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Report to Congressional Requesters:
July 2003:
Securities Investor Protection:
Update on Matters Related to the Securities Investor Protection
Corporation:
GAO-03-811:
GAO Highlights:
Highlights of GAO-03-811, a report to congressional requesters
Why GAO Did This Study:
As result of ongoing concerns about the adequacy of disclosures
provided to investors about the Securities Investor Protection
Corporation (SIPC) and investors’ responsibilities to protect their
investments, GAO issued a report in 2001 entitled Securities Investor
Protection: Steps Needed to Better Disclose SIPC Policies to Investors
(GAO-01-653). GAO was asked to determine the status of recommendations
made to the Securities and Exchange Commission (SEC) and SIPC in that
report. GAO was also asked to review a number of issues involving
excess SIPC insurance, private insurance securities firms purchase to
cover accounts that are in excess of SIPC’s statutory limits.
What GAO Found:
SEC has taken steps to implement each of the seven recommendations
directed to SEC in GAO’s May 2001 report. SEC has updated its Web site
to provide investors with more information about SIPC’s policies and
practices, particularly with regard to unauthorized trading and
nonmember affiliate claims. SEC has taken other steps consistent with
our recommendations to improve its oversight of SIPC and is working
with self-regulatory organizations (SRO) to increase investor
awareness of SIPC’s policies through distribution of the SIPC brochure
and disclosures on account statements.
Likewise, SIPC has taken steps to implement the three recommendations
directed to SIPC in our 2001 report, but additional work is needed on
one. SIPC has updated its brochure and Web site to clarify that
investors should complain in writing to their securities firms about
suspected unauthorized trades. SIPC also expanded a statement in its
brochure that discusses market risk and SIPC coverage and amended its
advertising bylaws to require firms that display an expanded statement
about SIPC to include a reference or link to SIPC’s Web site.
Moreover, SEC, the NASD, and many securities firms provide the
recommended disclosures about the scope of SIPC coverage to investors
on their Web sites. SIPC also added links to Web sites in its brochure
that offer information about investment fraud. However, investors
could benefit from more specific links to investor education
information.
Until this year, certain well-capitalized, large, and regional
securities firms were able to purchase and provide excess SIPC
coverage from four major insurers. The insurance policies varied by
firm and insurer in terms of the amount of coverage offered per
customer and in aggregate per firm. Attorneys familiar with the
policies agreed that the disclosure of the coverage and the terms of
coverage could be improved. During the review, GAO found that three of
the four major insurers that offered excess SIPC coverage in 2002
stopped underwriting these policies in 2003. Consequently, as the
policies expire in 2003, most insurers are not renewing their existing
policies and have stopped underwriting new policies. At this time,
holders of the insurance policies have not decided what to do going
forward. However, several options are being explored including self-
insuring and purchasing policies from the remaining major insurer.
What GAO Recommends:
To ensure that investors have access to relevant information about
SIPC, GAO recommends that SIPC provide more specific references to
investor education information in its brochure.
In addition, GAO recommends that SEC, in conjunction with the SROs,
ensure that firms are providing investors with meaningful disclosures
about excess SIPC and monitor firm disclosures about any changes in
the coverage.
SEC and SIPC generally agree with the report’s findings and
recommendations.
www.gao.gov/cgi-bin/getrpt?GAO-03-811.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Richard J. Hillman,
(202) 512-8678, hillmanr@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
SEC Has Taken Steps to Address Our Recommendations:
SIPC Has Taken Steps to Improve Investor Education:
Terms of Existing Excess SIPC Policies Vary, and Most Insurers Have
Stopped Underwriting New Policies:
Conclusions:
Recommendations:
Agency Comments:
Objectives, Scope, and Methodology:
Appendixes:
Appendix I: Comments from the U.S. Securities and Exchange Commission:
Appendix II: Comments from the Securities Investor Protection
Corporation:
Appendix III: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Acknowledgments:
Table:
Table 1: Examples of How SIPC Protects Investors:
Abbreviations:
FDIC: Federal Deposit Insurance Corporation:
IG : Inspector General:
NERO: Northeast Regional Office:
NYSE : New York Stock Exchange:
OCIE : Office of Compliance Inspections and Examinations:
OGC: Office of General Counsel:
PSA: public service announcement:
SEC: Securities and Exchange Commission:
SIA : Securities Industry Association:
SIPA : Securities Investor Protection Act of 1970:
SIPC : Securities Investor Protection Corporation:
SRO: self-regulatory organization:
Letter July 11, 2003:
The Honorable John D. Dingell
Ranking Minority Member
Committee on Energy and Commerce
House of Representatives:
The Honorable Barney Frank
Ranking Minority Member
Committee on Financial Services
House of Representatives:
The Honorable Paul E. Kanjorski
Ranking Minority Member
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
Committee on Financial Services
House of Representatives:
Disclosure has an important role in securities market regulation, and
the Securities Investor Protection Corporation (SIPC) has a
responsibility to inform investors of actions they can take to protect
their investments and help ensure that investors are afforded the full
protections allowable under the Securities Investor Protection Act of
1970 (SIPA). In our 2001 report, we concluded that many investors were
unaware of the steps they should take to protect their
investments.[Footnote 1] We found that SIPC and the Securities and
Exchange Commission (SEC), which play vital roles in investor
education, had missed opportunities to disclose information on SIPC's
policies, practices, and coverage to investors. Our report contained 10
recommendations to SEC and SIPC about ways to improve the information
available to the public about SIPC and SEC's oversight of SIPC.
This report responds to your August 16, 2001, and October 30, 2001,
requests that we followup on our 2001 report recommendations. As
requested, this report also includes information about "excess SIPC,"
which refers to private insurance that securities firms can purchase to
cover customer claims that are in excess of the $500,000 (which
includes $100,000 cash) limits established by SIPA. Excess SIPC
policies typically cover cash and securities like SIPC, but the dollar
amount of the coverage can vary from net equity coverage to a specific
dollar amount. Although the policies are advertised as excess SIPC, not
all policies may be consistent with SIPA. In light of these concerns,
you asked that we review implications for investors and possible
investor misunderstanding about these policies.
To determine the status of our 2001 report recommendations to SEC and
SIPC, we interviewed relevant officials from SEC and SIPC to determine
what steps they had taken to implement our recommendations since May
2001. We verified changes to SEC and SIPC Web sites and SIPC's brochure
to determine what SEC and SIPC disclosed to investors regarding SIPC's
policies and practices regarding unauthorized trading[Footnote 2] and
nonmember affiliate issues.[Footnote 3] We also spoke with self-
regulatory organization (SRO) officials about related disclosure
issues.[Footnote 4] To address issues surrounding excess SIPC coverage,
we interviewed SEC, SIPC, and SRO staff; representatives from
underwriters and insurance brokers; securities firms (policy holders);
SIPC trustees; and attorneys knowledgeable about excess SIPC. We also
reviewed a sample of excess SIPC policies, including one policy from
each of the four major underwriters that provided coverage in 2002. We
conducted our work from October 2002 through July 2003 in accordance
with generally accepted government auditing standards.
Results in Brief:
SEC has completed or is in the process of implementing each of the
seven recommendations made in our May 2001 report. Three
recommendations were aimed at improving the information SEC provides to
investors about SIPC's policies and practices, particularly with regard
to unauthorized trading and nonmember affiliate claims. In response to
our recommendations, SEC updated the investor education section of its
Web site to include more consistent information about documenting
unauthorized trading claims and updated a Web page dedicated to
providing information about SIPC policies and practices. SEC has also
implemented two recommendations intended to improve its oversight of
SIPC operations. As recommended, SEC adjusted the sample of
liquidations it examined in its recently completed review of SIPC to
include a larger number of liquidations involving unauthorized trading
or nonmember affiliate issues. In response to the SEC Inspector General
(IG) and our recommendation that SEC establish a formal procedure to
share information about SIPC among its various divisions and offices,
SEC began holding quarterly meetings. SEC has subsequently determined
that more frequent, informal meetings were more effective. If this
format continues to allow SEC to share information with all the
relevant parties, it would be an effective response to our
recommendation. Finally, SEC is still in the process of implementing
our recommendations to require firms to distribute the SIPC brochure to
customers and to require clearing firms to include information about
documenting unauthorized trades in writing on account statements. SEC
officials have sent letters to the New York Stock Exchange (NYSE) and
NASD asking them to explore how these recommendations could be
implemented through SRO rulemaking or notices to members, and the SROs
are evaluating possible approaches to implement these recommendations.
