It’s an organization that can go for years without ever making the news. Then along comes a financial crisis — and Lehman Brothers and Madoff — and suddenly the SIPC finds itself at the center of some very big stories. This post takes a look at the SIPC, its role in broker-dealer liquidations, how a SIPA liquidation differs from Chapter 7 liquidation, and how it affects businesses and individuals with accounts at a failed brokerage firm.

What Is The SIPC? SIPC stands for the Securities Investor Protection Corporation. This federally-created nonprofit corporation describes its mission as follows:

When a brokerage firm is closed due to bankruptcy or other financial difficulties and customer assets are missing, SIPC steps in as quickly as possible and, within certain limits, works to return customers’ cash, stock and other securities. Without SIPC, investors at financially troubled brokerage firms might lose their securities or money forever or wait for years while their assets are tied up in court.

The SIPC and its activities are governed by the Securities Investor Protection Act, known as SIPA, which was enacted in 1970. The SIPA is not in Title 11 of the United States Code where the Bankruptcy Code is found, but in Title 15, together with other securities laws. That said, the SIPA incorporates many provisions of the Bankruptcy Code.

When Does The SIPC Get Involved? When a SIPC-member brokerage fails, the SIPC has the authority to step in. If the brokerage has filed a bankruptcy — and notwithstanding the automatic stay — the SIPC can file a lawsuit in the district court seeking a protective decree. Once granted, the Chapter 7 bankruptcy proceeding is put on hold and the case becomes a SIPA liquidation instead.  Here’s how the SIPC explains its role:

The [SIPC] either acts as trustee or works with an independent court-appointed trustee in a missing asset case to recover funds. The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities that are already registered in their names or in the process of being registered. All other so-called "street name" securities are distributed on a pro rata basis. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims of each customer up to a maximum of $500,000. This figure includes a maximum of $100,000 on claims for cash. Recovered funds are used to pay investors whose claims exceed SIPC’s protection limit of $500,000. SIPC often draws down its reserve to aid investors.  

As this explanation notes, there is a $500,000 per customer limit to SIPC protection, including a $100,000 limit on claims for cash held in an account. These apply to both businesses and individuals. Some brokerage firms also have private insurance in addition to the SIPC protection.

How Is A SIPA Liquidation Different From A Chapter 7 Bankruptcy? Although Chapter 7 bankruptcy and SIPA liquidations both involve the liquidation of a brokerage firm, there is an enormous difference in terms of what happens to each customer’s securities.

In a Chapter 7 bankruptcy of a brokerage firm, the bankruptcy trustee is required to liquidate — that means sell — all of the securities held in "street name" by the failed brokerage. Section 748 of the Bankruptcy Code, part of Chapter 7’s special stockbroker liquidation provisions, spells it out:

As soon as practicable after the date of the order for relief, the trustee shall reduce to money, consistent with good market practice, all securities held as property of the estate, except for customer name securities delivered or reclaimed under section 751 of this title.

Subject to certain exceptions, in Chapter 7 customers receive a pro rata share of the proceeds from the sale of the securities, not the securities themselves. The only securities that are not sold are "customer name securities," which are handed back to their owners. (More on the difference between street name and customer name securities below.)

In a SIPA liquidation, the trustee’s goal is exactly the opposite. Instead of being required to sell the securities, a SIPA trustee works to return to customers the securities in their accounts, often through a transfer of the accounts to a financially healthy brokerage firm.  When that isn’t possible, the SIPA trustee has the authority to purchase securities to replace any that were missing, tapping into the SIPC’s reserve fund when necessary to cover the acquisition costs. If securities are missing or the SIPA trustee is otherwise unable to return a customer’s "street name" securities, then the brokerage’s firms remaining customer assets are divided up and funds distributed on a pro rata basis based on the total size of "net equity claims" of customers (generally, net of any margin loans owed by the customer). As in a Chapter 7, "customer name securities" are returned to the customer, including those in the process of being registered in the customer’s name.

Customers generally prefer SIPA liquidations over Chapter 7 bankruptcy. (Stockbrokers and commodity brokers are not permitted to file a Chapter 11 bankruptcy.) Most SIPC member brokerages that file bankruptcy end up either in a SIPA liquidation or with the SIPC directly involved.

What Are Customer Name Securities? As an aside, there is a big distinction between street name and customer name securities.

  • As the term implies, customer name securities are a typically limited group of securities held by a brokerage firm that are literally registered with the issuer in the customer’s name, such as an actual stock certificate registered in and bearing the customer’s own name.
  • These days most securities are registered in "street name," with the actual legal owner being Cede & Co., the Depository Trust Corporation’s nominee name.
  • Each brokerage has its own DTC participant account holding the securities for all of its customers, and the brokerage in turn keeps records of which customer owns which securities in the DTC account.
  • Street name securities are far easier to trade than customer name securities because the trade can be accomplished via DTC instead of having to make a physical transfer of a stock certificate.

The Customer Claim Bar Date. In both a Chapter 7 and a SIPA liquidation, a deadline, known as a bar date, will be established by which creditors claims must be filed. However, in a SIPA liquidation a separate "customer claim" bar date is also set. Customers seeking SIPC protection must file their claims by that date using a special customer claim form, which asks for details on the securities in the customer’s account, dates of trades, and other information. Follow the link for an example of the SIPC claim form used in the Lehman Brothers SIPA liquidation. If the customer’s account has not already been transferred to a solvent brokerage firm, a customer with an allowed claim will receive back the securities that were held in their account at the failed brokerage firm, together with any cash held, up to the SIPC protection limits.

Where To Learn More About SIPA Liquidations. For additional information on SIPA liquidations and their Chapter 7 counterparts, you may find this discussion on the U.S. Court system’s website of interest. In addition, SIPA trustees appointed in brokerage cases frequently establish a case-specific website. These links will take you to the websites created by the Lehman Brothers SIPA trustee and the Bernard L. Madoff Investment Securities SIPA trustee.

Conclusion. They may not be common, and the SIPC does not provide the same type of protection as the FDIC, but SIPA liquidations can play an important role in protecting investors when brokerage firms fail. However, the SIPC is generally able to intervene only when one of its member firms fails, making that little-noticed "Member SIPC" designation more significant that most investors realize.