. However, SIPC has expanded a statement in its brochure that
discusses market risk and SIPC coverage and amended its advertising bylaws
to require firms that display an expanded statement to include a reference
or link to SIPC*s Web site. In addition, we found that SEC, SROs, and many
securities firms provide the recommended disclosures to investors on their
Web sites. In combination, such actions collectively respond to our
recommendation. Third, we recommended that
SIPC revise its brochure to warn investors to exercise caution when
calling to complain about an unauthorized trade in order to avoid
unintentionally ratifying an unauthorized trade. In response, SIPC
provided investors with links to Web sites, such as SEC*s, that offer
information about investment fraud. However, SIPC provides links to only
the main Web site and not to specific Web pages that contain the relevant
information, so investors may have difficulty locating information about
specific types of fraud. For example, based on the Web address provided in
the brochure, investors searching SEC*s Web site for *fraud,* would be
linked to over 5,000 possible references. Providing more specific links to
investor education information would make it much easier for investors to
locate relevant information.
Until this year, excess SIPC coverage was generally available to certain
well- capitalized, large, and regional securities firms. The policies
varied by firm and insurer in terms of the amount of coverage offered per
customer and in aggregate per firm. Attorneys familiar with the policies
agreed that the disclosure of the coverage and the terms of coverage are
sometimes unclear. In our review of some of the policies, it was unclear
who was covered and how the claims process would work in the case of a
firm*s bankruptcy. The policies were also unclear in terms of when a claim
can be filed and whether the trustee or the customer would file it. During
our
review, three of the four major insurers that offered excess SIPC coverage
in 2002 stopped underwriting these policies in 2003. Some of these
insurers said they had stopped providing coverage primarily because of the
complexity of quantifying their potential risk exposure in relation to the
relatively low premiums. 5 Consequently, as the policies expire in 2003,
most
insurers are not renewing their existing policies and have stopped
underwriting new policies. At this time, some of the policyholders have
not decided what to do going forward. However, several options are being
explored, including self- insuring and purchasing policies from the
remaining major insurer. 5 To evaluate and measure the impact of losses to
a firm, maximum potential loss and
maximum probable loss must be determined. The maximum potential loss,
which is the absolute maximum dollar amount of loss, could be significant
because it is simply the aggregate of all customer account balances over
SIPC*s $500,000 limit. Conversely, the maximum probable loss is the likely
dollar loss if a firm were to become part of a SIPC
liquidation proceeding. This type of calculation is usually based on
historical loss data for the particular event, but unlike most other
insurance products, actuaries have no historical loss data for excess SIPC
products because no claims- related losses have been incurred.
Given the important and ongoing role that SEC and SIPC play in investor
education and protection, we make new recommendations to SEC and SIPC
aimed at further improving investor education and protection. First, we
recommend SIPC modify its brochure to provide more specific links to
investor education information as SIPC continues its efforts to improve
investor awareness of SIPC*s policies and practices and to educate
investors in general. Finally, as existing excess SIPC policies expire and
are replaced with new policies or are not replaced at all, we recommend
that SEC take actions to monitor these ongoing developments. We requested
comments on a draft of this report from the Chairman, SEC,
and the Chairman, SIPC. We received comments from the Director, Division
of Market Regulation, SEC, and President, SIPC. Both generally agreed with
the report*s findings and recommendations. SEC*s and SIPC*s comments are
discussed in greater detail at the end of this letter, and the written
comments are reprinted as appendixes I and II, respectively.
Background SIPA established SIPC to provide certain financial protections
to the customers of insolvent securities firms. As required under law,
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. 6 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 2002, SIPC initiated a total
of 304 liquidation proceedings and paid about $406 million to satisfy such
customer claims.
SIPC*s Mission 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
6 SIPA authorizes an alternative to liquidation under certain
circumstances when all customer claims aggregate to less than $250,000.
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 could not account for their
customers* property. 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 when 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.* SIPC 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. 7 SIPA sets 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 31 staff located in Washington, D. C.
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, 2002, SIPC had 6,679 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
7 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.
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, 8 (2) selling variable annuities, 9 (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. 10 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 cover situations where an individual has a debtor- creditor
relationship, such as a lending arrangement, with a SIPC member firm.
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. Although bankers and brokers are customers under SIPA, they are not
eligible for SIPC fund advances. SIPA states that most customers are
eligible for SIPC assistance, but SIPC funds may not be used to pay claims
of any failed brokerage firm customer who is
8 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. 9 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.
10 Typically, bank certificates of deposit are not securities under the
Securities Exchange Act of 1934; however, they are defined as securities
in SIPA.
a general partner, officer, or director of the firm; the beneficial
owner of 5 percent or more of any class of equity security
of the firm (other than certain nonconvertible preferred stocks); a
limited partner with a participation of 5 percent or more in the net
assets or net profits of the firm; someone with the power to exercise a
controlling influence over the
management or policies of the firm; and a broker or dealer or bank
acting for itself rather than for its own
customer or customers. The SIPC fund was valued at $1.26 billion as of
December 31, 2002, which it uses to make advances to trustees for customer
claims and to cover the administrative expenses of a liquidation
proceeding. 11 Administrative expenses in a SIPA 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. SIPC, after consultation with the
SROs, sets the amount of member assessments based on the amount necessary
to maintain the fund and repay any borrowings by SIPC. 12 At different
times during the 1970s, 1980s, and 1990s members were assessed at a higher
rate. Rates fluctuated depending on the level of expenses. SIPC*s board of
directors attempted to match assessment rate increases with declines in
the fund balance, so that years of high SIPC expenses were followed by
periods of higher assessments. Since 1996, SIPC has charged each broker-
dealer member an
11 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.
12 15 U. S. C. 78ddd( c)( 2). The assessments shall be a percentage of
each member*s gross revenues if (1) the fund is below a level that the
Commission determines is in the public interest; (2) SIPC is obligated on
any outstanding borrowings; or (3) SIPC is required to phase out the lines
of credit it has established. Otherwise, SIPC shall impose an annual
assessment. 15 U. S. C. 78ddd( d)( 1).
annual assessment of $150. 13 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 relend the funds to SIPC). In
addition, SIPC has a $1 billion line of credit with a consortium of banks.
SEC Oversight of SIPC SIPA gives SEC oversight responsibility over SIPC.
SEC*s primary mission is to protect investors and the integrity of the
securities markets. SEC
seeks to fulfill its mission by requiring public companies to disclose
financial and other information to the public. SEC is also responsible for
conducting investigations of potential securities law violations and
overseeing SROs such as securities exchanges, as well as broker- dealers
(securities firms), mutual funds, investment advisors, and public utility
holding companies. 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 SEC may require SIPC to adopt, amend, or repeal any
bylaw or rule. 14 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.
