When a Securities Brokerage Firm Goes Broke A Primer on the Securities Investment Protection Act of 1970
SIPA was enacted in response to a wave of failures of securities brokerage firms in the late 1960s and was intended to protect public investors against financial losses arising from the insolvency of registered brokers and dealers.5 The statutory scheme of SIPA facilitates the return of customer property held by the insolvent firm and reimburses customers for cash and securities mishandled or misappropriated by the brokerage firm or its agents.6 In order to accomplish these goals, SIPA created special rules for the liquidation of insolvent brokerage firms and established the Securities Investor Protection Corporation (SIPC).7
SIPC is a nonprofit private membership corporation to which almost all brokers and dealers registered under the Securities Exchange Act of 1934 belong.8 SIPC is neither an agency nor an establishment of the federal government.9 Nonetheless, five of the seven members of its board of directors are presidential appointees, while the other two members are government officials.10 The Securities and Exchange Commission (SEC) is responsible for regulating and supervising the activities of the SIPC.11 The SEC may apply to a district court of the United States in which the principal office of the SIPC is located for an order requiring the SIPC to discharge its obligations under SIPA where the SIPC refuses to commit its funds or otherwise to act for the protection of customers of any member of the SIPC.12
The fundamental role of SIPC is to step in and liquidate a brokerage firm in financial difficulty and to arrange for the payment of claims asserted by its customers.13 The purposes of SIPC are “to protect individual investors from financial hardship, to insulate the economy from the disruption which can follow the failure of major financial institutions, and to achieve a general upgrading of financial responsibility requirements of brokers and dealers to eliminate, to the maximum extent possible, the risks which lead to customer loss.”14
To carry out these purposes, SIPC administers a fund to protect the accounts of securities investors. The fund essentially constitutes an insurance program designed to protect the customers of brokerage firms subject to SIPA from loss in case of financial failure of the member brokerage firm.15 In a liquidation proceeding under SIPA, the SIPC fund is available if the debtor-brokerage firm’s16 general estate is insufficient to pay customer claims.17 Most securities brokers must be members of the SIPC and must contribute to the fund the SIPC maintains for investor protection.18 If the SIPC’s funds should become inadequate to carry out the statutory purposes, SIPA authorizes a borrowing of funds from the U.S. Treasury of up to $1 billion.19
What Types of Investors Are Protected by SIPA?
The protection afforded by SIPA is only available to “customers” of a registered securities brokerage firm. SIPA defines the term “customer” as:
[A]ny person...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 consum-mated sales, pursuant to purchases, as collateral security or for purposes of effecting transfer. The term “customer” includes any person who has a claim against the debtor arising out of sales or conversions of such securities, and any person who has deposited cash with the debtor for the purpose of purchasing securities....20
Thus, SIPA confers preferential standing upon “customers.”21 Other creditors of the insolvent securities brokerage firms must recover their debts out of the general estate of the debtor.
Moreover, to qualify as a customer, an investor must also demonstrate that the cash deposited with the debtor was deposited “for the purpose of purchasing securities.”22 Most kinds of securities are covered, including stocks, bonds, notes and certificates of deposits, as well as mutual funds and stock options.23 However, coverage only extends to instruments registered as securities with the SEC under the Securities Act of 1933.24 SIPA provides protection even if the claimant does not identify specific securities for the broker to purchase.25
Summary of the Protections Available to Customers
In a SIPA liquidation proceeding, each customer is entitled to receive their “customer name securities,” which are actually held for the customer’s account. Customer name securities are securities that are held for the account of a customer on the filing date by or on behalf of the debtor and that on the filing date are registered in the name of the customer, or are in the process of being so registered pursuant to instructions from the debtor.26 However, “customer name securities” do not include securities registered in the name of the customer that, by endorsement or otherwise, were in negotiable form. There is no limit as to amount or value of the securities.
