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If you have your life savings in custody with a US investment bank or stock broker, you may wake up one morning to find that your savings have disappeared.

After the Crash of 2008, you should be aware that it is possible that the institution holding your savings may suddenly go belly-up.

No government guarantees

The Securities and Exchange Commission will not protect you, nor will the SPIC — the Securities Investor Protection Corporation.

Could your family fall upon the charity of relatives and neighbors?

Nor will FINRA — the Financial Industry Regulatory Authority.

It won’t matter than you invested with great care and selected the safest, most conservative bonds and money market funds.

You might even have all your savings in cash.

Unlike an FDIC guaranteed bank account, assets that you have on deposit with a stock-broker or investment bank are not guaranteed by the US government — not even partially.

Lessons from Lehman Brothers

In 2008, thousands of investors learned the bitter lesson of what it means to have their money with a broker-dealer that is not safe.

Lehman Brothers was among the most respected financial companies in the world.

It had been in business continuously since 1850, having survived numerous financial panics, including the Panic of  1857, the Panic of  1873,  the Panic of 1893, the Panic of 1896,  the Panic of 1907, the Panic of 1910-1911,  the Depression of 1920-1921, the Great Depression, the Crash of 1987, the Attack of Nine-Eleven, and numerous wars and lesser recessions.

Richard S. Fuld Jr., CEO and Chairman of Lehman Brothers.

The CEO and Chairman of Lehman, Richard S. Fuld Jr. had worked in many departments of Lehman Brothers for almost forty years, held an MBA from NYU’s Stern School of Business, had been named #1 CEO by Institutional Investors Magazine in 2007, had served on the Board of Directors of the Federal Reserve Bank of New York, and was on the Board of Directors of Middlebury College and the New York Presbyterian Hospital.

The Lehman bankruptcy was a can of worms for customers.

When Lehman Brothers declared bankruptcy on September 15, 2008, over one hundred thousand investors across the world suddenly found their custodial accounts frozen, with multi-billions of dollars of customer wealth blocked and uncertain for an undefined period.

Lehman Brothers was not a single company, but the generic name for thousands of companies and esoteric financial vehicles in multiple legal jurisdictions.

Scores of courts and bankruptcy administrators were involved.

In some cases, clients were able to retrieve assets in full and relatively quickly.  In other cases, assets were blocked for years.  On December 19, 2008, Bloomberg reported that Lehman customers could lose $1 billion from Lehman’s German unit.

If you were a customer of Lehman Brothers making a claim to the SIPC, you had until the deadline of January 20, 2009, four and one-half months after the bankruptcy, to file a claim.

The difficulty in receiving any payment from the SIPC can be judged by this excerpt from the SIPC’s administrator on the Lehman case:

The claims process under SIPA provides for the orderly and efficient examination and satisfaction of customer claims, and it has continued to function well in the LBI liquidation. Nevertheless, Lehman Brothers operated as a global firm in over 40 countries with cross-border interdependencies and investment assets with cross-border implications. As a result, Lehman Brothers entities are now subject to insolvency proceedings in at least fifteen countries worldwide. The coordination of these proceedings requires extensive international cooperation among the various Lehman entities and their regulators. The treatment of customer claims related to cross-border transactions, often involving complex derivatives instruments and other financial products, will also present important and novel legal issues.

The bar date for filing customer and general creditor claims is June 1, 2009. Claim forms and information about how to fill them out are maintained on the Trustee’s website, www.lehmantrustee.com. Given the enormity of the task and the high volume of claims that arrive on a daily basis, there is no current estimate of when all claim determinations will be complete, or what the total dollar amount of customer or other claims may be. Producing determination letters for all customer claims will take several months, and any contested claims will be subject to judicial resolution.

The lesson of the Lehman Brother’s bankruptcy is that if your broker-dealer goes bankrupt, it may be months or even years before you get your money back, if ever.

Furthermore, you may have legal expenses in pursuing your claim and will lose income, without compensation, while awaiting payment.

Lessons from Bernard Madoff

On December 11, 2008, Bernard Madoff, CEO and founder of Bernard L. Madoff Investment Securities LLC was arrested for securities fraud — a Ponzi scheme that had bilked thousands of investors of billions of dollars. Customers’ money had simply vanished.

Although this case was completely different from the Lehman Brothers bankruptcy, it is similar in that Bernard Madoff managed to create an impression of sterling reputation in the minds of clients so that they felt safe until, suddenly in December 2008 they read in the newspaper that they had lost their life savings.

NASD Headquarters, K Street, Washington DC. At one time, Madoff headed this market regulator.