SEC Rules Strengthen The law that created SIPC also required SEC to
strengthen customer Customer Protection in the
protection and increase investor confidence in the securities markets by
Securities Market increasing the financial responsibility of broker-
dealers. Pursuant to this mandate, SEC developed a framework for customer
protection based on two key rules: (1) the customer protection rule and
(2) the net capital rule. These rules respectively require broker- dealers
that carry customer accounts to (1) keep customer cash and securities
separate from those of the company itself and (2) maintain sufficient
liquid assets to protect customer interests if the firm ceases doing
business. SEC and SROs, such
13 15 U. S. C. 78ddd( d)( 1)( C). *The minimum assessment imposed upon
each member of SIPC shall be $25 per annum through the year ending
December 31, 1979, and thereafter shall be the amount from time to time
set by SIPC bylaw, but in no event shall the minimum assessment be greater
than $150 per annum.* Id.
14 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 a type that SEC
determines by rule does not require SEC approval.
as NYSE, are responsible for enforcing the net capital and customer
protection rules.
Excess SIPC Coverage Was Under a typical SIPC property distribution
process, SIPC customers are to
Introduced in the 1970s receive any securities that the firms holds that
are registered in their name or that are being registered in their name,
subject to the payment of any
debt to the firm. If some of the customer assets are missing and cannot be
found by the trustee, the customer will receive a pro rata share of the
firm*s remaining customer property. In addition, SIPC is required to
replace
missing securities and cash in an investor*s account up to the statutory
limits. For firms with excess SIPC policies, this coverage would be
available as well. For example, if a firm is liquidated by a SIPC trustee
that
should have $10 billion in customer assets, but the trustee can account
for only $9.8 billion or 98 percent of the $10 billion in assets, each
customer would receive 98 percent of their net equity (pro rata share). A
customer with net equity of $10 million would receive 98 percent or $9.8
million of their $10 million. In addition the trustee may use up to
$500,000 advanced
from the SIPC fund to satisfy the customer*s claim, but only $100, 000 may
be advanced for cash. With a $200,000 advance from SIPC, the customer in
this example would have received the entire $10 million in assets owed. To
protect customers who have claims in excess of the SIPC limit, Travelers
Bond 15 first began offering excess SIPC coverage to brokerage firms in
1970, soon after SIPA was enacted. Other companies began to join the
market in the mid- 1980s. However, such claims above the SIPA limit are
rare and regulatory and industry officials confirmed that most customers
would not be affected by such policies because their accounts are within
the SIPA limits.
As seen in table 1, the amount of customer funds recovered determines if
the investor will have a loss and whether excess SIPC would be triggered.
For example, if the trustee determined that 50 percent of the customer
assets were missing, a customer who is owed $1 million in assets would
receive a $500, 000 pro rata share from the estate and an advance from
SIPC at its statutory limit of $500,000. However, a customer with $5
million in assets with the same 50 percent pro rata share would have $2
million in excess of the $500,000 SIPC advance and could be eligible for
excess SIPC coverage if offered by the securities firm. Conversely, a
customer with 15 Travelers Bond is now Travelers Property Casualty Corp.
$5 million in assets and a pro rata share of 90 percent or higher would be
made whole by SIPC and would not have losses in excess of SIPC limits.
Tabl e 1: Examples of How SIPC Protects Investors Percent of customer Pro
rata share of assets
Amount in excess of Customer assets property recovered returned to
customer SIPC advance SIPC limit
$1,000,000 50 $500,000 $500, 000 $0 5,000, 000 50 2,500,000 500, 000
2,000, 000 5,000, 000 60 3,000,000 500, 000 1,500, 000 5,000, 000 70
3,500,000 500, 000 1,000, 000 5,000, 000 80 4,000,000 500, 000 500, 000
5,000, 000 90 4,500,000 500, 000 0 10,000,000 50 5,000,000 500, 000 4,500,
000 10,000,000 60 6,000,000 500, 000 3,500, 000 10,000,000 70 7,000,000
500, 000 2,500, 000 10,000,000 80 8,000,000 500, 000 1,500, 000 10,000,000
90 9,000,000 500, 000 500, 000 10,000,000 98 9,800,000 200, 000 0 Source:
SIPC and GAO analysis of how SIPC protects investors.
SEC Has Taken Steps In our 2001 report, we made seven recommendations to
SEC to address
to Address Our needed improvements to information it provided to investors
about SIPC*s policies and practices, particularly regarding the
evidentiary standard for
Recommendations unauthorized trading claims and to expand its review of
SIPC operations
among others. SEC has taken action to address all of the recommendations
either directly or indirectly by delegating the implementation to the
SROs.
First, we recommended that SEC review sections of its Web site and, where
appropriate, advise customers to complain promptly in writing when they
believe trades in their account were not authorized. This advice should
include an explanation of SIPC*s policies and practices regarding claims
and a general warning about how to avoid ratifying potentially
unauthorized trades during telephone conversations. In 2001, we found that
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 generated
controversy,
primarily because of the large numbers of claims that were denied and the
methods used to satisfy certain approved claims. In addition, we found
that SIPC*s policies and practices were often not
transparent to investors and SEC had missed opportunities to provide
investors with consistent information about SIPC*s evidentiary standard
for unauthorized trading. For example, some sections of SEC*s Web site
encouraged investors to call to complain about unauthorized trades, while
other sections told the investor to complain immediately in writing.
Although the telephone- based approach SEC recommended was reasonable if
the firm acted in good faith to resolve problem trades, fraudulently
operated firms were known to have used high pressure and/ or
fraudulent tactics to convince persons who called to complain about
potentially unauthorized trades to ratify these trades. In response to our
recommendation, SEC updated sections of its Web site to include consistent
information on making unauthorized trading complaints in writing. In
addition, they expanded the section entitled Cold Calling to include
warnings about high- pressure sales tactics that some brokers may use.
Second, we recommended that SEC require firms that it determines to have
engaged in or are engaging in systematic or pervasive unauthorized trading
to prominently notify their customers about the importance of
documenting disputed transactions in writing. In 2001, we found that
although SEC may identify and impose sanctions on firms that have engaged
in pervasive unauthorized trading long before they ever become SIPA
liquidations, it does not routinely require such firms to notify their
clients about documenting unauthorized trading claims. For example,
between 1992 and 1997, one securities firm operated under intensive SEC
and court supervision in connection with, among other violations,
pervasive unauthorized trading and stock price manipulation. However,
there was no requirement that the firm notify their customers to document
their complaints in writing. Imposing this requirement could help
investors
protect their interests and benefit unsophisticated investors who may not
review the SIPC brochure or other disclosures made on account statements.
At the time the report was issued, SEC had agreed to implement this
requirement on a case- by- case basis. Since 2001, SEC officials said that
they have not had a case that required this action. Moreover, SEC
officials noted that their first course of action would be to shut down
firms that engage in pervasive unauthorized trading.