Moreover, each customer is entitled to receive their ratable share of “customer property” based on the customer’s “net equity.” During a standard SIPA liquid-ation, the trustee must “satisfy net equity claims of customers” of the failed broker-dealer.27 Each customer’s “net equity” is “the dollar amount of the account or accounts of a customer, to be determined by calculating the sum which would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase on the filing date, all securities positions of such customer” corrected for “any indebtedness of such customer to the debtor on the filing date.”28 These net equity claims are paid first by a pro rata distribution of “customer property,” which is defined as “cash and securities” held by the debtor (excluding any non-negotiable securities held in a particular customer’s name).29
Finally, SIPC will advance funds to the trustee to satisfy each customer’s claim to the extent the foregoing does not fully satisfy the customer’s claim for cash and securities. There are, however, limits on the amount of funds that will be advanced by the SIPC. Those limits are $500,000 for each customer, of which not more than $100,000 may be for a cash credit balance owed to the customer.30 When practicable, the trustee will use the funds advanced by SIPC to buy securities of the same class and series as those owed to the customer.31 The customer receives the cash value of the security as of the filing date of the proceeding when this is not practicable.32 To the extent customer property and SIPC advances are not sufficient to pay or satisfy in full the net equity claims of customers, then customers are entitled to participate in the estate as unsecured creditors.33
The Commencement of the SIPA Proceeding
SIPC may commence a proceeding under SIPA if a broker-dealer has failed or is in danger of failing to meet its obligations to customers, and the broker-dealer is insolvent within the meaning of §101 of the Code or is unable to meet its obligations as they mature; a receiver, trustee or liquidator for the broker-dealer has been appointed; or the broker-dealer is not in compliance with the SEC’s regulations regarding financial responsibility or hypothecation of customer securities, or cannot demonstrate its compliance with those requirements.34
A SIPA proceeding is commenced by the filing of an application for a customer protective decree in federal district court.35 Upon the filing of an application for the customer protective decree, the district court has exclusive jurisdiction of the debtor and its property.36 To the extent a brokerage firm has commenced a liquidation under the Code, the subsequent commencement of a case under the SIPA brings the bankruptcy case to a halt.37 The SIPA filing stays all proceedings in the bankruptcy case until the SIPC action is completed.38 Moreover, the automatic stay of 11 U.S.C. §362 goes into effect on behalf of the debtor-brokerage firm upon the filing of a SIPC application.39 As in Title 11, here too the intent of the automatic stay is to prevent the broker-debtor from being dismembered so that there will be an orderly and equitable distribution of the debtor’s property.40
Unlike a liquidation proceeding under the Code, however, where the exercise of a contractual right to liquidate a securities contract41 or a repo42 is not stayed as a result of a stockbroker liquidation under 11 U.S.C. §741 et. seq., the automatic stay will remain in effect as to these sorts of transactions if such a stay is issued in the SIPA liquidation proceeding.43 The continuance of the automatic stay enables the SIPC and the trustee to determine whether the securities that are the subject of the contract or repo are necessary for the satisfaction of customer claims.44 If so, SIPC may request the trustee to obtain such securities either by paying for the securities or performing the debtor’s obligations under the agreement.45
SIPA provides that the district court shall issue a protective decree if the debtor consents, the debtor fails to contest the application for a protective decree, or the district court finds that one of the conditions specified in 15 U.S.C. §78eee(b)(1) has been satisfied.46 If the district court issues a protective decree, then the district court will appoint a trustee and an attorney for the trustee named by SIPC in its sole discretion.47 Upon the issuance of a protective decree and appointment of a trustee, or a trustee and counsel, the court will order the removal of the entire liquidation proceeding to the bankruptcy court in the same judicial district.48 The bankruptcy court will then have all the jurisdiction, powers and duties conferred by SIPA originally conferred upon the district court in which the application for the issuance of the protective decree was made.49
The powers of the SIPC trustee are essentially the same as those vested in a chapter 7 trustee appointed under Title 11. “The trustee may, with the approval of the SIPC but without any need for court approval, (1) hire and fix the compensation of all personnel (including officers and employees of the debtor and of its examining authority) and other persons (including accountants) that are deemed by the trustee necessary for all or any purposes of the liquidation proceeding, (2) utilize the SIPC employees for all or any purposes of a liquidation proceeding, and (3) margin and maintain customer accounts of the debtor....”50 Further, the SIPC trustee is responsible for investigating the acts, conduct and condition of the debtor and making reports thereon to the court.51 The trustee must also provide a statement on the investigation to the SIPC and to other persons as the court might direct.52 Lastly, the trustee must make periodic reports to the court and to the SIPC on the progress of distribution of cash and securities to customers.53