SIPC has taken steps to implement each of our three recommendations,
but needs to complete additional work on one. We made recommendations
to SIPC aimed at improving the information it provides to investors
about its policies and practices, particularly regarding unauthorized
trading and nonmember affiliate claims. First, we recommended that SIPC
revise its informational brochure and Web site to include a full
explanation of the steps necessary to document an unauthorized trading
claim. In response to our recommendation, SIPC has updated its brochure
and Web site to clarify that investors should complain in writing to
their securities firms about suspected unauthorized trades. Second, we
recommended that SIPC amend its advertising bylaws to include a
statement that SIPC does not protect against losses due to market
fluctuations. According to SIPC officials, such a statement would be
misleading unless additional explanations were added. However, SIPC has
expanded a statement in its brochure that discusses market risk and
SIPC coverage and amended its advertising bylaws to require firms that
display an expanded statement to include a reference or link to SIPC's
Web site. In addition, we found that SEC, SROs, and many securities
firms provide the recommended disclosures to investors on their Web
sites. In combination, such actions collectively respond to our
recommendation. Third, we recommended that SIPC revise its brochure to
warn investors to exercise caution when calling to complain about an
unauthorized trade in order to avoid unintentionally ratifying an
unauthorized trade. In response, SIPC provided investors with links to
Web sites, such as SEC's, that offer information about investment
fraud. However, SIPC provides links to only the main Web site and not
to specific Web pages that contain the relevant information, so
investors may have difficulty locating information about specific types
of fraud. For example, based on the Web address provided in the
brochure, investors searching SEC's Web site for "fraud," would be
linked to over 5,000 possible references. Providing more specific links
to investor education information would make it much easier for
investors to locate relevant information.
Until this year, excess SIPC coverage was generally available to
certain well-capitalized, large, and regional securities firms. The
policies varied by firm and insurer in terms of the amount of coverage
offered per customer and in aggregate per firm. Attorneys familiar with
the policies agreed that the disclosure of the coverage and the terms
of coverage are sometimes unclear. In our review of some of the
policies, it was unclear who was covered and how the claims process
would work in the case of a firm's bankruptcy. The policies were also
unclear in terms of when a claim can be filed and whether the trustee
or the customer would file it. During our review, three of the four
major insurers that offered excess SIPC coverage in 2002 stopped
underwriting these policies in 2003. Some of these insurers said they
had stopped providing coverage primarily because of the complexity of
quantifying their potential risk exposure in relation to the relatively
low premiums.[Footnote 5] Consequently, as the policies expire in 2003,
most insurers are not renewing their existing policies and have stopped
underwriting new policies. At this time, some of the policyholders have
not decided what to do going forward. However, several options are
being explored, including self-insuring and purchasing policies from
the remaining major insurer.
Given the important and ongoing role that SEC and SIPC play in investor
education and protection, we make new recommendations to SEC and SIPC
aimed at further improving investor education and protection. First, we
recommend SIPC modify its brochure to provide more specific links to
investor education information as SIPC continues its efforts to improve
investor awareness of SIPC's policies and practices and to educate
investors in general. Finally, as existing excess SIPC policies expire
and are replaced with new policies or are not replaced at all, we
recommend that SEC take actions to monitor these ongoing developments.
We requested comments on a draft of this report from the Chairman, SEC,
and the Chairman, SIPC. We received comments from the Director,
Division of Market Regulation, SEC, and President, SIPC. Both generally
agreed with the report's findings and recommendations. SEC's and SIPC's
comments are discussed in greater detail at the end of this letter, and
the written comments are reprinted as appendixes I and II,
respectively.
Background:
SIPA established SIPC to provide certain financial protections to the
customers of insolvent securities firms. As required under law, SIPC
either liquidates a failed firm itself (in cases where the liabilities
are limited and there are less than 500 customers) or a trustee
selected by SIPC and appointed by the court liquidates the
firm.[Footnote 6] In either situation, SIPC is authorized to make
advances from its customer protection fund to promptly satisfy customer
claims for missing cash and securities up to amounts specified in SIPA.
Between 1971 and 2002, SIPC initiated a total of 304 liquidation
proceedings and paid about $406 million to satisfy such customer
claims.
SIPC's Mission:
SIPC was established in response to a specific problem facing the
securities industry in the late 1960s: how to ensure that customers
recover their cash and securities from securities firms that fail or
cease operations and cannot meet their custodial obligations to
customers. The problem peaked in the late 1960s, when outdated methods
of processing securities trades, coupled with the lack of a centralized
clearing system able to handle a large surge in trading volume, led to
widespread accounting and reporting mistakes and abuses at securities
firms. Before many firms could modernize their trade processing
operations, stock prices declined sharply, which resulted in hundreds
of securities firms merging, failing, or going out of business. During
that period, some firms used customer property for proprietary
activities, and procedures broke down for proper customer account
management, making it difficult to locate and deliver securities
belonging to customers. The breakdown resulted in customer losses
exceeding $100 million because failed firms could not account for their
customers' property. Congress became concerned that a repetition of
these events could undermine public confidence in the securities
markets.
SIPC's statutory mission is to promote confidence in securities markets
by allowing for the prompt return of missing customer cash and/or
securities held at a failed firm. SIPC fulfills its mission by
initiating liquidation proceedings when appropriate and transferring
customer accounts to another securities firm or returning the cash or
securities to the customer by restoring to customer accounts the
customer's "net equity." SIPC defines net equity as the value of cash
or securities in a customer's account as of the filing date, less any
money owed to the firm by the customer, plus any indebtedness the
customer has paid back with the trustee's approval within 60 days after
notice of the liquidation proceeding was published. The filing date
typically is the date that SIPC applies to a federal district court for
an order initiating proceedings.[Footnote 7] SIPA sets coverage at a
maximum of $500,000 per customer, of which no more than $100,000 may be
a claim for cash. SIPC is not intended to keep firms from failing or to
shield investors from losses caused by changes in the market value of
securities.
SIPC is a nonprofit corporation governed by a seven-member Board of
Directors that includes two U.S. government, three industry, and two
public representatives. SIPC has 31 staff located in Washington, D.C.
Most securities firms that are registered as broker-dealers under
Section 15(b) of the Securities Exchange Act of 1934 automatically
become SIPC members, regardless of whether they hold customer property.
As of December 31, 2002, SIPC had 6,679 members. SIPA excludes from
membership securities firms whose principal business--as determined by
SIPC subject to SEC review--is conducted outside of the United States,
its territories, and:
possessions. Also, a securities firm is not required to be a SIPC
member if its business consists solely of (1) distributing shares of
mutual funds or unit investment trusts,[Footnote 8] (2) selling
variable annuities,[Footnote 9] (3) providing insurance, or (4)
rendering investment advisory services to one or more registered
investment companies or insurance company separate accounts. SIPA, as
recently amended, also exempts a certain class of firms that are
registered with SEC solely because they may affect transactions in
single stock futures.
SIPA covers most types of securities such as notes, stocks, bonds, and
certificates of deposit.[Footnote 10] However, some investments are not
covered. SIPA does not cover any interest in gold, silver, or other
commodity; commodity contract; or commodity option. Also, SIPA does not
cover investment contracts that are not registered as securities with
SEC under the Securities Act of 1933. Shares of mutual funds are
protected securities; but securities firms that deal only in mutual
funds are not SIPC members, and thus their customers are not protected
by SIPC. In addition, SIPA does not cover situations where an
individual has a debtor-creditor relationship, such as a lending
arrangement, with a SIPC member firm.
Investors who attain SIPC customer status are a preferred class of
creditors compared with other individuals or companies that have claims
against the failed firm and are much more likely to get a part or all
of their claims satisfied. This is because SIPC customers share in any
customer property that the bankrupt firm possesses before any other
creditors may do so. Although bankers and brokers are customers under
SIPA, they are not eligible for SIPC fund advances. SIPA states that
most customers are eligible for SIPC assistance, but SIPC funds may not
be used to pay claims of any failed brokerage firm customer who is:
* a general partner, officer, or director of the firm;
* the beneficial owner of 5 percent or more of any class of equity
security of the firm (other than certain nonconvertible preferred
stocks);
* a limited partner with a participation of 5 percent or more in the
net assets or net profits of the firm;
* someone with the power to exercise a controlling influence over the
management or policies of the firm; and:
* a broker or dealer or bank acting for itself rather than for its own
customer or customers.