Third, we recommended 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*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 2001, we found that SEC had missed opportunities to
educate investors about the potential risks associated with certain
nonmember affiliates. SEC*s Web site provided limited information about
dealing with nonmember affiliates, and investors may not have been fully
aware of the risks that can be associated with certain nonmember
affiliates. In response to this recommendation, SEC updated an on- line
publication called Securities Investor Protection Corporation, which
discusses the problems that can occur when investors place their cash or
securities with non- SIPC members. Investors are also told to always make
sure that the securities firm and clearing firm 16 are members of SIPC
because firms are required by law to tell you if they are not. Next, we
recommended that SEC take several actions to improve its
oversight of SIPC. Specifically, we recommended that SEC implement the SEC
IG*s recommendation that the Division of Market Regulation, the Division
of Enforcement, the Northeast Regional Office (NERO) and the Office of
Compliance, Inspections, and Examinations (OCIE) conduct periodic
briefings to share information related to SIPC. In 2000, SEC*s IG found
that communication among SEC*s internal units regarding SIPC could be
improved. 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. At the time our report was issued, SEC had not yet
implemented this recommendation, and we recommended that they do so. SEC
officials said that they began to hold quarterly meetings, but determined
that more frequent, informal meetings were more effective. They said that
they meet to discuss SIPC as issues arise, which is typically more than
once every quarter. As long as SEC continues to meet frequently and share
information among all the relevant units, this approach effectively
responds to the concern our recommendation was intended to address.
Fifth, we recommended that SEC expand its ongoing examination of SIPC to
include a larger number of liquidations with claims involving
16 Clearing firms clear customer transactions and hold customer cash and
securities.
unauthorized trading or nonmember affiliate issues. SEC periodically
conducts examinations of SIPC*s operations to ensure compliance with SIPA.
In May 2000, the Division of Market Regulation and OCIE initiated a joint
examination of SIPC. As of March 2001, SEC had included four SIPA
liquidations involving unauthorized trading in its sample, but had not
included any liquidations involving nonmember affiliate issues. Given the
controversies involving SIPA*s liquidations involving unauthorized trading
and nonmember affiliates, we believed that including a larger number of
liquidations with these types of claims was warranted. SEC agreed with
this recommendation and included a larger number of liquidations involving
unauthorized trading or nonmember affiliate issues in the sample used for
the review. Of the eight liquidations in SEC*s sample, five involved
unauthorized trading and two involved nonmember affiliate issues.
SEC completed its examination in January 2003 and issued its examination
report in April 2003, which assessed SIPC*s policies and procedures for
liquidating failed securities firms and identified several areas of
improvement that warrant SIPC*s consideration.
SEC found that there was insufficient guidance for SIPC personnel and
trustees to follow when determining whether claimants have established
valid unauthorized trading claims. Although the evidentiary
standards used were found to be reasonable, the standards differed between
trustees. Therefore, SEC recommended that SIPC develop written guidance to
help establish consistency between trustees and liquidations. SIPC agreed
to adopt such written guidance for reviewing unauthorized trading claims.
Concerning SIPC*s investor education programs, SEC found that SIPC
should continue to review the information that it provides to investors
about its policies and practices. For example, SEC found that some
statements in SIPC*s brochure and Web site might overstate the extent of
SIPC coverage and mislead investors. SIPC plans to continue to reexamine
the adequacy of the information provided in its brochure and Web site to
eliminate any potential confusion.
SEC also found that SIPC should improve its controls over the fees
awarded to trustees and their counsel for the services rendered and their
expenses. SEC found that some descriptions of the work that the trustees
performed were vague, making it difficult to assess whether the work was
necessary or appropriate. SEC believed that SIPC could do a better job of
reviewing and assessing fees that were requested. SIPC
agreed to ask trustees and counsel in SIPC cases to submit invoices at
least quarterly and arrange billing records into project categories. SIPC
also agreed to instruct its personnel to document discussions with
trustees and counsel regarding fee applications and to note any
differences in amounts initially requested by trustees and counsel and
those amounts recommended for payment by SIPC.
In addition, SEC found that SIPC lacks a record retention policy for
records generated in liquidations where SIPC appoints an outside trustee.
It was found that trustees had different procedures for retention of
records, and SEC was not able to review records from one liquidation
because the trustee had destroyed the records. SIPC has agreed to develop
a uniform record retention policy for all SIPA liquidations, following a
cost analysis.
SEC also found that the SIPC fund was at risk in the case of failure of
one or more of the large securities firms. SEC found that even if SIPC
were to triple the fund in size, a very large liquidation could deplete
the fund. Therefore, SEC suggested that SIPC examine alternative
strategies for dealing with the costs of such a large liquidation. SIPC
management
agreed to bring this issue to the attention of the Board of Directors, who
evaluates the adequacy of the fund on a regular basis.
Also as part of SEC*s ongoing oversight effort, in September of 2000,
SEC*s Office of General Counsel (OGC) initiated a 1- year pilot program to
monitor SIPA liquidations. According to SEC, the primary objective of the
pilot program was to provide oversight of claims determinations in SIPA
liquidation proceedings in order to make certain that the determinations
were consistent with SIPA. According to SEC officials, this program has
since been made permanent. SEC*s OGC now enters notices of appearance in
all SIPA liquidation proceedings. The cases are followed mostly by
NERO and the Midwest Regional Office, given the significant numbers of
SIPA liquidations in these locations. The staff can recommend that
Commission staff intervene in SIPA liquidations, if appropriate. Sixth, we
recommended that SEC, in conjunction with the SROs, establish a uniform
disclosure rule requiring clearing firms to put a standard statement about
documenting unauthorized trading claims on their trade confirmations and/
or other account statements. In 2001, we found that SEC, NASD, and the
NYSE, did not have requirements that clearing firms notify customers that
they should immediately complain in writing about allegedly unauthorized
trades. A review of a judgmental sample of trade
confirmations and account statements found that many firms voluntarily
notify their customers to immediately complain if they experience any
problems with their trades, but instructions about the next course of
action varied and did not necessarily specify that the investor should
complain in writing. Initially, SEC expressed concern about promulgating a
rule itself. However, in 2003, SEC began to take steps to implement this
recommendation. Specifically, SEC has asked NYSE and NASD to explore how
this recommendation can be more fully implemented through SRO rulemaking
and Notices to Members. As of June 9, the SROs were still evaluating how
best to implement this recommendation. According to an SRO official,
concern about potentially penalizing investors who may not complain in
writing but may file claims in other forums, such as arbitration
proceedings, will need to be resolved. However, SEC believes that they
will be able to craft acceptable language that ensures that these
investors are not harmed.
Lastly, we recommended that 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 existing customers more widely. This
recommendation was an additional step aimed at educating and better
informing customers about how to protect their investments. The SIPC
informational brochure called How SIPC Protects You provides useful
information about SIPC and its coverage. However, SIPC bylaws and SEC
rules do not require SIPC members to distribute the brochure to their
customers. The authority lies with SEC or the SROs to require the firms to
provide the brochure to their customers. To date, it is unclear what
action will be taken. SEC officials expressed concern about imposing
another rule on securities firms. Instead, SEC included this
recommendation in its letter to NYSE and NASD to explore how this could be
implemented through SRO rulemaking and Notices to Members. According to
SEC and SRO officials, both NASD and NYSE are in the process of exploring
how best to implement this recommendation. SEC officials said that they
did not expect the SROs to have problems implementing this recommendation.