Both Lehman Brothers and Bernard Madoff were similar in one respect — snob  appeal.

Both firms appealed to high net worth investors.  Both effused an ambience of exclusivity — a club that is not that easy to join.

There is an element of economic prestige, like a Patek Philippe, Vacheron Constantin, Girard-Perregaux wrist watch, or a Bugatti Veyron or Enzo Ferrari motor car.

Most customers of Bernard Madoff gave him their money because of recommendations of other Madoff clients — other rich people, often members of the same country club or synagogue.

Madoff managed to give clients the impression that not just anyone would be permitted to be his client.  His clients formed positive opinions of his success by his carefully cultivated image of wealth and respectability:

1. Madoff lived in a luxury apartment in Manhattan’s Upper East Side. He had a house on the ocean in Montauk, a house in Palm Beach, a membership in the Palm Beach Country Club, and property in Cap d’Antibes, France. Madoff had yachts and his family demonstrated conspicuous consumption behavior of the Super-Rich.
2. Madoff was a prominent philanthropist and served on the boards of various nonprofit institutions. He donated millions to medical research, did charitable work with the Gift of Life Bone Marrow Foundation, and had a $19 million Madoff Family Foundation.
   

   Downtown, Palm Beach, Florida

3. He was an active leader in cultural and academic circles. He was Chairman of the Board of Directors of the Sy Syms School of Business at Yeshiva University, and as Treasurer of its Board of Trustees. He was on the Board of New York City Center, and a member of New York City’s Cultural Institutions Group.
4. He was active in supporting the Democratic Party, donating hundreds of thousands of dollars to candidates, and was an active supporter of Senators Chuck Schumer and Chris Dodd.
5. He was well-connected at high levels of financial market regulators, claiming personal friendship with Commissioners Mary Shapiro and Elisse Walter of the Securities and Exchange Commission.  A relative, Shana Madoff, was married to an SEC official. Madoff was active in the National Association of Securities Dealers (NASD), a self-regulatory securities industry organization and had served as the Chairman of the Board of Directors and on the Board of Governors of the NASD.
   In this article:

   • No government guarantees
   • Lessons from Lehman Brothers
   • Lessons from Bernard Madoff
   • Why stockbroker customers are unprotected
   • Extreme leveraage
   • Unsecured insurance
   • What to expect from a broker-dealer
   • Operations hold the key
   • See: “How securities ledgers work”
   • See: “The basics of 'internal control'”
   • See: “Disaster recovery planning”
   • No insurance available
   • Broker-dealer economics simplified
   • Danger signals
   • Other ways to protect your assets
   • Your comments

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A few, very sophisticated investors who took the time to check out Madoff’s accountant or who understood the technicalities and practical limitations of the investment scheme that Madoff claimed to use, saw the dangers of his operation and were saved.

However the vast majority of clients were lulled by outward appearances of respectability and success, and by the tragically mistaken belief that the US Securities and Exchange Commission would somehow protect them.

Why stockbroker customers are unprotected

In both the Lehman and Madoff cases, investors had monthly account statements that showed  assets belonging to them and held by these investment houses in custody.  Lehman Brothers and Madoff clients believed that these assets in custody could be withdrawn at any time, on demand.

You may be suddenly surprised by the lack of coverage for your assets

This is the nature of a broker-dealer custody account — cash and securities that a client can withdraw on any business day.

However, in neither instance did the client have a statement from an independent auditor, attesting that such securities and cash actually existed.

The SEC does not require broker-dealers to provide investors with an audited report indicating the value of securities in custody relative to the capital and resources of the broker-dealer.

Extreme leveraage

No one knows the total value of securities and cash held in custody for clients by US broker-dealers.  According to Federal Reserve flow of funds accounts for Q3 2009, the total value of debt and equity securities held by US households was about $15 trillion.

Not all of this is held in custody accounts with broker-dealers. The total does not include holdings of foreign financial assets.

The Fed flow of funds accounts for securities brokers and dealers in Q3 2009, shows a difference between institutional financial assets and liabilities of about $81 billion — a rough, but almost certainly optimistic approximation of the net worth of these firms on liquidation.

These figures suggest that if you have $100,000 in financial assets in custody with a US broker-dealers, not more than $1,000 of this value is likely to be covered by the net financial assets of the firm.

Unsecured insurance

Custodial Insurance: inadequate reserves, no government guarantee.

SIPC, the Securities Investor Protection Corporation, is a private insurance scheme supported by broker-dealers.

The SIPC had only $263 million in net assets on December 31, 2008, —  the tiniest fraction of customer assets at risk.