The SIPC fund was valued at $1.26 billion as of December 31, 2002,
which it uses to make advances to trustees for customer claims and to
cover the administrative expenses of a liquidation proceeding.[Footnote
11] Administrative expenses in a SIPA liquidation include the expenses
incurred by a trustee and the trustee's staff, legal counsel, and other
advisors. The SIPC fund is financed by annual assessments on all member
firms--periodically set by SIPC--and interest generated from its
investments in U.S. Treasury notes. SIPC, after consultation with the
SROs, sets the amount of member assessments based on the amount
necessary to maintain the fund and repay any borrowings by
SIPC.[Footnote 12] At different times during the 1970s, 1980s, and
1990s members were assessed at a higher rate. Rates fluctuated
depending on the level of expenses. SIPC's board of directors attempted
to match assessment rate increases with declines in the fund balance,
so that years of high SIPC expenses were followed by periods of higher
assessments. Since 1996, SIPC has charged each broker-dealer member an
annual assessment of $150.[Footnote 13] If the SIPC fund becomes or
appears to be insufficient to carry out the purposes of SIPA, SIPC may
borrow up to $1 billion from the U.S. Treasury through SEC (i.e., SEC
would borrow the funds from the U.S. Treasury and then relend the funds
to SIPC). In addition, SIPC has a $1 billion line of credit with a
consortium of banks.
SEC Oversight of SIPC:
SIPA gives SEC oversight responsibility over SIPC. SEC's primary
mission is to protect investors and the integrity of the securities
markets. SEC seeks to fulfill its mission by requiring public companies
to disclose financial and other information to the public. SEC is also
responsible for conducting investigations of potential securities law
violations and overseeing SROs such as securities exchanges, as well as
broker-dealers (securities firms), mutual funds, investment advisors,
and public utility holding companies. SEC may sue SIPC to compel it to
act to protect investors. SIPC must submit all proposed changes to
rules or bylaws to SEC for approval; and SEC may require SIPC to adopt,
amend, or repeal any bylaw or rule.[Footnote 14] In addition, SIPA
authorizes SEC to conduct inspections and examinations of SIPC and
requires SIPC to furnish SEC with reports and records that it believes
are necessary or appropriate in the public interest or to fulfill the
purposes of SIPA.
SEC Rules Strengthen Customer Protection in the Securities Market:
The law that created SIPC also required SEC to strengthen customer
protection and increase investor confidence in the securities markets
by increasing the financial responsibility of broker-dealers. Pursuant
to this mandate, SEC developed a framework for customer protection
based on two key rules: (1) the customer protection rule and (2) the
net capital rule. These rules respectively require broker-dealers that
carry customer accounts to (1) keep customer cash and securities
separate from those of the company itself and (2) maintain sufficient
liquid assets to protect customer interests if the firm ceases doing
business. SEC and SROs, such as NYSE, are responsible for enforcing the
net capital and customer protection rules.
Excess SIPC Coverage Was Introduced in the 1970s:
Under a typical SIPC property distribution process, SIPC customers are
to receive any securities that the firms holds that are registered in
their name or that are being registered in their name, subject to the
payment of any debt to the firm. If some of the customer assets are
missing and cannot be found by the trustee, the customer will receive a
pro rata share of the firm's remaining customer property. In addition,
SIPC is required to replace missing securities and cash in an
investor's account up to the statutory limits. For firms with excess
SIPC policies, this coverage would be available as well. For example,
if a firm is liquidated by a SIPC trustee that should have $10 billion
in customer assets, but the trustee can account for only $9.8 billion
or 98 percent of the $10 billion in assets, each customer would receive
98 percent of their net equity (pro rata share). A customer with net
equity of $10 million would receive 98 percent or $9.8 million of their
$10 million. In addition the trustee may use up to $500,000 advanced
from the SIPC fund to satisfy the customer's claim, but only $100,000
may be advanced for cash. With a $200,000 advance from SIPC, the
customer in this example would have received the entire $10 million in
assets owed. To protect customers who have claims in excess of the SIPC
limit, Travelers Bond[Footnote 15] first began offering excess SIPC
coverage to brokerage firms in 1970, soon after SIPA was enacted. Other
companies began to join the market in the mid-1980s. However, such
claims above the SIPA limit are rare and regulatory and industry
officials confirmed that most customers would not be affected by such
policies because their accounts are within the SIPA limits.
As seen in table 1, the amount of customer funds recovered determines
if the investor will have a loss and whether excess SIPC would be
triggered. For example, if the trustee determined that 50 percent of
the customer assets were missing, a customer who is owed $1 million in
assets would receive a $500,000 pro rata share from the estate and an
advance from SIPC at its statutory limit of $500,000. However, a
customer with $5 million in assets with the same 50 percent pro rata
share would have $2 million in excess of the $500,000 SIPC advance and
could be eligible for excess SIPC coverage if offered by the securities
firm. Conversely, a customer with $5 million in assets and a pro rata
share of 90 percent or higher would be made whole by SIPC and would not
have losses in excess of SIPC limits.
Table 1: Examples of How SIPC Protects Investors:
Customer assets: $1,000,000; Percent of customer property recovered:
50; Pro rata share of assets returned to customer: $500,000; SIPC
advance: $500,000; Amount in excess of SIPC limit: $0.
Customer assets: 5,000,000; Percent of customer property recovered: 50;
Pro rata share of assets returned to customer: 2,500,000; SIPC advance:
500,000; Amount in excess of SIPC limit: 2,000,000.
Customer assets: 5,000,000; Percent of customer property recovered: 60;
Pro rata share of assets returned to customer: 3,000,000; SIPC advance:
500,000; Amount in excess of SIPC limit: 1,500,000.
Customer assets: 5,000,000; Percent of customer property recovered: 70;
Pro rata share of assets returned to customer: 3,500,000; SIPC advance:
500,000; Amount in excess of SIPC limit: 1,000,000.
Customer assets: 5,000,000; Percent of customer property recovered: 80;
Pro rata share of assets returned to customer: 4,000,000; SIPC advance:
500,000; Amount in excess of SIPC limit: 500,000.
Customer assets: 5,000,000; Percent of customer property recovered: 90;
Pro rata share of assets returned to customer: 4,500,000; SIPC advance:
500,000; Amount in excess of SIPC limit: 0.
Customer assets: 10,000,000; Percent of customer property recovered:
50; Pro rata share of assets returned to customer: 5,000,000; SIPC
advance: 500,000; Amount in excess of SIPC limit: 4,500,000.
Customer assets: 10,000,000; Percent of customer property recovered:
60; Pro rata share of assets returned to customer: 6,000,000; SIPC
advance: 500,000; Amount in excess of SIPC limit: 3,500,000.
Customer assets: 10,000,000; Percent of customer property recovered:
70; Pro rata share of assets returned to customer: 7,000,000; SIPC
advance: 500,000; Amount in excess of SIPC limit: 2,500,000.
Customer assets: 10,000,000; Percent of customer property recovered:
80; Pro rata share of assets returned to customer: 8,000,000; SIPC
advance: 500,000; Amount in excess of SIPC limit: 1,500,000.
Customer assets: 10,000,000; Percent of customer property recovered:
90; Pro rata share of assets returned to customer: 9,000,000; SIPC
advance: 500,000; Amount in excess of SIPC limit: 500,000.
Customer assets: 10,000,000; Percent of customer property recovered:
98; Pro rata share of assets returned to customer: 9,800,000; SIPC
advance: 200,000; Amount in excess of SIPC limit: 0.
Source: SIPC and GAO analysis of how SIPC protects investors.
[End of table]
SEC Has Taken Steps to Address Our Recommendations:
In our 2001 report, we made seven recommendations to SEC to address
needed improvements to information it provided to investors about
SIPC's policies and practices, particularly regarding the evidentiary
standard for unauthorized trading claims and to expand its review of
SIPC operations among others. SEC has taken action to address all of
the recommendations either directly or indirectly by delegating the
implementation to the SROs.