The SIPA Liquidation Process
Customers must file written claim statements in order to receive compensation for amounts lost due to failure of the securities brokerage firm, but need not file formal proofs of claim.54 Upon receipt of a written claim statement, SIPA directs the SIPC trustee to promptly discharge obligations of the debtor relating to cash and securities by delivering cash or securities to customers, provided those claims are (1) “ascertainable” from the failed brokerage firm’s records or (2) established to the satisfaction of the SIPC trustee.55 The value of securities delivered is calculated as of the close of business on the filing date.56 The court must authorize the trustee to satisfy claims out of monies advanced by SIPC for this purpose, notwithstanding that the estate may have insufficient funds for such payment.57
The purposes of the SIPA liquidation are to (1) deliver customer name securities to or on behalf of customers, (2) distribute customer property and otherwise satisfy net equity claims of customers, (3) sell or transfer offices and other productive units of the debtor’s business, (4) enforce SIPC’s subrogation rights and (5) liquidate the securities brokerage firm as soon as possible.58 To the extent possible, consistent with SIPA, the liquidation is conducted in accordance with chapters 1, 3, 5 and subchapters I and II of chapter 7 of Title 11.59 To that end, SIPA provides that costs and expenses of the administration of the estate of the debtor and of the liquidation proceeding shall be borne by the general estate of the debtor to the extent it has sufficient funds.60 SIPA also provides that the priorities of distribution from the general estate will be the same as provided in §726 of Title 11.61 Funds advanced by SIPC to the trustee for costs and expenses are recouped from the estate, provided there are any assets in the estate.62
A SIPA Liquidation vs. Bankruptcy Liquidation
Although SIPA can be viewed as essentially a bankruptcy proceeding, since a liquidation proceeding under SIPA will be carried out in accordance with many of the provisions found in a liquidation under Title 11 of the Code,63 these two types of proceedings are fundamentally distinct. The primary difference between these two proceedings can be found in the statutory mandates of the trustees in each proceeding. A SIPC trustee is required to distribute securities to customers to the greatest extent practicable in satisfaction of their claims against the debtor.64 Indeed, there is a statutory grant of authority to a SIPC trustee to purchase securities to satisfy customer net equity claims to specified securities.65 Under SIPA, the trustee essentially seeks to preserve a customer’s investment portfolio as it stood on the filing date.66 The customer will receive securities whenever possible.67
In contrast, a trustee under the Code is charged with converting securities to cash as quickly as possible and, with the exception of the delivery of customer name securities, making cash distributions to customers of the debtor in satisfaction of their claims.68 A trustee operating under the Code is without authority and lacks the resources to purchase securities to satisfy customer claims to specified securities. Indeed, a trustee is prohibited by statute from distributing to a claimant any securities other than “customer name securities.”69 The Code merely seeks to protect the filing date value of a customer’s securities account by liquidating all non-customer name securities.70
In sum, a failing brokerage firm can be liquidated in a proceeding under SIPA as an alternative to a stockbroker liquidation proceeding under the Code. A SIPA liquidation is fundamentally distinct in that SIPA confers preferential standing upon “customers,” while other creditors of the insolvent securities brokerage firm must recover their debts out of the general estate of the debtor. A claimant who is a “customer” in a SIPA liquidation has the distinct advantage of being compensated from the SIPC fund and has the potential to receive securities in satisfaction of their claim in addition to their “customer name securities.” This would not be the case in a liquidation proceeding under the Code. A trustee operating under the Code is without authority to and lacks the resources to purchase securities to satisfy customer claims to specified securities. For these reasons, a SIPA liquidation may prove more beneficial for a claimant that is a “customer” than a claimant under a stockbroker liquidation under the Code. n
1 SIPA is codified in Title 15 of the U.S. Code at §§78aaa-111
2 See 11 U.S.C. §741 et seq. (West 2005).
3 See SIPC v. Ambassador Church Finance/Development Group Inc., 788 F.2d 1208, 1210 (6th Cir. 1986) cert. denied sub nom, Pine Street Baptist Church v. SIPC, 479 U.S. 850 (1986) (“essentially, a liquidation under the SIPA is a bankruptcy proceeding”). Indeed, SIPA expressly mandates that a liquidation proceeding under SIPA shall be conducted in accordance with, and as though it were being conducted under chapters 1, 3 and 5 and subchapters I and II of chapter 7 of Title 11 to the extent such provisions are consistent with the provisions of SIPA. See 78ffff(b).
4 11 U.S.C. §748 (“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 §751 of this title”).
5 See, generally, Joo, Thomas W., “Who Watches the Watchers? The Securities Investor Protection Act, Investor Confidence and the Subsidization of Failure,” 72 S. Cal. L. Rev. 1071, 1074 (1999) (hereafter “Joo”).
