CLEARING AWAY CONFUSION ON FDIC AND SIPC PROTECTION
What You Need To Know And How You Can Enhance Your Protection
With recent bank failures, the goverment’s take over of Fannie Mae, Freddie Mac, and AIG, and the collapse of Bear Stearns and Lehman Brothers, clients are understandably concerned and questioning their exposure to institutional failure. We have therefore compiled a summary of the relevant law and how protection can be enhanced. Proper planning can significantly multiply the extent of coverage that is generally offered by the FDIC and SIPC, but steps need to be taken. Enhancing protection often involves use of certain trusts and methods of titling accounts, but the most significant protection (100%) can sometimes be gained for securities (stocks and bonds) through a particular account type held with the financial institution.
The Federal Deposit Insurance Corporation, or FDIC, is an agency of the U.S. government that insures accounts with banks and thrift institutions. It does not insure investment securities which, therefore, excludes from FDIC coverage, mutual funds, stocks, bonds, annuities, and non-FDIC insured money funds. FDIC coverage does insure qualified certificates of deposit (CDs) and FDIC insured money market accounts. In general, each account owner is insured for up to $100,000, and certain retirement accounts are insured for up to $250,000.
Enhancing FDIC coverage is not difficult. Commonly used revocable living trusts can be drafted, in many cases, consistent with estate planning objectives to increase coverage into the millions. Trust coverage is based upon the number of “qualified beneficiaries,” and qualified beneficiaries can include a spouse, children, and grandchildren, who are the customary objects of estate plans. Making them qualified beneficiaries is a function of how the trust is drafted, which should always take into consideration federal and state estate, gift, and generation skipping tax laws. To an experienced estate planner, this is generally not a difficult task. Furthermore, additional account title planning and use of other family entities can increase coverage.
SIPC, or the Securities Investor Protection Corporation, is a private nonprofit corporation that is capitalized by its members. It is not a U.S. government agency, and is privately funded by member broker-dealers. Each customer of a participating broker is protected against loss as a result of broker-dealer’s insolvency for up to $500,000 in securities, which may include $100,000 in cash. However, this is misleading and may be irrelevant in the event of an institution’s collapse, where 100% protection may be available if your accounts are properly qualified.
Most standard form brokerage and investment firm account agreements have a provision that allows them to register all of your securities in “street name,” which means their own firm name. They then essentially owe you the securities reflected in your account. The securities are not separately vested in you. This is typically desired by brokerage and investment firms, as it permits them to conduct margin and futures trading activities using your securities as collateral. Even if a financial institution suffers financial loss with your securities, they owe you what is stated in your account agreement. You are ostensibly no different than any other creditor in the event of a failure of the institution and would be exposed to the extent the firm is insolvent. However, if your account is in street name, certain rules and laws enhance your position in the case of a failure or bankruptcy over and above general creditor status. But, risk is not completely removed as it is with customer name securities status. Accounts that are classified as “customer name securities” (bankruptcy law terminology), or those “registered in the name of customers” (SIPC terminology), provide a complete form of protection.
If a SIPC member firm collapses and is either liquidated under the Securities Investor Protection Act of 1970 (“SIPA”) or the Bankruptcy Code, your recovery of your investments will depend on the type of account you have and, in general, a three-tier recovery process. Customer named accounts offer a status that is superior to all others, since your securities remain yours. Securities in customer name are returned to you or, upon your direction, transferred to another member firm in the event of insolvency. No loss should therefore be incurred. Cash and other securities held for customers (including stocks and bonds that are, for example, held in “street name”) by an insolvent investment firm are divided among all such customers on a pro rata basis. This leaves the possibility for a shortfall if all available securities in street name do not adequately cover the total of street name account positions. Any shortfall in what is owed to street name account owners places them in the position of a general creditor, and this is where SIPC coverage provides protection. Protection offered by SIPC is $500,000 for securities, which may include $100,000 in cash per customer. Like with FDIC rules, proper use of trusts and multiple forms of ownership can enhance and multiply coverage, in many cases exceeding millions where family circumstances and estate plans permit.
If an institution were to fail, and your accounts did not possess customer name securities, and your loss exceeded available SIPC insurance coverage, many financial institutions possess private insurance. This coverage would compensate you for losses above the statutory limits under SIPA. (Remember, the SIPA limits can be multiplied with proper planning.) Some well known firms obtain this insurance from Lloyd’s of London, while some have formed a captive insurance company known as Customer Asset Protection Company or CAPCO. This coverage, however, is not per account, as sometimes customers are lead to believe, but is cumulative coverage for all accounts having losses. Furthermore, the level of protection is subject to the solvency of these insurers.
Although securities held by a broker-dealer in a customer’s name are largely without risk, most securities are held by broker-dealers in street name and would be available to satisfy other customers’ claims in the event of a broker-dealer’s insolvency. As a practical matter, it may not always be possible to hold any significant percentage of securities in customer name, which therefore encourages planning to multiply the extent of coverage. Most broker-dealers or investment houses will resist customer name security accounts. Therefore, and where this is the case, steps should be taken to enhance protection using trusts and other vehicles, such as family partnerships. Nevertheless, a customer should closely monitor the financial condition of broker-dealers. Inasmuch as securities that are registered in the name of a customer would be transferred to another firm in the event of a broker-dealer’s failure, customers with significant portfolios should consider establishing accounts with several different broker-dealers. This will facilitate the expeditious transfer of customer name securities in the event of failure, and will have the important benefit of further enhancing and multiplying coverage.
As a further option, most custodial or trust accounts held with trust companies are in the nature of customer name securities. Stocks and bonds are generally segregated from the bank or trust company’s assets and are vested in the trust or account owner. Generally, there is an added cost with the use of a trust company for this purpose, but some investors choose to do so even when discretionary management is undertaken by outside money managers.