First, we recommended that SEC review sections of its Web site and,
where appropriate, advise customers to complain promptly in writing
when they believe trades in their account were not authorized. This
advice should include an explanation of SIPC's policies and practices
regarding claims and a general warning about how to avoid ratifying
potentially unauthorized trades during telephone conversations. In
2001, we found that SIPC liquidations involving unauthorized trading
accounted for nearly two-thirds of all liquidations initiated from 1996
through 2000. SIPC's policies and practices in these liquidation
proceedings generated controversy, primarily because of the large
numbers of claims that were denied and the methods used to satisfy
certain approved claims.
In addition, we found that SIPC's policies and practices were often not
transparent to investors and SEC had missed opportunities to provide
investors with consistent information about SIPC's evidentiary standard
for unauthorized trading. For example, some sections of SEC's Web site
encouraged investors to call to complain about unauthorized trades,
while other sections told the investor to complain immediately in
writing. Although the telephone-based approach SEC recommended was
reasonable if the firm acted in good faith to resolve problem trades,
fraudulently operated firms were known to have used high pressure and/
or fraudulent tactics to convince persons who called to complain about
potentially unauthorized trades to ratify these trades. In response to
our recommendation, SEC updated sections of its Web site to include
consistent information on making unauthorized trading complaints in
writing. In addition, they expanded the section entitled Cold Calling
to include warnings about high-pressure sales tactics that some brokers
may use.
Second, we recommended that SEC require firms that it determines to
have engaged in or are engaging in systematic or pervasive unauthorized
trading to prominently notify their customers about the importance of
documenting disputed transactions in writing. In 2001, we found that
although SEC may identify and impose sanctions on firms that have
engaged in pervasive unauthorized trading long before they ever become
SIPA liquidations, it does not routinely require such firms to notify
their clients about documenting unauthorized trading claims. For
example, between 1992 and 1997, one securities firm operated under
intensive SEC and court supervision in connection with, among other
violations, pervasive unauthorized trading and stock price
manipulation. However, there was no requirement that the firm notify
their customers to document their complaints in writing. Imposing this
requirement could help investors protect their interests and benefit
unsophisticated investors who may not review the SIPC brochure or other
disclosures made on account statements. At the time the report was
issued, SEC had agreed to implement this requirement on a case-by-case
basis. Since 2001, SEC officials said that they have not had a case
that required this action. Moreover, SEC officials noted that their
first course of action would be to shut down firms that engage in
pervasive unauthorized trading.
Third, we recommended that SEC update its Web site to inform investors
about the frauds that may be associated with certain SIPC member firms
and their affiliates as well as the steps that can be taken to avoid
falling victim to such frauds. SIPC's policies and practices in
liquidations of member firms that had nonmember affiliates have also
been controversial because SIPC and trustees have denied many claims in
such liquidation proceedings. In 2001, we found that SEC had missed
opportunities to educate investors about the potential risks associated
with certain nonmember affiliates. SEC's Web site provided limited
information about dealing with nonmember affiliates, and investors may
not have been fully aware of the risks that can be associated with
certain nonmember affiliates. In response to this recommendation, SEC
updated an on-line publication called Securities Investor Protection
Corporation, which discusses the problems that can occur when investors
place their cash or securities with non-SIPC members. Investors are
also told to always make sure that the securities firm and clearing
firm[Footnote 16] are members of SIPC because firms are required by law
to tell you if they are not.
Next, we recommended that SEC take several actions to improve its
oversight of SIPC. Specifically, we recommended that SEC implement the
SEC IG's recommendation that the Division of Market Regulation, the
Division of Enforcement, the Northeast Regional Office (NERO) and the
Office of Compliance, Inspections, and Examinations (OCIE) conduct
periodic briefings to share information related to SIPC. In 2000, SEC's
IG found that communication among SEC's internal units regarding SIPC
could be improved. Although the SEC IG report found that SEC officials
tried to keep each other informed about relevant SIPC issues, there was
no formal procedure for doing so. At the time our report was issued,
SEC had not yet implemented this recommendation, and we recommended
that they do so. SEC officials said that they began to hold quarterly
meetings, but determined that more frequent, informal meetings were
more effective. They said that they meet to discuss SIPC as issues
arise, which is typically more than once every quarter. As long as SEC
continues to meet frequently and share information among all the
relevant units, this approach effectively responds to the concern our
recommendation was intended to address.
Fifth, we recommended that SEC expand its ongoing examination of SIPC
to include a larger number of liquidations with claims involving
unauthorized trading or nonmember affiliate issues. SEC periodically
conducts examinations of SIPC's operations to ensure compliance with
SIPA. In May 2000, the Division of Market Regulation and OCIE initiated
a joint examination of SIPC. As of March 2001, SEC had included four
SIPA liquidations involving unauthorized trading in its sample, but had
not included any liquidations involving nonmember affiliate issues.
Given the controversies involving SIPA's liquidations involving
unauthorized trading and nonmember affiliates, we believed that
including a larger number of liquidations with these types of claims
was warranted. SEC agreed with this recommendation and included a
larger number of liquidations involving unauthorized trading or
nonmember affiliate issues in the sample used for the review. Of the
eight liquidations in SEC's sample, five involved unauthorized trading
and two involved nonmember affiliate issues.
SEC completed its examination in January 2003 and issued its
examination report in April 2003, which assessed SIPC's policies and
procedures for liquidating failed securities firms and identified
several areas of improvement that warrant SIPC's consideration.
* SEC found that there was insufficient guidance for SIPC personnel and
trustees to follow when determining whether claimants have established
valid unauthorized trading claims. Although the evidentiary standards
used were found to be reasonable, the standards differed between
trustees. Therefore, SEC recommended that SIPC develop written guidance
to help establish consistency between trustees and liquidations. SIPC
agreed to adopt such written guidance for reviewing unauthorized
trading claims.
* Concerning SIPC's investor education programs, SEC found that SIPC
should continue to review the information that it provides to investors
about its policies and practices. For example, SEC found that some
statements in SIPC's brochure and Web site might overstate the extent
of SIPC coverage and mislead investors. SIPC plans to continue to
reexamine the adequacy of the information provided in its brochure and
Web site to eliminate any potential confusion.
* SEC also found that SIPC should improve its controls over the fees
awarded to trustees and their counsel for the services rendered and
their expenses. SEC found that some descriptions of the work that the
trustees performed were vague, making it difficult to assess whether
the work was necessary or appropriate. SEC believed that SIPC could do
a better job of reviewing and assessing fees that were requested. SIPC
agreed to ask trustees and counsel in SIPC cases to submit invoices at
least quarterly and arrange billing records into project categories.
SIPC also agreed to instruct its personnel to document discussions with
trustees and counsel regarding fee applications and to note any
differences in amounts initially requested by trustees and counsel and
those amounts recommended for payment by SIPC.
* In addition, SEC found that SIPC lacks a record retention policy for
records generated in liquidations where SIPC appoints an outside
trustee. It was found that trustees had different procedures for
retention of records, and SEC was not able to review records from one
liquidation because the trustee had destroyed the records. SIPC has
agreed to develop a uniform record retention policy for all SIPA
liquidations, following a cost analysis.
* SEC also found that the SIPC fund was at risk in the case of failure
of one or more of the large securities firms. SEC found that even if
SIPC were to triple the fund in size, a very large liquidation could
deplete the fund. Therefore, SEC suggested that SIPC examine
alternative strategies for dealing with the costs of such a large
liquidation. SIPC management agreed to bring this issue to the
attention of the Board of Directors, who evaluates the adequacy of the
fund on a regular basis.
Also as part of SEC's ongoing oversight effort, in September of 2000,
SEC's Office of General Counsel (OGC) initiated a 1-year pilot program
to monitor SIPA liquidations. According to SEC, the primary objective
of the pilot program was to provide oversight of claims determinations
in SIPA liquidation proceedings in order to make certain that the
determinations were consistent with SIPA. According to SEC officials,
this program has since been made permanent. SEC's OGC now enters
notices of appearance in all SIPA liquidation proceedings. The cases
are followed mostly by NERO and the Midwest Regional Office, given the
significant numbers of SIPA liquidations in these locations. The staff
can recommend that Commission staff intervene in SIPA liquidations, if
appropriate.