There is insufficient financial coverage to protect all investors with assets in custody with US broker-dealers.

The US government provides no guarantees to investors.  The US SEC is not effective in providing practical protection with respect to custodial accounts.

In other words, if you have your assets in custody with a broker-dealer or investment bank, you need to rely on commonsense and your knowledge of the issues to protect yourself.

In this article, I try to provide information on issues that will help you make an informed decision.

What to expect from a broker-dealer

Your securities broker-dealer performs three basic services:

1. Trade Execution: A broker-dealer acts as your agent to buy and sell securities on an organized exchange or as a dealer, buying and selling securities from the dealer’s own account to or from your account.

How do I know this?

Securities broker-dealers are complex organizations. Years ago I set up a broker-dealer in Brazil. a market (at that time) without professionals experienced in modern broker-dealer accounting, custodial services, marketing controls, or trade execution systems. I wrote operations manuals and trained the  internal auditors.



John Schroy.

This firm was a major broker-dealer in Brazil for two decades.

I learned “internal controls” as a management trainee with Citibank, way back in the 1950s, when the bank was generally rated among the strongest in the world.

Since then, I’ve advised governments, stock exchanges and clearinghouses on systems and operations and have visited a dozen countries to study broker-dealer and exchange practices.

2. Custodian: A broker-dealer holds your cash and securities in custody and provides administrative services concerning such assets, such as the collection of dividends, the exercise of rights, the transfer of ownership, the settlement of transactions, the arranging of financing to buy, sell, and hold securities, and the receipt and distribution of annual reports and other information provided by issuers of the securities held in your account.
3. Advisor: A broker-dealer provides you with investment advice.

Choosing the right broker-dealer can be as important, and often more important, as choosing the securities to buy, sell, and hold.

All investment has risk, but one of the most important is the  financial and operational safety of the broker-dealer with whom you operate.

Operations hold the key

Since there is no effective insurance coverage for assets in custody with US broker-dealers, the  only practical defense (for the firm)  lies in operational measures:

1. Accounting system: Even a small broker-dealer  may have thousands of customers, with tens of thousands of securities in custody, in hundreds of locations. This tangle of information is controlled by a highly specialized accounting system called securities ledgers.
2. Internal controls: Any financial institution with fiduciary and legal responsibility for the assets of others, must have a strong system of internal controls. This means that the firm must have strict rules of behavior and an organizational structure that provide constant, day-to-day, checks and balances that protect the firm against defalcation, fraud, human error, and external attacks and schemes. These controls require an informed, committed management and a strong team of internal auditors.
   In this article:

   • No government guarantees
   • Lessons from Lehman Brothers
   • Lessons from Bernard Madoff
   • Why stockbroker customers are unprotected
   • Extreme leveraage
   • Unsecured insurance
   • What to expect from a broker-dealer
   • Operations hold the key
   • See: “How securities ledgers work”
   • See: “The basics of 'internal control'”
   • See: “Disaster recovery planning”
   • No insurance available
   • Broker-dealer economics simplified
   • Danger signals
   • Other ways to protect your assets
   • Your comments

   Powered by SEO TOC 1.7.3
3. Disaster recovery systems: Fires, earthquakes, hurricanes, tsunami, and atomic war — data losses from such events are generally  not fully insured (or even insurable) and can result in destruction of books and records that a financial institution needs to remain in business. Although an investment bank may have impressive buildings and outward signs of strength — the real security of a financial institution lies in its books and records. If these go, the firm goes. The accounting systems of a broker-dealer are more vital to survival than those of, say, an automobile manufacturer. Without continuity of systems, an investment bank simply ceases to exist.

No insurance available

It is impossible for a broker-dealer to buy insurance that fully protects the firm against the multiple risks of managing custodial accounts.   Even if such insurance existed, the cost would be too high.

To my knowledge, there is no government-backed insurance that fully protects clients against risks to custodial accounts.

Therefore, the only assurance that a broker-dealer can offer clients is to have strong accounting systems, internal controls, and disaster recovery methods.

Unfortunately, few, if any, broker-dealers provide clients with reliable information about operations in any of these areas.

The United States Securities and Exchange Commission provides investors with absolutely no support in this area.

This means that investors are ‘flying blind’ with regard to the safety of the broker-dealer that holds their life savings.

To get the most from this article, you must read the sections in the “You Should Know” box.

Broker-dealer economics simplified

Of the three core functions of a broker dealer (trade execution, investment advice, and custodial service), the latter is the most costly to the firm, but usually is given away for free.

