House Legislation Would Significantly Amend Securities Investor Protection Regime

The $65 billion Madoff fraud exposed faults in the Securities Investor Protection Act (SIPA), the law that returns money to the customers of insolvent fraudulent broker-dealers. Legislation moving through the House fixes these shortcomings.

Passed in 1970, SIPA authorized the formation of the Securities Investor Protection Corporation (SIPC), a private nonprofit corporation of which most broker-dealers registered with the SEC are required to be members. Whenever SIPC determines that a member firm has failed or is in danger of failing to meet its obligations to customers, and finds certain other statutory conditions satisfied, it may ask for a protective decree in federal district court. Once a court finds grounds for granting such a petition, it must appoint a trustee charged with liquidating the member firm.

Currently, under the Securities Investor Protection Act, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The legislation increases the maximum cash advance amount to $250,000 and authorize SIPC, subject to the approval of the SEC, to make inflationary adjustments every 5 years to that amount starting in 2010.

Since the establishment of SIPC in 1970, Congress has generally increased the SIPC cash advance amount each time it has increased the amount of Federal Deposit Insurance Corporation coverage. Consistent with changes to FDIC coverage levels made in 2005, the legislaition would bring SIPC and FDIC coverage back in line and provide a commensurate level of protection for customers of securities brokerage firms as customers of depository institutions.

The measure updates SIPA to increase the minimum assessments paid by members of the Securities Investor Protection Corporation to the SIPC Fund. Currently, SIPA provides that the minimum assessment of a SIPC member must not exceed $150 per year, regardless of the size of the SIPC member. This limit was imposed when SIPA was first enacted in 1970 and has never been adjusted to reflect either inflation or the substantial growth of the securities industry. The measure thus strikes this current minimum assessment level and sets a new minimum assessment at 2 basis points of a SIPC member’s gross revenues.

Similarly, in the event that the SIPC Fund is or may reasonably appear to be insufficient to satisfy its statutory requirements, the SEC is authorized to make loans to the SIPC Fund by issuing notes or other obligations to Treasury. The current limit of $1 billion was imposed at the time of SIPA’s enactment and has never been adjusted to reflect either inflation or the substantial growth of the securities industry. The legislation increases the SEC’s authority to issue notes or other obligations to the lesser of $2.5 billion or the target amount of the SIPC fund specified in the SIPC by-laws.

Under current law, SIPC must designate an outside trustee for the liquidation of a failed SIPC member broker-dealer when the failed firm’s liabilities to unsecured general creditors and to subordinated lenders exceed $750,000 and where the failed firm appears to have more than 500 customers. Experience has shown that administration expenses are substantially reduced when SIPC personnel perform the liquidation functions, with equal benefit to customers as when an outside trustee is appointed. Thus, the measure permits SIPC to designate itself as trustee for the liquidation of a failed SIPC member firm regardless of the size of the firm’s liabilities to unsecured general creditors and where the failed firm appears to have less than 5,000 customers. The measure also adds insiders to the class of customers ineligible for SIPC advances.

The legislation permits SIPC to use the direct payment procedure to resolve the failure of small firms with total claims of all customers up to an aggregate of $850,000. The direct payment procedure enables SIPC to quickly and inexpensively resolve the failure of small firms without the need to use the more time-consuming and expensive procedures applicable in a judicial liquidation proceeding. Current law limits the use of the direct payment procedure to cases in which all customer claims of an affected SIPC member aggregate to less than $250,000. Congress imposed this limit when the direct payment procedure was added to SIPA in 1978, and the figure has not been adjusted since then.

SIPA currently identifies and prescribes criminal penalties up to $50,000 for several prohibited acts and for fraudulent conversion. The maximum penalty amount has remained constant since the enactment of the provisions concerning prohibited acts and fraudulent conversions, more than 3 decades ago. The legislation would increase the maximum fine under SIPA to $250,000. The measure would add false advertising and misrepresentation regarding SIPC membership or protection to the list of prohibited acts under SIPA. It would also prescribe civil liability for damages caused by such misrepresentations and criminal liability in the form of a fine up to $250,000 or imprisonment up to 5 years. Civil liability would be extended to Internet service providers who knowingly transmit such misrepresentations and provide for court jurisdiction to issue injunctions.

Under SIPA, claims of securities customers take priority over claims of general creditors. SIPC insurance, however, does not extend to futures positions, other than securities futures. The legislation would extend SIPC insurance to futures positions held in a customer portfolio margining account under a program approved by the SEC. This provision is intended to address the possibility that current law would treat a portfolio margining customer as a general creditor with respect to the proceeds from such customer’s futures positions, while the same portfolio margining customer would have priority for their securities holdings in the case of insolvency of their broker-dealer.

This uneven treatment, along with the Commodity Exchange Act requirement that futures be held in a segregated account, prevents customers from including related futures products in their portfolio margining securities accounts. These obstacles preclude those customers from taking full advantage of the efficiencies created from hedging related positions in a single account.

This provision would be fully operative when the CFTC provides exemptive relief from the CEA’s requirements regarding segregation of customer funds. However, the provision neither amends the CEA nor limits the CFTC’s discretion in granting exemptive relief.

The term customer of a debtor means any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer. Customer also includes any person who has a claim arising out of sales or conversions of such securities.

The Act would also clarify that claims for cash or securities arising out of repurchase agreements and reverse repurchase agreements are ineligible for customer relief under SIPAS. It does so by excluding from the term customer persons to the extent they have a claim relating to an open repurchase or open reverse repurchase agreement. For this purpose, the term repurchase agreement means the sale of a security at a specified price with a simultaneous agreement or obligation to repurchase the security at a specified price on a specified future date.

The draft legislation directed SIPC to levy risk-based premiums on SIPC member firms, using a variety of factors such as the size of the brokerage, number of enforcement and compliance actions in recent years, and years in operation. However, the Frank-Kanjorski Amendment adopted during mark up requires only that the Comptroller General study the feasibility of a risk-based assessment regime and report to Congress in one year.

In planning and conducting the study, the Comptroller General must consult with the SEC, the FDIC, and FINRA. The study must examine modeling and other approaches to measure brokerage firm operational risk and analyze of they cam be used to manage the aggregate risk to the SIPC fund. The study must also explore if such factors as the size of the brokerage, number of enforcement and compliance actions in recent years, and years in operation can be used to assess the probability the fund will incur a loss with regard to a member firm. The study must examine the impact that risk-based assessments could have on large and small firms; and on institutional and retail brokers.

Finally, the legislation clarifies that SIPC is a budgetary entity as defined by the Federal Credit Reform Act, codifying a recent OMB determination to this effect. This provision would neither affect the status of SIPC staff as non-government employees nor subject SIPC to federal procurement law. It would, however, require an accounting of SIPC expenses and revenues in monthly Treasury statements. This clarification is needed because, for the first time, SIPC may need to borrow money from the SEC as a result of the Madoff fraud.