Sixth, we recommended that SEC, in conjunction with the SROs, establish
a uniform disclosure rule requiring clearing firms to put a standard
statement about documenting unauthorized trading claims on their trade
confirmations and/or other account statements. In 2001, we found that
SEC, NASD, and the NYSE, did not have requirements that clearing firms
notify customers that they should immediately complain in writing about
allegedly unauthorized trades. A review of a judgmental sample of trade
confirmations and account statements found that many firms voluntarily
notify their customers to immediately complain if they experience any
problems with their trades, but instructions about the next course of
action varied and did not necessarily specify that the investor should
complain in writing. Initially, SEC expressed concern about
promulgating a rule itself. However, in 2003, SEC began to take steps
to implement this recommendation. Specifically, SEC has asked NYSE and
NASD to explore how this recommendation can be more fully implemented
through SRO rulemaking and Notices to Members. As of June 9, the SROs
were still evaluating how best to implement this recommendation.
According to an SRO official, concern about potentially penalizing
investors who may not complain in writing but may file claims in other
forums, such as arbitration proceedings, will need to be resolved.
However, SEC believes that they will be able to craft acceptable
language that ensures that these investors are not harmed.
Lastly, we recommended that SEC require SIPC member firms to provide
the SIPC brochure to their customers when they open an account and
encourage firms to distribute the brochure to existing customers more
widely. This recommendation was an additional step aimed at educating
and better informing customers about how to protect their investments.
The SIPC informational brochure called How SIPC Protects You provides
useful information about SIPC and its coverage. However, SIPC bylaws
and SEC rules do not require SIPC members to distribute the brochure to
their customers. The authority lies with SEC or the SROs to require the
firms to provide the brochure to their customers. To date, it is
unclear what action will be taken. SEC officials expressed concern
about imposing another rule on securities firms. Instead, SEC included
this recommendation in its letter to NYSE and NASD to explore how this
could be implemented through SRO rulemaking and Notices to Members.
According to SEC and SRO officials, both NASD and NYSE are in the
process of exploring how best to implement this recommendation. SEC
officials said that they did not expect the SROs to have problems
implementing this recommendation.
SIPC Has Taken Steps to Improve Investor Education:
In our 2001 report, we made three recommendations to SIPC to improve
the information available to investors about its coverage, particularly
with regard to unauthorized trading. In addition to taking steps to
implement our recommendations, SIPC has continued a nationwide investor
education program that addresses many of the specific issues raised in
our 2001 report. SIPC has a responsibility to inform investors of
actions they can take to protect their investments and help ensure that
they are afforded the full protections allowable under SIPA. Our 2001
report found that investors might confuse the coverage offered by SIPC,
Federal Deposit Insurance Corporation (FDIC), and state insurance
guarantee associations and not fully understand the protection offered
under SIPA. This was significant because the type of financial
protection that SIPC provides is similar to that provided by these
programs, but important differences exist. To address these and other
investor education issues, SIPC began a major public education campaign
in 2000. As part of the campaign, SIPC worked with a public relations
firm to make its Web site and brochure more reader friendly and less
focused on legal terminology. The changes were designed to ensure that
the Web site is easy to use and written in plain English. In addition
to revising its brochure and Web site, SIPC produced a series of audio
and video public service announcements (PSA).[Footnote 17] From June
15, 2002, to November 15, 2002, the PSAs were aired over 76,000 times.
According to SIPC's 2002 annual report, the TV PSAs have appeared on
129 stations, in 106 cities, in 46 states; and the radio spots have
aired on 415 stations, in 249 cities, in 49 states. They have also been
aired nationally on CNBC and the Fox News Channel.
SIPC and its public relations firm are continuing to work together to
improve investor awareness of SIPC and its policies. They are
developing a new television and radio campaign scheduled to begin in
July 2003. They are also working to better explain the claims process
through a new brochure and video. The claims process brochure will
provide information to individuals that do not have access to the
Internet. This investor education campaign has increased the amount and
clarity of information available about SIPC and has provided investors
who review it with important information.
As mentioned, in addition to identifying investor education concerns in
our 2001 report, we recommended that SIPC take three specific actions
to improve its disclosure. First, we recommended that SIPC revise its
brochure and Web site to include a full explanation of the steps
necessary to document unauthorized trading claims. SIPC has determined,
and courts have agreed, that an objective evidentiary standard, such as
written complaints, is necessary to protect the SIPC fund from
fraudulent claims. However, in our 2001 report, we found that SIPC had
also missed opportunities to provide investors with complete
information about dealing with unauthorized trading. For example, we
found that claimants in 87 percent of the claims we reviewed telephoned
complaints to their brokers. Given that many investment transactions
are largely made by telephone, we were concerned that investors were
not aware of the importance of documenting their complaints in writing
if they were ever required to file a claim with SIPC. Furthermore, we
found the SIPC brochure did not advise investors that SIPA covers
unauthorized trading and that investors should promptly complain in
writing about allegedly unauthorized trades. As previously mentioned,
the brochure was revised as part of the investor education campaign and
now includes the statement, "If you ever discover an error in a
confirmation or statement, you should immediately bring the error to
the attention of the [firm], in writing." In addition, SIPC has created
a Web page, entitled Documenting an Unauthorized Trade, which includes
the same information on complaining in writing to the firm about any
errors.
We also recommended that SIPC amend its advertising bylaws to include a
statement that SIPC does not protect against loss due to market
fluctuations. SIPC officials did not agree with the recommended
statement and felt that it would be misleading unless additional
explanations were added. Instead, SIPC has expanded a statement in its
brochure that discusses SIPC coverage of market fluctuation to read,
"Most market losses are a normal part of the ups and downs of the risk-
oriented world of investing. That is why SIPC does not bail out
investors when the value of their stocks, bonds, and other investments
fall for any reason. Instead, SIPC replaces missing stocks and other
securities where it is possible to do so…even when investments have
increased in value.":
In addition, SIPC amended its advertising bylaws in 2002 to require
firms that choose to make an explanatory statement about SIPC to
include a link to the SIPC Web site.[Footnote 18] This will further
enable the customer to access information about what SIPC does and does
not cover. NASD and SEC have also begun to make disclosures about SIPC
and market risk to investors. For example, the NASD Web site says,
"SIPC does not protect against market risk, which is the risk inherent
in a fluctuating market. It protects the value of the securities held
by the [firm] as of the time the SIPC trustee is appointed." SEC
informs investors that "SIPC does not protect you against losses caused
by a decline in the market value of your securities." Furthermore, many
securities firms also include similar statements about SIPC protection
on their Web sites. SIPC's statement about market risk and amended
bylaws as well as the availability of other disclosures by the
regulators and firms effectively responds to the concern our
recommendation was intended to address.
Finally, we recommended that SIPC revise its brochure to warn investors
to exercise caution in ratifying potential unauthorized trades in
telephone discussions with firm officials. SIPC believes that the
statement discussed above encouraging investors to complain in writing
about unauthorized trades in its brochure and Web site will make oral
ratification unlikely. SIPC officials also maintain that this type of
information is best handled in those publications and Web pages that
warn investors about securities fraud. Therefore, in its brochure, SIPC
provides links to several Web sites, such as SEC's, that have investor
education information about investment fraud. However SIPC provides
links to only the main Web site and not to the specific Web pages that
contain the relevant information, so investors may have difficulty
locating information about specific types of fraud, such as
unauthorized trading. For example, based on the Web address provided in
the brochure, investors searching SEC's Web site for "fraud," would be
linked to over 5,000 possible sites. SIPC also recommends the
Securities Industry Association[Footnote 19] (SIA) Web site for
information about investment fraud. However, based on the information
SIPC provided, a search for "unauthorized trading" on this Web site
yields only three results, none of which send the investor to useful
educational information contained on the Web site. Investors are also
directed to NASD's Web site, which has a page entitled Investors Best
Practices, which includes detailed information on cold calling and
unauthorized trading. However, an investor may not be able to find this
useful information without specific links to the relevant Web pages for
this and other Web sites listed in the brochure. For example, a search
for "unauthorized trading" on NASD's Web site only yields one result,
which provides a link to a definition for unauthorized trading but no
reference to the useful educational information.
Terms of Existing Excess SIPC Policies Vary, and Most Insurers Have
Stopped Underwriting New Policies:
Excess SIPC coverage is generally offered by well-capitalized, large,
and regional securities firms and is generally marketed by the firms as
additional protection for their large account holders. Our review of
the excess SIPC policies offered by the four major insurers found the
policies varied by firm and insurer in terms of the amount of coverage
offered per customer and in aggregate per firm. In our review of some
of the policies, we found that excess SIPC coverage was not uniform and
was not necessarily consistent with SIPC protection. Attorneys familiar
with the policies also agreed that the disclosure of the coverage and
the terms of coverage could be improved. During our review, three of
the four major insurers that offered excess SIPC coverage in 2002
stopped underwriting these policies in 2003 for a variety of reasons.