SIPC Has Taken Steps In our 2001 report, we made three recommendations to
SIPC to improve
to Improve Investor the information available to investors about its
coverage, particularly with
regard to unauthorized trading. In addition to taking steps to implement
Education
our recommendations, SIPC has continued a nationwide investor education
program that addresses many of the specific issues raised in our 2001
report. 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. Our 2001 report found that
investors might confuse the coverage offered by SIPC, Federal Deposit
Insurance Corporation (FDIC), and state insurance guarantee associations
and not fully understand the protection offered under SIPA. This was
significant because the type of financial protection that SIPC provides is
similar to that provided by these programs, but important differences
exist. To address these and other investor education issues, SIPC began a
major public education campaign in 2000. As part of the campaign, SIPC
worked with a public relations firm to make its Web site and brochure more
reader friendly and less focused on legal terminology. The changes were
designed to ensure that the Web site is easy to use and written in plain
English. In addition to revising its brochure and Web site, SIPC produced
a series of audio and video public service announcements (PSA). 17 From
June 15, 2002, to November 15, 2002, the PSAs were aired over 76, 000
times. According to SIPC*s 2002 annual report, the TV PSAs have appeared
on 129 stations, in 106 cities, in 46 states; and the radio spots have
aired on 415 stations, in 249 cities, in 49 states. They have also been
aired nationally on CNBC and the Fox News Channel. SIPC and its public
relations firm are continuing to work together to
improve investor awareness of SIPC and its policies. They are developing a
new television and radio campaign scheduled to begin in July 2003. They
are also working to better explain the claims process through a new
brochure and video. The claims process brochure will provide information
to individuals that do not have access to the Internet. This investor
education campaign has increased the amount and clarity of information
available about SIPC and has provided investors who review it with
important information. As mentioned, in addition to identifying investor
education concerns in our
2001 report, we recommended that SIPC take three specific actions to
improve its disclosure. First, we recommended that SIPC revise its
brochure and Web site to include a full explanation of the steps necessary
to document unauthorized trading claims. SIPC has determined, and courts
have agreed, that an objective evidentiary standard, such as written
complaints, is necessary to protect the SIPC fund from fraudulent claims.
However, in our 2001 report, we found that SIPC had also missed
opportunities to provide investors with complete information about dealing
with unauthorized trading. For example, we found that claimants in 87
17 These PSAs may also be viewed at www. sipc. org/ streaming. html.
percent of the claims we reviewed telephoned complaints to their brokers.
Given that many investment transactions are largely made by telephone, we
were concerned that investors were not aware of the importance of
documenting their complaints in writing if they were ever required to file
a claim with SIPC. Furthermore, we found the SIPC brochure did not advise
investors that SIPA covers unauthorized trading and that investors should
promptly complain in writing about allegedly unauthorized trades. As
previously mentioned, the brochure was revised as part of the investor
education campaign and now includes the statement, *If you ever discover
an error in a confirmation or statement, you should immediately bring the
error to the attention of the [firm], in writing.* In addition, SIPC has
created a Web page, entitled Documenting an Unauthorized Trade, which
includes the same information on complaining in writing to the firm about
any errors.
We also recommended that SIPC amend its advertising bylaws to include a
statement that SIPC does not protect against loss due to market
fluctuations. SIPC officials did not agree with the recommended statement
and felt that it would be misleading unless additional explanations were
added. Instead, SIPC has expanded a statement in its brochure that
discusses SIPC coverage of market fluctuation to read,
*Most market losses are a normal part of the ups and downs of the risk-
oriented world of investing. That is why SIPC does not bail out investors
when the value of their stocks, bonds, and other investments fall for any
reason. Instead, SIPC replaces missing stocks and other securities where
it is possible to do so* even when investments have increased in value.*
In addition, SIPC amended its advertising bylaws in 2002 to require firms
that choose to make an explanatory statement about SIPC to include a link
to the SIPC Web site. 18 This will further enable the customer to access
information about what SIPC does and does not cover. NASD and SEC have
also begun to make disclosures about SIPC and market risk to investors.
For example, the NASD Web site says, *SIPC does not protect against market
risk, which is the risk inherent in a fluctuating market. It protects the
value of the securities held by the [firm] as of the time the SIPC trustee
is appointed.* SEC informs investors that *SIPC does not protect you
against losses caused by a decline in the market value of your
securities.* Furthermore, many securities firms also include similar
statements about
18 Firms are required to mention their SIPC membership in advertisements,
but are not required to use one of the explanatory statements provided by
SIPC.
SIPC protection on their Web sites. SIPC*s statement about market risk and
amended bylaws as well as the availability of other disclosures by the
regulators and firms effectively responds to the concern our
recommendation was intended to address.
Finally, we recommended that SIPC revise its brochure to warn investors to
exercise caution in ratifying potential unauthorized trades in telephone
discussions with firm officials. SIPC believes that the statement
discussed above encouraging investors to complain in writing about
unauthorized trades in its brochure and Web site will make oral
ratification unlikely. SIPC officials also maintain that this type of
information is best handled in those publications and Web pages that warn
investors about securities fraud. Therefore, in its brochure, SIPC
provides links to several Web sites, such as SEC*s, that have investor
education information about investment
fraud. However SIPC provides links to only the main Web site and not to
the specific Web pages that contain the relevant information, so investors
may have difficulty locating information about specific types of fraud,
such as unauthorized trading. For example, based on the Web address
provided in the brochure, investors searching SEC*s Web site for *fraud,*
would be linked to over 5,000 possible sites. SIPC also recommends the
Securities Industry Association 19 (SIA) Web site for information about
investment fraud. However, based on the information SIPC provided, a
search for *unauthorized trading* on this Web site yields only three
results, none of which send the investor to useful educational information
contained on the
Web site. Investors are also directed to NASD*s Web site, which has a page
entitled Investors Best Practices, which includes detailed information on
cold calling and unauthorized trading. However, an investor may not be
able to find this useful information without specific links to the
relevant Web pages for this and other Web sites listed in the brochure.
For example, a search for *unauthorized trading* on NASD*s Web site only
yields one
result, which provides a link to a definition for unauthorized trading but
no reference to the useful educational information.
19 SIA is a trade group that represents broker- dealers of taxable
securities. SIA lobbies for its members* interests in Congress and before
SEC and educates its members and the public about the securities industry.
