SIPC's Ambiguous $100K Brokerage 'Cash' Protection

Bernard Madoff has certainly got us to focus new attention on the technicality of SIPC protection. The easy answer is $500K is covered, including up to $100K in cash held and the remainder in securities, missing from a failed brokerage. SIPC does not protect the value of securities.

I can imagine the litigation emanating from whether a Madoff managed account is in and of itself a security or fund, rather than an individual brokerage account containing securities. While trying to predict the SIPC interpretation of Madoff’s client claims is an interesting exercise, I am more interested in the safety of the cash balances in traditional brokerage accounts.

Cash is a term the SIPC has trouble defining. Non-interest bearing cash on deposit with a brokerage to pay for securities purchases is definitely included. So is cash from security sales, interest, and dividends waiting to be swept into a money market fund or FDIC bank account. But, money market funds and bank accounts are not cash. Money market funds are considered securities and bank accounts would be covered by the FDIC up to their insurance limits.

Now for the ambiguity: Many brokerages do not provide money market funds or bank accounts for credit balances, but pay interest on those balances. The money is used to fund margin loans to other customers, with the brokerage earning the spread. SIPC states the cash balances held at a brokerage for the sole purpose of earning interest are not covered, but you can earn interest on covered cash balances to be used to purchase securities. That leaves a lot of room for interpretation.

I wrote to the SIPC asking for an interpretation, since most investors will shift from securities to cash for periods of time and always have at least a partial cash balance. I got multiple replies with multiple interpretations. I included the best one below:

“The determination whether cash is on deposit with a broker-dealer "for the purpose of purchasing securities," and is thus eligible for SIPC protection, is made based upon on all factors that reflect and are relevant to the investor's intent with respect to the use of the cash in question. Each determination is made on a case by case basis, and it is not possible to enumerate all of the factors that may be relevant in evaluating a particular investor's intent.

Standing alone, the receipt of interest on a cash deposit is not determinative, and may be compatible with a finding that an investor's intent was to use the cash for the purpose of purchasing securities, but does suggest that the cash was not on deposit for that purpose. Likewise, standing alone, the longer cash remains on deposit with a broker-dealer without deployment in the securities markets, the greater the inference that the investor's intent was not to use the cash for the purpose of purchasing securities. Again, the factor is relevant to, but may not be determinative of, the investor's intent.”

This interpretation does not add comfort to investors with cash waiting to seize opportunities. After all, brokerages require cash balances to support all open buy limit orders and any mark to market unrealized losses on shorts.

Comments

[sr9web:]

Good post

2008 Dec 29 12:44 PM

[Crocodilian:]

Wow. That's a nice piece of digging. "Made on a case-by-base basis" are not words to comfort anyone; a thorough investigation of the specifics of each customer's cash balances in the event of a major failure is a dismaying and impractical prospect. As they're only guaranteeing $100K of deposits, and legal fees for a complex regulatory/financial matter would start with a $25K retainer, and easily amount to $100K, the investor wouldn't have much protection in the event of failure. Any recourse that is contingent on intent or behavior, rather than a blanket characterization of assets, is going to be contentious and expensive to navigate.

That said, the response to "breaking the buck" on money market funds is indicative of what the Federal response would have to be. As the financial authorities want to encourage spending, borrowing, and lending, the worst thing that could happen would be to force everyone to buy Treasuries or other instruments with an explicit Federal guarantee.

2008 Dec 31 06:01 PM