Consequently, as the policies expire, most insurers are not renewing
their existing policies beyond 2003 and have stopped underwriting new
policies in general. At this time, it is unclear what some of the
securities firms that had excess SIPC coverage plan to do going
forward.
Excess SIPC Coverage Is Generally Limited to Larger Firms:
Excess SIPC is generally limited to certain well-capitalized, large,
and regional firms that have a relatively low probability of being part
of a SIPC liquidation. Moreover, the policies--usually structured as
surety bonds--are generally purchased by clearing firms.[Footnote 20]
The insurance underwriters of excess SIPC policies told us that they
use strict underwriting guidelines and have minimum requirements for a
firm requesting coverage. Most insurers evaluate a securities firm for
excess SIPC coverage by reviewing its operational and financial risks.
Insurers also consider the firm's internal control and risk management
systems, the type of business that the firm conducts, its size, its
reputation, and the number of years in business. Some insurers also
required the firms to annually submit information on the number and
value of customer accounts above the $500,000 SIPC limit, to help gauge
their maximum potential exposure in the unlikely event that the firm
became part of a SIPC liquidation. Firms below a certain dollar net
capital threshold were generally not considered for coverage.
Excess SIPC Coverage Is Not Uniform and Is Not Necessarily Consistent
with SIPC Coverage:
Although an excess SIPC claim has never been filed in the more than 30
years that the coverage has been offered, we identified several
potential investor protection issues.[Footnote 21] Our review of excess
SIPC policies, which included one from each of the four major insurers,
revealed that excess SIPC coverage is not uniform and that some
policies are not always consistent with SIPC coverage. Although the
policies were advertised as covering losses (or losses up to an amount
specified in the policy) that would otherwise be covered by SIPC except
for the $500,000 limit, we found that claims under the policies could
be subject to various terms and limitations that do not apply to SIPC
coverage. Attorneys familiar with SIPA and excess SIPC have also raised
questions about who is covered in the policies and how the claims
process would work in the case of a firm's bankruptcy. These potential
inconsistencies or concerns include:
* Some policies included customers that would generally be ineligible
under SIPA. The wording in some of the policies could be interpreted as
protecting individuals who are not customers eligible for SIPC
advances. Others contained specific riders that expanded the excess
SIPC policy to include classes of customers beyond those covered by
SIPC. For example, some policies have riders that extend coverage to
officers and directors of the failed firm, as long as they are not
involved with any fraud that contributed to the firm's demise. As
mentioned previously, SIPC coverage excludes certain customers, such as
officers and directors of the failed firm and broker-dealers and banks
acting on their own behalf.
* Some policies limited the duration of coverage. Each policy we
reviewed provided coverage only if SIPC were to institute judicial
proceedings to liquidate the firm while the policy was in effect. Three
of the four policies provided for specific periods of time during which
they were in effect, as well as for cancellation by the insurer under
specified conditions. Although each of the three policies required the
securities firm to notify its customers of a cancellation, none of the
policies expected notification to the customers regarding
expiration.[Footnote 22] According to NYSE and NASD, there are not any
specific SRO rules that require these firms to notify their customers.
However, NYSE said that they generally expect firms to notify investors
of any changes in their excess SIPC protection under rules involving
disclosure requirements for fees changes. NASD generally expects firms
to notify their customers under NASD's Just and Equitable Rule.
* Some excess SIPC policies varied from SIPA in scope of coverage.
Certain policies also differed from SIPA in terms of the scope of
excess coverage. Specifically, customer cash, which would generally be
covered under SIPA, was not covered by two of the policies we reviewed.
One of the policies specifically restricted coverage to lost
securities; the other described coverage as pertaining only to a
customer's claim for "loss of securities."[Footnote 23] Also, in
addition to a cap on the amount of coverage per customer, one policy
contained a cap on the insurer's overall exposure--the policy
established an aggregate cap of $250 million--regardless of the total
amount of customer claims. SIPC has no such aggregate cap.
* The mechanics of the claims process were unclear. In addition to
limitations on coverage, at least one policy had other characteristics
that could either restrict a customer's ability to recover losses that
exceed the amount covered under SIPA or delay a customer's recovery
until long after the net equity covered by the insurance has been
determined. The policy conditioned the customer's recovery upon the
customer providing the insurer with a claim notice subject to specific
time, form, and content specifications. Among other things, the
customer was required to submit a written claim accompanied by evidence
satisfactory to the insurer and an assignment to the insurer of the
customer's rights against the firm. The other policies did not address
when a customer must file a claim.
* The role of the trustee in the claims process was unclear. Another
difference we found is the role of the trustee regarding customer
claims under SIPA and excess SIPC coverage policies. Under SIPA, the
trustee acts on behalf of customers who properly file claims to see
that they recover losses as provided in SIPA. It is unclear whether the
trustee could represent customers on claims for excess insurance
because, in some cases, the policies indicate that only individual
customers could bring claims and, in any case, the trustee may not have
authority under the bankruptcy laws to do so.[Footnote 24] SIPC
trustees and other attorneys experienced with SIPA liquidations also
agreed that it was not clear who was responsible for filing the claim,
the customer or the trustee.
* The policies did not clearly state when a claim would be paid. The
policies also differed from SIPC coverage regarding when customers
could recover their losses. For purposes of SIPC coverage, the trustee
discharges obligations of the debtor from available customer property
and, if necessary, SIPC advances, without waiting for the court to rule
on customer property and net equity share calculations. Under the
excess coverage policies, it is unclear when customers would be
eligible to recover assets in excess of those replaced by SIPC. Some of
the policies provide for "prompt" replacement or payment of the portion
of a customer's covered net equity. In contrast to SIPC coverage,
however, they specify that the insurer shall not be liable for a claim
until the customer's net equity has been "finally determined by a
competent tribunal or by written agreement between the Trustee and the
Company," which could take years. Under another policy, the insurer
could wait until after liquidation of the broker-dealer's general
estate before replacing a customers' missing assets. The general
creditor claims process could also take several years. An attorney
knowledgeable about SIPC and excess SIPC said that some policies
indicate that the insurance company has no liability until the customer
claim is paid by SIPC. However, in many cases SIPC does not directly
pay investors, but does so through a trustee. Therefore, the policy, if
taken literally, would preclude an investor from ever being paid
through excess SIPC insurance.
* Excess SIPC coverage appears to be limited to clearing firm failures.
Most of the excess SIPC polices we reviewed provide that only the
policy holder, usually a clearing firm, is covered under the policy.
Introducing firms of clearing firms may advertise the coverage provided
by their clearing firm. For example, we reviewed the Web sites of 53
introducing firms and found that about 25 percent advertised the excess
SIPC protection provided by the clearing firm. This creates the
potential for investor confusion because the coverage would apply only
in the case of the clearing firm's failure. Because introducing firms
do not clear securities transactions or hold customer cash or
securities, the customer's assets should be unaffected in the event of
an introducing firm's failure. However, there have been cases where
customer funds were "lost" before they were sent to the clearing firm,
typically due to fraudulent activity. If the introducing firm fails
while the assets are still with the introducing firm but the clearing
firm continues to operate, investors may not be aware that the excess
SIPC protection would only apply in the event of the clearing firm's
failure. Conversely, SIPC will initiate liquidation proceedings against
introducing firms and protect their investors in certain situations.
Three of the Four Major Insurers Identified Stopped Underwriting Excess
SIPC Policies in 2003:
During our review, three of the four major insurers that offered excess
SIPC coverage in 2002 stopped underwriting these policies beyond 2003.
The insurers provided various reasons for not continuing to underwrite
excess SIPC policies, such as their concern about the complexity of
quantifying their maximum probable loss. In addition, officials from
securities firms and attorneys knowledgeable about excess SIPC had
opinions about why the insurers are no longer underwriting excess SIPC
policies.
According to the insurers that have stopped offering excess SIPC, they
made a business decision to stop offering the coverage after reviewing
their existing product offerings. They said that this practice of
periodically reviewing product lines and profitability is not uncommon.