Terms of Existing Excess SIPC coverage is generally offered by well-
capitalized, large, and
Excess SIPC Policies regional securities firms and is generally marketed
by the firms as additional protection for their large account holders. Our
review of the
Vary, and Most Insurers excess SIPC policies offered by the four major
insurers found the policies
Have Stopped varied by firm and insurer in terms of the amount of coverage
offered per
Underwriting New customer and in aggregate per firm. In our review of some
of the policies, we found that excess SIPC coverage was not uniform and
was not
Policies necessarily consistent with SIPC protection. Attorneys familiar
with the
policies also agreed that the disclosure of the coverage and the terms of
coverage could be improved. During our review, three of the four major
insurers that offered excess SIPC coverage in 2002 stopped underwriting
these policies in 2003 for a variety of reasons. Consequently, as the
policies expire, most insurers are not renewing their existing policies
beyond 2003 and have stopped underwriting new policies in general. At this
time, it is unclear what some of the securities firms that had excess SIPC
coverage plan to do going forward.
Excess SIPC Coverage Is Excess SIPC is generally limited to certain well-
capitalized, large, and
Generally Limited to Larger regional firms that have a relatively low
probability of being part of a SIPC
Firms liquidation. Moreover, the policies* usually structured as surety
bonds*
are generally purchased by clearing firms. 20 The insurance underwriters
of excess SIPC policies told us that they use strict underwriting
guidelines and have minimum requirements for a firm requesting coverage.
Most insurers evaluate a securities firm for excess SIPC coverage by
reviewing its operational and financial risks. Insurers also consider the
firm*s internal control and risk management systems, the type of business
that the firm conducts, its size, its reputation, and the number of years
in business. Some insurers also required the firms to annually submit
information on the number and value of customer accounts above the
$500,000 SIPC limit, to help gauge their maximum potential exposure in the
unlikely event that the firm became part of a SIPC liquidation. Firms
below a certain dollar net capital threshold were generally not considered
for coverage. 20 In general terms, a surety bond represents a contract in
which one party to the contract,
the *surety,* is obligated to pay third parties if the other party to the
contract fails to perform a duty owed to the third parties. See REST 3d ~
1.
Excess SIPC Coverage Is Although an excess SIPC claim has never been filed
in the more than 30
Not Uniform and Is Not years that the coverage has been offered, we
identified several potential investor protection issues. 21 Our review of
excess SIPC policies, which
Necessarily Consistent with included one from each of the four major
insurers, revealed that excess
SIPC Coverage SIPC coverage is not uniform and that some policies are not
always
consistent with SIPC coverage. Although the policies were advertised as
covering losses (or losses up to an amount specified in the policy) that
would otherwise be covered by SIPC except for the $500,000 limit, we found
that claims under the policies could be subject to various terms and
limitations that do not apply to SIPC coverage. Attorneys familiar with
SIPA and excess SIPC have also raised questions about who is covered in
the policies and how the claims process would work in the case of a firm*s
bankruptcy. These potential inconsistencies or concerns include
Some policies included customers that would generally be ineligible
under SIPA. The wording in some of the policies could be interpreted as
protecting individuals who are not customers eligible for SIPC advances.
Others contained specific riders that expanded the excess SIPC policy to
include classes of customers beyond those covered by SIPC. For example,
some policies have riders that extend coverage to officers and directors
of the failed firm, as long as they are not involved with any fraud that
contributed to the firm*s demise. As
mentioned previously, SIPC coverage excludes certain customers, such as
officers and directors of the failed firm and broker- dealers and banks
acting on their own behalf.
Some policies limited the duration of coverage. Each policy we reviewed
provided coverage only if SIPC were to institute judicial proceedings to
liquidate the firm while the policy was in effect. Three of the four
policies provided for specific periods of time during which they
were in effect, as well as for cancellation by the insurer under specified
conditions. Although each of the three policies required the securities
firm to notify its customers of a cancellation, none of the policies
expected notification to the customers regarding expiration. 22 21
According to one insurer, while no claims have been filed, certain
attorney fees and a very
small number of settlements have been paid to a few investors. 22 Two of
the policies specified that it was the broker- dealer*s *responsibility*
to notify its customers of discontinuance of the coverage, but neither the
insurer nor the firm was
obligated to make this disclosure.
According to NYSE and NASD, there are not any specific SRO rules that
require these firms to notify their customers. However, NYSE said that
they generally expect firms to notify investors of any changes in their
excess SIPC protection under rules involving disclosure requirements for
fees changes. NASD generally expects firms to notify their customers under
NASD*s Just and Equitable Rule.
Some excess SIPC policies varied from SIPA in scope of coverage. Certain
policies also differed from SIPA in terms of the scope of excess coverage.
Specifically, customer cash, which would generally be covered under SIPA,
was not covered by two of the policies we reviewed. One of the policies
specifically restricted coverage to lost securities; the other described
coverage as pertaining only to a customer*s claim for *loss of
securities.* 23 Also, in addition to a cap on the amount of coverage per
customer, one policy contained a cap on the insurer*s overall exposure*
the policy established an aggregate cap of $250 million* regardless of the
total amount of customer claims. SIPC has no such aggregate cap.
The mechanics of the claims process were unclear. In addition to
limitations on coverage, at least one policy had other characteristics
that could either restrict a customer*s ability to recover losses that
exceed the amount covered under SIPA or delay a customer*s recovery until
long after the net equity covered by the insurance has been determined.
The policy conditioned the customer*s recovery upon the customer providing
the insurer with a claim notice subject to specific time, form, and
content specifications. Among other things, the
customer was required to submit a written claim accompanied by evidence
satisfactory to the insurer and an assignment to the insurer of the
customer*s rights against the firm. The other policies did not address
when a customer must file a claim.
The role of the trustee in the claims process was unclear. Another
difference we found is the role of the trustee regarding customer claims
under SIPA and excess SIPC coverage policies. Under SIPA, the trustee acts
on behalf of customers who properly file claims to see that they recover
losses as provided in SIPA. It is unclear whether the trustee
could represent customers on claims for excess insurance because, in 23 A
similar policy contained a rider specifying coverage for lost cash in
excess of the $100, 000 SIPA cap.
some cases, the policies indicate that only individual customers could
bring claims and, in any case, the trustee may not have authority under
the bankruptcy laws to do so. 24 SIPC trustees and other attorneys
experienced with SIPA liquidations also agreed that it was not clear who
was responsible for filing the claim, the customer or the trustee.
The policies did not clearly state when a claim would be paid. The
policies also differed from SIPC coverage regarding when customers could
recover their losses. For purposes of SIPC coverage, the trustee
discharges obligations of the debtor from available customer property and,
if necessary, SIPC advances, without waiting for the court to rule on
customer property and net equity share calculations. Under the excess
coverage policies, it is unclear when customers would be eligible to
recover assets in excess of those replaced by SIPC. Some of the policies
provide for *prompt* replacement or payment of the portion of a customer*s
covered net equity. In contrast to SIPC coverage, however, they specify
that the insurer shall not be liable for a claim until the customer*s net
equity has been *finally determined by a competent
tribunal or by written agreement between the Trustee and the Company,*
which could take years. Under another policy, the insurer could wait until
after liquidation of the broker- dealer*s general estate before replacing
a customers* missing assets. The general creditor claims process could
also take several years. An attorney knowledgeable about SIPC and excess
SIPC said that some policies
indicate that the insurance company has no liability until the customer
claim is paid by SIPC. However, in many cases SIPC does not directly pay
investors, but does so through a trustee. Therefore, the policy, if taken
literally, would preclude an investor from ever being paid through excess
SIPC insurance.