6 See In re Primeline Sec. Corp., 295 F.3d 1100, 1106 (10th Cir. 2002).
7 See Joo, 72 S. Cal. L. Rev. at 1074.
8 15 U.S.C. §78ccc(a)(1) and (2)(A) (West 2005). Certain types of securities dealers are excluded from SIPC membership, including government securities dealers registered under §15C of the 1934 Act and brokers or dealers “whose principal business, in the determination of SIPC, taking into account business of affiliated entities, is conducted outside the United States, and its territories and possessions.” See 15 U.S.C. §78ccc(a)(2)(A) (West 2005).
9 15 U.S.C. §78ccc(a)(1)(A) (West 2005).
10 15 U.S.C. §78ccc(c)(2) (West 2005).
11 15 U.S.C. §78ggg (West 2005).
12 15 U.S.C. §78ggg(b).
13 See Guttman, Egon, 28A Modern Securities Transfers §20:7 (3d
14 See Id. (citing S. Rep. No. 1218, 91st Cong., 2d Sess. 4 (1970). See, also, S. Rep. No. 763, 95th Cong., 2d Sess. 1 (1978)).
15 The fund is authorized under 15 U.S.C. §78ddd(a) (West 2005).
16 15 U.S.C. §78lll(5) (under SIPA, the term “debtor” means “a member of SIPC with respect to whom an application for a protective decree has been filed under §78eee(a)(3)...”) (West 2005).
17 See 15 U.S.C. §§78ccc and 78fff-3(a) (West 2005).
18 See 15 U.S.C. §§78ddd(c) and (d).
19 See 15 U.S.C. §78ddd(f), (g) and (h).
20 See 15 U.S.C. §78 lll(2) (West 2005).
21 The issue of whether an investor was a “customer” within the meaning of SIPA arises frequently in a SIPA liquidation. See, e.g., In re New Times Sec. Serv. Inc., 318 B.R. 753 (Bankr. E.D.N.Y. 2004) (holding that claimants were not “customers,” even though the claimants’ funds were originally deposited with the debtors for the purchase of securities, because the funds were subsequently transferred to promissory notes and remained as such as of the filing date); In re First Interregional Equity Corp., 290 B.R. 265 (Bankr. D. N.J. 2003) (holding that claimant did not qualify as a “customer” because bearer bonds that a claimant delivered to a broker on the understanding that, in exchange for the increased risk to which she was exposed as a result of the broker’s physical possession, she would be paid a rate of interest in excess of the coupon rate, were not delivered for investment, trading or participation in the securities market, but in connection with a “loan” of these bonds from the claimant to the broker).
22 See 15 U.S.C. §78 lll(2).
23 SIPA expressly defines the term “security” to mean “any note, stock, treasury stock, bond, debenture, evidence of indebtedness, any collateral trust certificate, preorganization certificate or subscription, transferable share, voting trust certificate, certificate of deposit, certificate of deposit for a security, or any security future as that term is defined in §78c(a)(55)(A) of this title, any investment contract or certificate of interest or participation in any profit-sharing agreement or in any oil, gas or mineral royalty or lease (if such investment contract or interest is the subject of a registration statement with the commission pursuant to the provisions of the Securities Act of 1933 [15 U.S.C.A. §77a et seq.] ), any put, call, straddle, option or privilege on any security, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option or privilege entered into on a national securities exchange relating to foreign currency, any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of or warrant or right to subscribe to or purchase or sell any of the foregoing, and any other instrument commonly known as a security. Except as specifically provided above, the term “security” does not include any currency, or any commodity or related contract or futures contract, or any warrant or right to subscribe to or purchase or sell any of the foregoing. See 15 U.S.C. §78 lll(14) (West 2005).
24 See Id.
25 In re Old Naples Sec. Inc., 223 F.3d 1296, 1305 (11th Cir. 2000) (holding that claimants who wired funds with the intent to purchase “discount bonds of some sort” entitled to customer status under SIPA); In re C.J. Wright & Co., 162 B.R. 597, 608-09 (Bankr. M.D. Fla. 1993) (concluding that claimants who invested in debtor brokerage’s “money market club” and “deposit account,” with the understanding that the funds would be used to purchase unnamed certificates of deposit, are entitled to customer status under SIPA).
26 See 15 U.S.C. §78 lll(2) (West 2005).
27 15 U.S.C. §78fff(a)(1)(A)-(B) (West 2005).
28 15 U.S.C. §78 lll(11) (West 2005).