Most of the underwriters were property and casualty insurance
companies, and the excess SIPC product was viewed as a relatively small
part of their standard product line and provided low return in the form
of premiums relative to the significant potential risk exposure. Some
of the underwriters said that documenting and explaining the potential
risk associated with excess SIPC policies is difficult. For example,
the maximum potential loss for excess SIPC could be significant because
it is simply the aggregate of all customer account balances over SIPC's
$500,000 limit. Quantifying the probability of loss, which would be
significantly less, is much more difficult because insurers have never
had a claims-related loss associated with the excess SIPC policies;
therefore, no historical loss data exists.
Another insurer said credit rating agencies began to ask questions
about potential risk exposures from excess SIPC; and rather than risk a
change to its credit rating, it opted to stop providing the coverage
given the limited number of policies it underwrote.[Footnote 25] Others
in the industry said that in light of the Enron Corporation failure and
the losses experienced by the insurance underwriters that had exposure
from Enron-related surety bonds, credit rating agencies have begun to
more closely scrutinize potential losses and risk exposures of
insurance companies overall. While surety bonds are still considered
relatively low-risk products, insurers are more sensitive to their
potential risk exposures. As mentioned, given the absence of actuarial
data it is difficult for insurers to quantify the maximum probable
losses from excess SIPC.
Securities firms and others also had opinions about why insurers
stopped underwriting the policies. Some believed that a general lack of
knowledge about the securities industry and SIPC, in particular, might
have contributed to the products being withdrawn from the market. Many
firms said that the risk of an excess SIPC claim ever being filed is
low for two primary reasons. First, securities firms that carry
customer accounts are required to adhere to certain customer protection
rules. Specifically, firms must keep customer cash and securities
separate from those of the firm itself and maintain sufficient liquid
assets to protect customer interests if the firm ceases doing business.
Moreover, SEC and the SROs have established inspection schedules and
procedures to routinely monitor broker-dealer compliance with customer
protection (segregation of assets) and net capital rules. Firms not in
compliance can be closed.
Second, SIPA liquidations are rare in general and claims in excess of
the SIPA limit are even more rare. For example, since 1998, more than
4,000 firms have gone out of business, but less than 1 percent or 37
firms became part of a SIPA liquidation proceeding. This is consistent
with historical data dating back to the 1970s. Moreover, since 1971 of
the almost 623,000 claims satisfied in completed or substantially
completed cases as of December 31, 2002, a total of 310 were for values
in excess of SIPC limits (less than one-tenth of 1 percent). Of these
310 claims, 210 were filed before 1978 when the limit was raised to
$500,000. Only two firms involved in a SIPA liquidation have offered
excess SIPC, but no claims have been filed to date. According to
officials knowledgeable about a 2001 proceeding, which included a firm
with an excess SIPC policy, claims for excess SIPC are likely to be
filed. However, the amount of claims to be filed are unclear at this
time.
Securities Firms Are Exploring a Variety of Options:
Most of the six holders of the excess SIPC policies we contacted are
currently exploring a number of options; but at this time, it is
unclear what most will do. Although most said that the coverage is
largely a marketing tool, some felt that the policies increased
investor confidence in the firm because an independent third party (the
insurance company) had examined the financial and operational risks of
the firm prior to providing them coverage. Several of the firms and
those in the securities industry we contacted said that they were
surprised to learn that the insurers planned to stop providing excess
SIPC coverage. Therefore, most firms are still exploring a number of
options on how best to proceed, including:
* Self-insuring or creating a "captive" insurance company that would
offer the coverage.[Footnote 26] However, firm officials involved in
exploring the captive expressed concerns about whether they could
establish the insurance company by the end of 2003. Others questioned
whether this option was feasible given the competitive nature of the
securities industry.
* Purchasing policies from the remaining major insurer. While some have
already chosen this option, officials from some of the larger firms
said that this might not be an acceptable option because the remaining
insurer generally limits the amount of the coverage per firm. Firms
that currently offer net equity coverage were concerned that their high
net worth customers may not be satisfied with a policy that has a cap
on its coverage. Additionally, the policy of the remaining underwriter
raised the most questions about its consistency with SIPC coverage.
* Letting the policies expire and not replacing them. Some of the firms
we spoke with said that the larger firms really do not need the excess
SIPC because they are well capitalized and the existing customer
protection rules offer sufficient protection. However, some officials
said that if one larger firm continued to offer the coverage, they all
would have to continue to offer the coverage in order to effectively
compete for high, net worth client business. Other firm officials
suggested that SIPA might need to be reexamined in light of the
numerous changes that have occurred in securities markets since 1970.
Some officials said that at a minimum, the SIPA securities limit of
$500,000 should be raised to $1.5 million. Another said that it is
still possible that another insurance company may decide to fill the
void left by the companies exiting the business. Other industry
officials said that they were still in negotiations with the remaining
insurer to increase the coverage limits, which was a concern for the
larger firms.
Many of the securities firms we spoke with had policies that will
expire by the end of 2003. All planned to notify affected customers,
but many had not developed specific time frames. Most firms said that
they planned to have some type of comparable coverage, which could
mitigate the importance of notifying customers. In the interim, several
securities firms have asked SIA to produce information for the firms to
use when talking to their customers about SIPA and the protections they
have under the act. The information being developed for the securities
firms is to also include information about SIPC, excess SIPC, and how
securities markets work. As mentioned previously, NYSE officials said
that there is no specific rule that requires securities firms to notify
investors if the SIPC coverage expires without being replaced. However,
they generally expect firms to notify customers under rules concerning
fee disclosure requirements. Likewise, NASD officials said that it had
no specific rule requirements but would generally expect firms to
notify affected investors under general rules concerning just and
equitable principles.
In March 2003, in response to concerns raised about excess SIPC
coverage and the potential investor protection issues, SEC began its
own limited review of these issues. Initially, SEC planned to collect
information on the securities firms that offer the coverage, the major
providers, and the nature of the coverage offered. Because most of the
firms that have excess SIPC coverage are NYSE members, SEC asked NYSE
to gather information about excess SIPC coverage and information about
the policies. In response, NYSE compiled information on its members
with excess SIPC insurance policies and their insurers. NYSE also
analyzed other data and descriptive statistics such as assets protected
under excess SIPC. NYSE also reviewed the coverage offered by the major
insurers. Out of more than 250 NYSE members, they determined that 123
had excess SIPC insurance coverage and that most of the members were
insured by one of the four major insurance providers. However, when
several underwriters decided to stop providing the coverage, SEC
suspended most of its review activity and has not actively monitored
the changes in the availability of the coverage or the firms' plans
going forward. Given the changes occurring in this market and the
potential concerns about the policies, SEC officials agreed that they
should continue to monitor these ongoing developments to ensure that
investors are obtaining adequate and accurate information about whether
excess SIPC coverage exists and what protection it provides.
Conclusions:
SEC and SIPC have taken steps to implement all of the recommendations
made in our May 2001 report. However, SEC has some additional work to
do with the SROs to implement two of our recommendations. Although SEC
has asked the SROs to explore actions to encourage broader
dissemination of the SIPC brochure to customers and to include
information on periodic statements or trade confirmations to inform
investors that they should document any unauthorized trading
complaints, no final actions have been taken to implement these
recommendations.
We also found that SIPC has substantially revamped its brochure and Web
site and continues to be committed to improving its investor education
program to ensure that investors have access to information about
investing and the role and function of SIPC. By doing so, SIPC has
shown a commitment to making its operations more transparent. We did
note, however, that SIPC's response to our recommendation about warning
customers about unintentionally ratifying unauthorized trades, has not
completely addressed our concern that investors have specific
information about the risks of unintentionally ratifying trades when
talking to brokers. In 2001, we recommended that SIPC revise its
brochure to warn investors to exercise caution in discussions with firm
officials. Rather than including this information in its brochure, SIPC
revised its brochure to provide references or links to Web sites, such
as SEC and NASD, but not to the specific investor education oriented
Web pages discussing ratifying potentially unauthorized trades or
fraud. We found that these broad references make it difficult or
virtually impossible for investors to find the relevant information.
More specific links to investor education Web pages within each Web
site would mitigate this problem.