Excess SIPC coverage appears to be limited to clearing firm failures.
Most of the excess SIPC polices we reviewed provide that only the policy
holder, usually a clearing firm, is covered under the policy. Introducing
firms of clearing firms may advertise the coverage provided
by their clearing firm. For example, we reviewed the Web sites of 53
introducing firms and found that about 25 percent advertised the excess
24 See Caplin v. Marine Midland Grace Trust Co., 406 U. S. 416, 434, 32 L.
Ed. 2d 195, 92 S. Ct. 1678 (1972) (Bankruptcy trustee did not have
standing to assert debenture holders* claims of misconduct against
respondent indenture trustee where the cause of action belonged solely to
the debenture holders and not to the bankruptcy estate.)
SIPC protection provided by the clearing firm. This creates the potential
for investor confusion because the coverage would apply only in the case
of the clearing firm*s failure. Because introducing firms do not clear
securities transactions or hold customer cash or securities, the
customer*s assets should be unaffected in the event of an introducing
firm*s failure. However, there have been cases where customer funds were
*lost* before they were sent to the clearing firm, typically due to
fraudulent activity. If the introducing firm fails while the assets are
still with the introducing firm but the clearing firm continues to
operate, investors may not be aware that the excess SIPC protection would
only
apply in the event of the clearing firm*s failure. Conversely, SIPC will
initiate liquidation proceedings against introducing firms and protect
their investors in certain situations.
Three of the Four Major During our review, three of the four major
insurers that offered excess Insurers Identified Stopped
SIPC coverage in 2002 stopped underwriting these policies beyond 2003.
Underwriting Excess SIPC The insurers provided various reasons for not
continuing to underwrite
Policies in 2003 excess SIPC policies, such as their concern about the
complexity of
quantifying their maximum probable loss. In addition, officials from
securities firms and attorneys knowledgeable about excess SIPC had
opinions about why the insurers are no longer underwriting excess SIPC
policies.
According to the insurers that have stopped offering excess SIPC, they
made a business decision to stop offering the coverage after reviewing
their existing product offerings. They said that this practice of
periodically reviewing product lines and profitability is not uncommon.
Most of the underwriters were property and casualty insurance companies,
and the excess SIPC product was viewed as a relatively small part of their
standard product line and provided low return in the form of premiums
relative to the significant potential risk exposure. Some of the
underwriters said that documenting and explaining the potential risk
associated with excess SIPC policies is difficult. For example, the
maximum potential loss for excess SIPC could be significant because it is
simply the aggregate of all customer account balances over SIPC*s $500,000
limit. Quantifying the probability of loss, which would be significantly
less, is much more difficult because insurers have never had a claims-
related loss associated with the excess SIPC policies; therefore, no
historical loss data exists.
Another insurer said credit rating agencies began to ask questions about
potential risk exposures from excess SIPC; and rather than risk a change
to
its credit rating, it opted to stop providing the coverage given the
limited number of policies it underwrote. 25 Others in the industry said
that in light of the Enron Corporation failure and the losses experienced
by the insurance underwriters that had exposure from Enron- related surety
bonds, credit rating agencies have begun to more closely scrutinize
potential losses and risk exposures of insurance companies overall. While
surety bonds are still considered relatively low- risk products, insurers
are more sensitive to their potential risk exposures. As mentioned, given
the absence of actuarial data it is difficult for insurers to quantify the
maximum probable losses from excess SIPC.
Securities firms and others also had opinions about why insurers stopped
underwriting the policies. Some believed that a general lack of knowledge
about the securities industry and SIPC, in particular, might have
contributed to the products being withdrawn from the market. Many firms
said that the risk of an excess SIPC claim ever being filed is low for two
primary reasons. First, securities firms that carry customer accounts are
required to adhere to certain customer protection rules. Specifically,
firms must keep customer cash and securities separate from those of the
firm itself and maintain sufficient liquid assets to protect customer
interests if the firm ceases doing business. Moreover, SEC and the SROs
have established inspection schedules and procedures to routinely monitor
broker- dealer compliance with customer protection (segregation of assets)
and net capital rules. Firms not in compliance can be closed.
Second, SIPA liquidations are rare in general and claims in excess of the
SIPA limit are even more rare. For example, since 1998, more than 4, 000
firms have gone out of business, but less than 1 percent or 37 firms
became part of a SIPA liquidation proceeding. This is consistent with
historical data
dating back to the 1970s. Moreover, since 1971 of the almost 623,000
claims satisfied in completed or substantially completed cases as of
December 31, 2002, a total of 310 were for values in excess of SIPC limits
(less than onetenth of 1 percent). Of these 310 claims, 210 were filed
before 1978 when the limit was raised to $500,000. Only two firms involved
in a SIPA 25 Credit ratings produced by credit rating agencies are widely
circulated; many investors
rely on these ratings to make investment decisions. These ratings include
opinions about the creditworthiness of certain public companies and their
financial obligations, including bonds, preferred stock, and commercial
paper. The credit ratings that result from analyses of this information
can affect securities markets in a number of important ways, including an
issuer*s access to and cost of capital, the structure of financial
transactions, and the ability of certain entities to invest in certain
rated obligations.
liquidation have offered excess SIPC, but no claims have been filed to
date. According to officials knowledgeable about a 2001 proceeding, which
included a firm with an excess SIPC policy, claims for excess SIPC are
likely to be filed. However, the amount of claims to be filed are unclear
at this time.
Securities Firms Are Most of the six holders of the excess SIPC policies
we contacted are
Exploring a Variety of currently exploring a number of options; but at
this time, it is unclear what
Options most will do. Although most said that the coverage is largely a
marketing
tool, some felt that the policies increased investor confidence in the
firm because an independent third party (the insurance company) had
examined the financial and operational risks of the firm prior to
providing them coverage. Several of the firms and those in the securities
industry we contacted said that they were surprised to learn that the
insurers planned to stop providing excess SIPC coverage. Therefore, most
firms are still exploring a number of options on how best to proceed,
including Self- insuring or creating a *captive* insurance company that
would offer
the coverage. 26 However, firm officials involved in exploring the captive
expressed concerns about whether they could establish the insurance
company by the end of 2003. Others questioned whether this option was
feasible given the competitive nature of the securities industry.
Purchasing policies from the remaining major insurer. While some have
already chosen this option, officials from some of the larger firms said
that this might not be an acceptable option because the remaining insurer
generally limits the amount of the coverage per firm. Firms that currently
offer net equity coverage were concerned that their high net worth
customers may not be satisfied with a policy that has a cap on its
coverage. Additionally, the policy of the remaining underwriter raised the
most questions about its consistency with SIPC coverage.