Most customers have little appreciation of the tremendous value of custodial services if performed properly, with the highest degree of security.  It would be difficult in today’s market to charge for such services.

Consequently, brokers make their money by buying and selling securities to their clients, either as commissions on trades or as underwriting fees collected from issuers.

In recent years, brokers had placed great emphasis on gambling in the markets through their proprietary trading desks — placing their capital at risk.

They also earn fees and interest on margin account financing and securities lending and borrowing.

Broker-dealers also have many other sources of income, but the point here is that high-cost custodial services, which involve contingent liabilities many, many times the capital of the firm and that present the greatest risk to clients, are given away free — and are not fully appreciated by investors.

Consequently, there is an enormous temptation for brokers to skimp on the quality of custodial services, especially in those areas like internal controls, accounting systems, and disaster recovery measures, where the client is unaware of the details and the securities regulators pay little attention.

A commonsense rule is that the greater a broker’s income from sources such as proprietary trading, mergers and acquisitions, and underwriting, the less attention top management will give to non-income producing custodial services.

Danger signals

If you are a client of a broker-dealer, your full attention should be directed to to the safety of your assets, not to the profits of the broker-dealer.

Remember, you are a creditor of the broker-dealer — not a shareholder.

Be on the look-out for signs that a broker-dealer is focusing too much on risk-taking and gambling, and too little on spending the money needed to protect your assets.

Here are some things to look for:

1. No indication of pride in custodial services: Many broker-dealers never mention the safety of their custodial services, internal controls, or disaster recovery plans. This is often a sign of the low priority given to matters that should be your primary concern.

Lest we forget: The Fall of Lehman Brothers: Part V
2. Extreme high remuneration for employees and executives: Investment bankers can only earn high salaries and exorbitant bonuses by taking big risks with other people’s money.  Watch out!
3. High leverage: A broker-dealer that has too little capital relative to debt runs the risk of going bankrupt.
4. Proprietary trading: Differentiated from ordinary dealing and market making, proprietary traders are engaged in chasing speculative opportunities and outsmarting the market. In the long run, they generally fail.

Lest we forget: The Fall of Lehman Brothers: Part VI
5. Sponsorship of complex derivatives: Some investment banks are in the business of manufacturing complex derivative products that they market aggressively under their brand names.  Often this involves high risk, not only for investors, but for the investment bank.
6. Over-the-counter derivative trading: The over-the-counter market in derivatives is extremely sloppy with huge counterparty risks.  Settlement discipline is lax and this often degrades the quality of the broker-dealer’s assets.

If you must keep you securities with a broker-dealer, the best bet would be one  with low leverage that specializes in low-cost trade execution, without much involvement in underwriting, proprietary trading, or OTC derivative markets.  If in addition, the firm also touts the safety of its custody service, you would be better off still.

If you can find a broker-dealer with the traits described in the last paragraph, that also can present special audit reports as to the safety of customers’ assets held in custody and the effectiveness of disaster recovery systems, you would be even better off.

Other ways to protect your assets

Buying and selling stock through a broker-dealer that holds your assets in custody is often the easiest and least expensive way to manage your investments. However, beyond exercising care in selecting your broker-dealer, there are other ways to reduce the risk of holding assets in custodial administration:

1. Diversify you holdings among brokers: If your assets exceed $500,000 ($100,000 in cash), you should definitely consider splitting your assets among more than one carefully selected broker-dealer.  Although SIPC protection is not foolproof, for ordinary investors limiting holdings to US securities, and not holding assets such as commodity contracts, diversification among brokers and observing SIPC limits might provide reasonable protection.

Julie Asti explains how to buy stock directly from a company.
2. Buy securities directly from issuers: Some US issuers allow investors to buy stock directly at reasonable cost. Some even offer periodic investment plans.  By holding stock directly from the issuer, you avoid custodial risks.  The company sends you documents proving your ownership and pays dividends directly to you. The company will also send you annual reports and provide most of the same services offered by a custodian. If the issuer is a mutual fund, you will get proof of ownership in the fund, and the fund, itself, ordinarily holds its assets with an institutional custodian, such as State Street Bank.
3. Combination of diversified brokerage accounts and direct investment: Perhaps the best way to keep your assets safe would be to combine holdings among a diversified group of broker-dealers with directly holdings with issuers.  This place a greater burden on you to keep your records safe and well-organized.  Nor does it eliminate the ordinary risks of investment.

This article has focused on investment in the United States.  Each country has different rules and conditions.  In some countries, the risk of leaving securities with a broker-dealer are even greater than in the US.  Laws protecting investors vary considerably.

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