Financial History Issue 118 (Summer 2016) - Page 35

The Evolution of Customer Asset Protection After Brokerage Bankruptcy By Ronald H. Filler Bettmann On “Black Monday,” October 19, 1987, the Dow Jones Industrial Average dropped 22%. It was an unusually volatile trading day in which the US stock market experienced its largest single-day decline. The market volatility caused many brokerage firms to fail and resulted in losses to customers beyond the declining price of their holdings. These losses were caused by the bankruptcy of their brokerages. Over the past 80 years, laws and regulations have evolved to provide greater protections to customers of US brokerage firms. However, they are not always effective, particularly on volatile trading days. The US Congress and market regulators want all US residents to open bank accounts, and to feel comfortable that their funds deposited in banks are protected. To that end, the government provides insurance protection on bank account deposits through the Federal Deposit Insurance Corporation (FDIC). Thanks to FDIC insurance, people no longer need to fear the “Wild, Wild West” stories of bank robbers fleeing with their deposits. However, banks can freely use customer deposits for legitimate business reasons, such as making auto and small business loans, issuing home mortgages, etc. To support these banking arrangements and to encourage people to deposit their funds in a bank account, the FDIC program provides important insurance protections to bank customers in the event their bank is robbed, or fails for any reason. Historically, FDIC insurance topped out at $100,000, but it was increased Bank failure notice from the Federal Deposit Insurance Corporation is tacked up on the New Jersey Title Guarantee and Trust Company’s door in 1939. At the time, it was by far the largest bank failure to be paid off by the FDIC since its inception. in 2008 to $250,000. For married couples, the $250,000 ceiling applies to each spouse’s account and a joint account in their names, as each account is for a different beneficial owner. Therefore, for singles the maximum coverage is $250,000, but for married couples it could be as high as $750,000. If a person has more cash than is covered by these ceilings, he or she should open accounts at multiple banks. The same is true for stock brokerage accounts. The US Securities and Exchange Commission (SEC) has adopted specific regulations that protect customers who fully pay for their securities (SEC Rule 15c3-3), but stock brokerage firms also use customer funds and securities for other purposes, especially when customers buy stocks on margin. Under these circumstances, the Securities Investor Protection Corporation (SIPC) program caps out at $500,000 (no more than $250,000 in cash) for a single person, but it also expands its insurance coverage for married couples, similar to the FDIC program. There are exceptions to these rules, however. An example from recent financial history is the Bernie Madoff case. Madoff stole more than $50 billion from his stock customers in an elaborate Ponzi scheme. Several court cases resulted when his scheme was unraveled. The courts held that many of Madoff’s customers could not receive additional insurance coverage if they had previously withdrawn amounts from their accounts with him over the years. For example, if someone had deposited $700,000 with Madoff in 1998, let’s assume his account increased in value to $1.8 million. If that person withdrew $500,000 in 2004 (leaving a balance of $1.3 million) and tried to claim his $500,000 in insurance coverage once the Ponzi scheme was discovered in December 2008, he would be out of luck. The SIPC Trustee appointed to oversee the Madoff estate said, in essence, that since he had already received more than $500,000 in 2004, he was not entitled to additional insurance coverage. Futures and Swaps Unlike bank and brokerage accounts, there is no insurance coverage program for accounts used to trade futures contracts and swaps, even though these financial products are subject to significant laws and regulations. The reason is simple; these markets are primarily institutional in nature, so they do not have the same public policy reason for the insurance as banks and stock brokerage firms, which are primarily retail in nature. The US Congress recognized this as far back as 1936, when it adopted the Commodity Exchange Act and added Section 4d, which required then, and still mandates today, that all futures commission merchants (FCM) — e.g., futures brokerage firms — maintain all customer assets held by the FCM in a “customer segregated” account at a custodian bank. This concept can be visualized as a ring fence around a specially protected customer asset account. Thus, if the FCM fails for any reason, creditors of that FCM cannot pierce that ring and use the customer assets held inside it to satisfy its debts. Moreover, FCMs cannot commingle its own assets with the customer assets held in this protected account. Customer segregation has worked quite well over the past 80 years. There have been a few bumps along the way but, for the most part, any time an FCM has failed, its customer assets have been protected. However, if there were not sufficient customer assets in the segregated account — and thus a shortfall occurred — pursuant to the US Bankruptcy Code (the Code), the remaining nondefaulting customers would be treated on a  |  Summer 2016  |  FINANCIAL HISTORY  33