Letting the policies expire and not replacing them. Some of the firms we
spoke with said that the larger firms really do not need the excess SIPC
because they are well capitalized and the existing customer protection
rules offer sufficient protection. However, some officials said that if
one 26 A captive insurance company is a type of self- insurance whereby a
insurance company insures all or part of the risks of its parent. This
company is created when a business or group of businesses form a
corporation to insure or reinsure their own risk.
larger firm continued to offer the coverage, they all would have to
continue to offer the coverage in order to effectively compete for high,
net worth client business. Other firm officials suggested that SIPA might
need to be reexamined in light of the numerous changes that have occurred
in securities markets since 1970. Some officials said that at a minimum,
the SIPA securities limit of $500,000 should be raised to $1.5 million.
Another said that it is still possible that another insurance company may
decide to fill the void left by the companies exiting the business. Other
industry officials said that they were still in negotiations with the
remaining insurer to increase the coverage limits, which was a concern for
the larger firms. Many of the securities firms we spoke with had policies
that will expire by
the end of 2003. All planned to notify affected customers, but many had
not developed specific time frames. Most firms said that they planned to
have some type of comparable coverage, which could mitigate the importance
of notifying customers. In the interim, several securities firms have
asked SIA to produce information for the firms to use when talking to
their customers about SIPA and the protections they have under the act.
The information being developed for the securities firms is to also
include information about SIPC, excess SIPC, and how securities markets
work. As mentioned
previously, NYSE officials said that there is no specific rule that
requires securities firms to notify investors if the SIPC coverage expires
without being replaced. However, they generally expect firms to notify
customers under rules concerning fee disclosure requirements. Likewise,
NASD officials said that it had no specific rule requirements but would
generally expect firms to notify affected investors under general rules
concerning
just and equitable principles. In March 2003, in response to concerns
raised about excess SIPC coverage and the potential investor protection
issues, SEC began its own limited review of these issues. Initially, SEC
planned to collect information on the securities firms that offer the
coverage, the major providers, and the nature of the coverage offered.
Because most of the firms that have excess SIPC coverage are NYSE members,
SEC asked NYSE to gather information about excess SIPC coverage and
information about the policies. In response, NYSE compiled information on
its members with excess SIPC insurance policies and their insurers. NYSE
also analyzed other data and descriptive statistics such as assets
protected under excess SIPC. NYSE also reviewed the coverage offered by
the major insurers. Out of more than 250 NYSE members, they determined
that 123 had excess SIPC insurance coverage and that most of the members
were insured by one of the four
major insurance providers. However, when several underwriters decided to
stop providing the coverage, SEC suspended most of its review activity and
has not actively monitored the changes in the availability of the coverage
or the firms* plans going forward. Given the changes occurring in this
market and the potential concerns about the policies, SEC officials agreed
that they should continue to monitor these ongoing developments to ensure
that investors are obtaining adequate and accurate information about
whether excess SIPC coverage exists and what protection it provides.
Conclusions SEC and SIPC have taken steps to implement all of the
recommendations made in our May 2001 report. However, SEC has some
additional work to
do with the SROs to implement two of our recommendations. Although SEC has
asked the SROs to explore actions to encourage broader dissemination of
the SIPC brochure to customers and to include information on periodic
statements or trade confirmations to inform investors that they should
document any unauthorized trading complaints, no final actions have been
taken to implement these recommendations.
We also found that SIPC has substantially revamped its brochure and Web
site and continues to be committed to improving its investor education
program to ensure that investors have access to information about
investing and the role and function of SIPC. By doing so, SIPC has shown a
commitment to making its operations more transparent. We did note,
however, that SIPC*s response to our recommendation about warning
customers about unintentionally ratifying unauthorized trades, has not
completely addressed our concern that investors have specific information
about the risks of unintentionally ratifying trades when talking to
brokers. In 2001, we recommended that SIPC revise its brochure to warn
investors to exercise caution in discussions with firm officials. Rather
than including this information in its brochure, SIPC revised its brochure
to provide references or links to Web sites, such as SEC and NASD, but not
to the specific investor education oriented Web pages discussing ratifying
potentially unauthorized trades or fraud. We found that these broad
references make it difficult or virtually impossible for investors to find
the relevant information. More specific links to investor education Web
pages within each Web site would mitigate this problem.
Concerning excess coverage, three of the four major insurance companies
stopped underwriting excess SIPC policies in 2003 after reevaluating their
potential risk exposures and product offerings. Although an excess SIPC
claim has never been filed to date, insurance companies have become more
sensitive to potential risk exposures in light of their recent experience
with Enron and other high profile failures. Most made business decisions
to stop offering this apparently low- risk product. Many of the firms
appear to have been surprised by this decision and are exploring several
options, including letting the coverage expire, purchasing coverage from
the remaining underwriter, or creating a captive insurance company to
provide the coverage. Given the limitations and concerns we and others
have raised about the protection afforded investors under excess SIPC,
including limitations on scope and terms of coverage and an overall lack
of information on the claims process and when claims would be paid, SEC
and the SROs have vital roles to play in ensuring that existing and future
disclosures concerning excess SIPC accurately reflect the level of
protection afforded customers. Recommendations As SIPC continues to revamp
and refine its investor education program, we
recommend that the Chairman, SIPC, revise SIPC*s brochure to provide links
to specific pages on the relevant Web sites to help investors access
information about avoiding ratifying potentially unauthorized trades in
discussions with firm officials and other potentially useful information
about investing. Given the concerns that we and others have raised about
excess SIPC coverage, we also recommend that the Chairman SEC, in
conjunction with the SROs, ensure that firms are providing investors with
meaningful disclosures about the protections provided by any new or
existing excess SIPC policies. Furthermore, we recommend that SEC and the
SROs monitor how firms inform customers of any changes in or loss of
excess SIPC protection to ensure that investors are informed of any
changes in
their coverage. Agency Comments SEC and SIPC generally agreed with our
report findings and recommendations. However, SIPC said that providing
more specific linkages in its brochure would prove problematic because of
the frequency in which Web sites are changed. Rather, they agreed to
provide a reference in the brochure to the SIPC Web site, which will
provide more specific links to the relevant portions of the sited web
pages. We agree that this alternative approach would implement the intent
of our recommendation to provide investors with more specific guidance
about fraud and unauthorized trading.
SEC agreed that securities firms have an obligation to ensure that
investors are provided accurate information about the extent of the
protection afforded by excess SIPC policies and that the policies should
be drafted to
ensure consistency with SIPC protection as advertised. SEC officials
reaffirmed their commitment to work with the SROs to ensure that excess
SIPC as advertised, is consistent with the policies. Moreover, SEC agreed
that investors should be properly notified of any changes in the coverage.