29 15 U.S.C. §78 lll(4) (West 2005).
30 15 U.S.C. §78fff-3(a) (West 2005).
31 See Focht, Theodore H., The Securities Investor Protection Act, C388 ALI-ABA 59 (1989).
32 See Id.
33 15 U.S.C. §78fff-2(c)(1) (West 2005).
34 See 15 U.S.C. §78eee(a)(3) (West 2005).
36 15 U.S.C. §78eee(b)(2)(A) (West 2005).
37 15 U.S.C. §78eee(b)(2)(B)(i) (West 2005). It should be noted that SIPC may file an application for a protective decree under SIPA irrespective of the automatic stay arising from a pending liquidation of the brokerage firm under the Code. See 11 U.S.C. §742; 15 U.S.C. §78aaa et. seq.
38 See 11 U.S.C. §742; 15 U.S.C. §78aaa et. seq.
39 See 11 U.S.C §362(a) (West 2005).
40 See Don, Michael E., and Wang, Josephine, “Stockbroker Liquidations Under the Securities Investor Protection Act and Their Impact on Securities Transfers,” 12 Cardozo L. Rev. 509, 518 (1990) (hereafter “Don and Wang”).
41 See 11 U.S.C. §555 (West 2005).
42 See 11 U.S.C. §559 (West 2005).
43 See 11 U.S.C. §§555 and 559. It should be noted that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) amends Code §362(b)(17) to protect netting provisions in swap agreements, security agreements and master netting agreements. A corresponding amendment is made to SIPA to provide that a SIPC stay does not operate as a stay against netting provisions.
44 See Don and Wang, 12 Cardozo L. Rev. at 518.
45 See Id. at 518-19.
46 See 15 U.S.C. §78eee(b)(1) (West 2005).
47 See 15 U.S.C. §78eee(b)(3) (West 2005).
48 See 15 U.S.C. §78eee(b)(4) (West 2005).
49 See Id.
50 15 U.S.C. §78fff-1(a) (West 2005).
51 15 U.S.C. §78fff-1(d)(1) (West 2005).
52 15 U.S.C. §78fff-1(d)(4) (West 2005).
53 15 U.S.C. §78fff-1(c) (West 2005).
54 15 U.S.C. §78fff-2(a)(2) (West 2005).
55 15 U.S.C. §§78fff-2(b) and 78fff-4(c) (West 2005); see, also, In re Stratton Oakmont Inc., 257 B.R. 644, 651-52 (Bankr. S.D.N.Y. 2001).
56 15 U.S.C. §78fff-2(b).
57 15 U.S.C. §78fff-2(b)(1).
58 15 U.S.C. §78fff(a).
59 15 U.S.C. §78fff(b). Indeed, SIPA expressly mandates that a liquidation proceeding under SIPA shall be conducted in accordance with, and as though it were being conducted under, chapters 1, 3 and 5 and subchapters I and II of chapter 7 of Title 11 to the extent such provisions are consistent with the provisions of SIPA. See §78ffff(b).
60 15 U.S.C. §78fff(e).
61 See Id.
62 See Id.
63 See SIPC v. Ambassador Church Fin./Dev. Group Inc., 788 F.2d 1208, 1210 (6th Cir. 1986) cert. denied sub nom, Pine Street Baptist Church v. SIPC, 479 U.S. 850 (1986) (“essentially, a liquidation under the SIPA is a bankruptcy proceeding”).
64 See 15 U.S.C. §78fff-1(b).
65 See 15 U.S.C. §78fff-2(d).
66 See First Fed. Sav. & Loan of Lincoln v. Bevill, Bresler & Schulman Inc. (In re Bevill, Bresler & Schulman Inc.), 59 B.R. 353, 372 (Bankr. D. N.J. 1986) (“the 1978 amendments to SIPA were intended to serve two major objectives. First, Congress intended that customer accounts be reconstituted as they existed on the filing date to the greatest extent practicable, and therefore that securities, rather than cash, be distributed to customers”).
67 See Joo, 72 S. Cal. L. Rev. at 1112 (“SIPA attempts to satisfy customer net equity claims with securities as much as possible, even to the extent of using the proceeds of customer property or SIPC advances to purchase them for the customer, regardless of their value”).
68 11 U.S.C. §748 (“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 §751 of this title”).
69 See 11 U.S.C §750 (West 2005).
70 See Joo, 72 S. Cal. L. Rev. at 1074.