Finally, SEC reiterates the recommendations it made to SIPC in its 2003
examination report, which as SEC describes are *important to enhance the
SIPA liquidation process for the benefit of public investors.*
Objectives, Scope, and Our objectives were to (1) discuss the status of
the recommendations that
Methodology we made to SEC in our 2001 report, (2) discuss the status of
the
recommendations that we made to SIPC in our 2001 report, and (3) discuss
the issues surrounding excess SIPC coverage. Finally, SEC reiterates the
recommendations made to SIPC in its 2003 examination report, which the
letter describes as *important to enhance the SIPA liquidation process for
the benefit of public investors.* To meet the first two objectives, we
interviewed staff from SEC*s Market Regulation, OGC, OCIE, and the
Division of Enforcement as well as SIPC officials to determine the status
of the recommendations that we made in our 2001 report. We also reviewed a
variety of SEC and SIPC informational sources, such as SIPC*s brochure and
SEC*s and SIPC*s Web sites, to determine what SEC and SIPC disclosed to
investors regarding SIPC*s policies and practices. We also reviewed the
Web sites of the sources
provided by SIPC, such as SIA, NASD, the National Fraud Information
Center, Investor Protection Trust, Alliance for Investor Education, and
the North American Securities Administrators Association. To address the
third objective* to discuss the issues surrounding excess
SIPC coverage* we interviewed agency officials, regulators, SROs, and
trade associations to determine what role, if any, they play in monitoring
excess SIPC. We also interviewed representatives or brokers of the four
major underwriters of excess SIPC policies to obtain information about the
coverage, their claim history, and their rationale for discontinuing the
excess SIPC product. In addition, we interviewed six securities firms that
had excess SIPC policies to (1) obtain their views on the scope of
coverage, (2) determine what they were told about the excess SIPC product
being withdrawn, and (3) to identify what they planned to do about
replacing the coverage going forward. We also interviewed two SIPC
trustees who had
liquidated firms that had excess SIPC policies to obtain their views and
opinions about the coverage. We also met with attorneys knowledgeable
about SIPC and excess SIPC policies and coverage to obtain their views and
perspectives on excess SIPC issues. Moreover, we also reviewed sample
policies from the four major excess SIPC providers to determine the
differences and similarities among the policies as well as their
consistency with SIPC*s coverage. We also reviewed a random sample of
clearing and introducing firms* Web sites to determine if they advertised
excess SIPC protection on their Web sites and the nature of the
protection.
We conducted our work in New York, NY, and Washington, D. C., from October
2002 through July 2003 in accordance with generally accepted government
auditing standards.
As 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. At that time, we will send copies of this report to the
Chairman, House Committee on Energy and Commerce; the Chairman, House
Committee on Financial Services; and the Chairman, Subcommittee on Capital
Markets, Insurance and Government Sponsored Enterprises, House
Committee on Financial Services. We will also send copies to the Chairman
of SEC and the Chairman of SIPC and will make copies available to others
upon request. In addition, the report will be available at no charge on
the GAO Web site at http:// www. gao. gov.
If you or your staff have any questons about this report, please contact
Orice Williams or me at (202) 512- 8678. Other GAO contacts and staff
acknowledgments are listed in appendix III.
Richard Hillman, Director Financial Markets and Community Investment
Appendi xes Comments from the U. S. Securities and
Appendi x I Exchange Commission
Comments from the Securities Investor
Appendi x II Protection Corporation
Appendi x III
GAO Contacts and Staff Acknowledgments GAO Contacts Richard J. Hillman
(202) 512- 8678 Orice M. Williams (202) 512- 8678 Acknowledgments In
addition to those individuals named above, Amy Bevan, Emily Chalmers,
Carl Ramirez, La Sonya Roberts, and Paul Thompson made key contributions
to this report.
(250105)
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GAO United States General Accounting Office
SEC has taken steps to implement each of the seven recommendations
directed to SEC in GAO*s May 2001 report. SEC has updated its Web site to
provide investors with more information about SIPC*s policies and
practices, particularly with regard to unauthorized trading and nonmember
affiliate claims. SEC has taken other steps consistent with our
recommendations to improve its oversight of SIPC and is working with self-
regulatory organizations (SRO) to increase investor awareness of SIPC*s
policies through distribution of the SIPC brochure and disclosures on
account statements.
Likewise, SIPC has taken steps to implement the three recommendations
directed to SIPC in our 2001 report, but additional work is needed on one.
SIPC has updated its brochure and Web site to clarify that investors
should complain in writing to their securities firms about suspected
unauthorized trades. SIPC also expanded a statement in its brochure that
discusses market risk and SIPC coverage and amended its advertising bylaws
to require firms that display an expanded statement about SIPC to include
a reference or link to SIPC*s Web site. Moreover, SEC, the NASD, and many
securities firms provide the recommended disclosures about the scope of
SIPC coverage to investors on their Web sites. SIPC also added links to
Web sites in its brochure that offer information about investment fraud.
However, investors could benefit from more specific links to investor
education information.
Until this year, certain well- capitalized, large, and regional securities
firms were able to purchase and provide excess SIPC coverage from four
major insurers. The insurance policies varied by firm and insurer in terms
of the amount of coverage offered per customer and in aggregate per firm.
Attorneys familiar with the policies agreed that the disclosure of the
coverage and the terms of coverage could be improved. During the review,
GAO found that three of the four major insurers that offered excess SIPC
coverage in 2002 stopped underwriting these policies in 2003.
Consequently, as the policies expire in 2003, most insurers are not
renewing their existing policies and have stopped underwriting new
policies. At this time, holders of the insurance policies have not decided
what to do going forward. However, several options are being explored
including self- insuring and purchasing policies from the remaining major
insurer. As result of ongoing concerns
about the adequacy of disclosures provided to investors about the
Securities Investor Protection Corporation (SIPC) and investors*
responsibilities to protect their investments, GAO issued a report in 2001
entitled Securities Investor
Protection: Steps Needed to Better Disclose SIPC Policies to Investors
(GAO- 01- 653). GAO was asked to determine the status of recommendations
made to the
Securities and Exchange Commission (SEC) and SIPC in that report. GAO was
also asked to review a number of issues involving excess SIPC insurance,
private
insurance securities firms purchase to cover accounts that are in excess
of SIPC*s statutory limits. To ensure that investors have access to
relevant information about SIPC, GAO recommends that SIPC provide more
specific references to investor education information in its brochure.
In addition, GAO recommends that SEC, in conjunction with the SROs, ensure
that firms are providing investors with meaningful
disclosures about excess SIPC and monitor firm disclosures about any
changes in the coverage. SEC and SIPC generally agree with the report*s
findings and recommendations.
www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 811. To view the full product,
including the scope and methodology, click on the link above. For more
information, contact Richard J. Hillman, (202) 512- 8678, hillmanr@ gao.
gov. Highlights of GAO- 03- 811, a report to congressional requesters
July 2003
SECURITIES INVESTOR PROTECTION
Update on Matters Related to the Securities Investor Protection
Corporation
Page i GAO- 03- 811 Securities Investor Protection
Contents
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Page 1 GAO- 03- 811 Securities Investor Protection United States General
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Appendix I Comments from the U. S. Securities and Exchange Commission Page
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Appendix II
Appendix II Comments from the Securities Investor Protection Corporation
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Appendix III
United States General Accounting Office Washington, D. C. 20548- 0001
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