Concerning excess coverage, three of the four major insurance companies
stopped underwriting excess SIPC policies in 2003 after reevaluating
their potential risk exposures and product offerings. Although an
excess SIPC claim has never been filed to date, insurance companies
have become more sensitive to potential risk exposures in light of
their recent experience with Enron and other high profile failures.
Most made business decisions to stop offering this apparently low-risk
product. Many of the firms appear to have been surprised by this
decision and are exploring several options, including letting the
coverage expire, purchasing coverage from the remaining underwriter, or
creating a captive insurance company to provide the coverage. Given the
limitations and concerns we and others have raised about the protection
afforded investors under excess SIPC, including limitations on scope
and terms of coverage and an overall lack of information on the claims
process and when claims would be paid, SEC and the SROs have vital
roles to play in ensuring that existing and future disclosures
concerning excess SIPC accurately reflect the level of protection
afforded customers.
Recommendations:
As SIPC continues to revamp and refine its investor education program,
we recommend that the Chairman, SIPC, revise SIPC's brochure to provide
links to specific pages on the relevant Web sites to help investors
access information about avoiding ratifying potentially unauthorized
trades in discussions with firm officials and other potentially useful
information about investing.
Given the concerns that we and others have raised about excess SIPC
coverage, we also recommend that the Chairman SEC, in conjunction with
the SROs, ensure that firms are providing investors with meaningful
disclosures about the protections provided by any new or existing
excess SIPC policies. Furthermore, we recommend that SEC and the SROs
monitor how firms inform customers of any changes in or loss of excess
SIPC protection to ensure that investors are informed of any changes in
their coverage.
Agency Comments:
SEC and SIPC generally agreed with our report findings and
recommendations. However, SIPC said that providing more specific
linkages in its brochure would prove problematic because of the
frequency in which Web sites are changed. Rather, they agreed to
provide a reference in the brochure to the SIPC Web site, which will
provide more specific links to the relevant portions of the sited web
pages. We agree that this alternative approach would implement the
intent of our recommendation to provide investors with more specific
guidance about fraud and unauthorized trading.
SEC agreed that securities firms have an obligation to ensure that
investors are provided accurate information about the extent of the
protection afforded by excess SIPC policies and that the policies
should be drafted to ensure consistency with SIPC protection as
advertised. SEC officials reaffirmed their commitment to work with the
SROs to ensure that excess SIPC as advertised, is consistent with the
policies. Moreover, SEC agreed that investors should be properly
notified of any changes in the coverage. Finally, SEC reiterates the
recommendations it made to SIPC in its 2003 examination report, which
as SEC describes are "important to enhance the SIPA liquidation process
for the benefit of public investors.":
Objectives, Scope, and Methodology:
Our objectives were to (1) discuss the status of the recommendations
that we made to SEC in our 2001 report, (2) discuss the status of the
recommendations that we made to SIPC in our 2001 report, and (3)
discuss the issues surrounding excess SIPC coverage. Finally, SEC
reiterates the recommendations made to SIPC in its 2003 examination
report, which the letter describes as "important to enhance the SIPA
liquidation process for the benefit of public investors.":
To meet the first two objectives, we interviewed staff from SEC's
Market Regulation, OGC, OCIE, and the Division of Enforcement as well
as SIPC officials to determine the status of the recommendations that
we made in our 2001 report. We also reviewed a variety of SEC and SIPC
informational sources, such as SIPC's brochure and SEC's and SIPC's Web
sites, to determine what SEC and SIPC disclosed to investors regarding
SIPC's policies and practices. We also reviewed the Web sites of the
sources provided by SIPC, such as SIA, NASD, the National Fraud
Information Center, Investor Protection Trust, Alliance for Investor
Education, and the North American Securities Administrators
Association.
To address the third objective--to discuss the issues surrounding
excess SIPC coverage--we interviewed agency officials, regulators,
SROs, and trade associations to determine what role, if any, they play
in monitoring excess SIPC. We also interviewed representatives or
brokers of the four major underwriters of excess SIPC policies to
obtain information about the coverage, their claim history, and their
rationale for discontinuing the excess SIPC product. In addition, we
interviewed six securities firms that had excess SIPC policies to (1)
obtain their views on the scope of coverage, (2) determine what they
were told about the excess SIPC product being withdrawn, and (3) to
identify what they planned to do about replacing the coverage going
forward. We also interviewed two SIPC trustees who had liquidated firms
that had excess SIPC policies to obtain their views and opinions about
the coverage. We also met with attorneys knowledgeable about SIPC and
excess SIPC policies and coverage to obtain their views and
perspectives on excess SIPC issues. Moreover, we also reviewed sample
policies from the four major excess SIPC providers to determine the
differences and similarities among the policies as well as their
consistency with SIPC's coverage. We also reviewed a random sample of
clearing and introducing firms' Web sites to determine if they
advertised excess SIPC protection on their Web sites and the nature of
the protection.
We conducted our work in New York, NY, and Washington, D.C., from
October 2002 through July 2003 in accordance with generally accepted
government auditing standards.
As agreed with your office, we plan no further distribution of this
report until 30 days from its issuance date unless you publicly release
its contents sooner. At that time, we will send copies of this report
to the Chairman, House Committee on Energy and Commerce; the Chairman,
House Committee on Financial Services; and the Chairman, Subcommittee
on Capital Markets, Insurance and Government Sponsored Enterprises,
House Committee on Financial Services. We will also send copies to the
Chairman of SEC and the Chairman of SIPC and will make copies available
to others upon request. In addition, the report will be available at no
charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questons about this report, please
contact Orice Williams or me at (202) 512-8678. Other GAO contacts and
staff acknowledgments are listed in appendix III.
Richard Hillman, Director Financial Markets and Community Investment:
Signed by Richard Hillman:
[End of section]
Appendixes:
Appendix I: Comments from the U.S. Securities and Exchange Commission:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549:
DIVISION OF MARKET REGULATION:
July 8, 2003:
Mr. Richard Hillman:
Director, Financial Markets and Community Investment
General Accounting Office Washington, DC 20548:
Dear Mr. Hillman:
Thank you for the opportunity to comment on the General Accounting
Office's ("GAO") draft report entitled Update to Matters Related to the
Securities Investor Protection Corporation (the "Report").
The Report assesses, among other things, the progress of the Securities
and Exchange Commission (the "Commission") in implementing the seven
recommendations that the GAO made in its report entitled Securities
Investor Protection: Steps Needed to Better Disclose SIPC Policies to
Investors, dated May 2001 (the "May 2001 Report"). Those
recommendations related to changes in the Commission's oversight of the
Securities Investor Protection Corporation ("SIPC") in an effort to aid
investor protection.
The Commission staff shares the Report's conclusion that it must
continue to work with self-regulatory organizations ("SROs") on two of
the May 2001 Report's recommendations. Specifically, the Commission
staff will continue to work with the SROs on the GAO's recommendation
that broker-dealers disseminate to new customers SIPC's brochure on the
scope of coverage of the Securities Investor Protection Act of 1970
("SIPA"). Likewise, we will continue to work with SROs to help ensure
that broker-dealers include information in customer statements or trade
confirmations recommending that customers document any complaint of
unauthorized trading in writing.
The Report also examines excess SIPC coverage that some broker-dealers
purchase from private insurers. According to the GAO, three of the four
major insurers who provide excess SIPC coverage to broker-dealers will
not renew existing policies, and will not write new policies, after
2003. The GAO recommends that the Commission and the SROs monitor how
firms inform customers about any changes in, or loss of, excess SIPC
coverage. Furthermore, the GAO recommends that the Commission, in
conjunction with the SROs, help ensure that firms provide investors
with meaningful disclosure about protection that any existing or new
excess SIPC policies provide. As the Commission
staff previously agreed, it will continue to monitor ongoing
developments related to excess SIPC coverage policies to help ensure
that investors obtain adequate and accurate information about whether
such coverage will continue and the scope of coverage available under
any policies provided.
The Report also summarizes Commission staff s findings and
recommendations from a recent inspection of SIPC. In our inspection
report, Commission staff recommended, among other issues, that SIPC
improve its controls for reviewing and assessing fee requests by
trustees and counsel administering SIPA liquidations to ensure that
fees paid to trustees and counsel are reasonable. Commission staff also
recommended that SIPC, to promote consistency in claim determinations
in different liquidations, develop written guidance to help trustees
and SIPC personnel determine whether claimants have established valid
unauthorized trading claims. In addition, we recommended that SIPC
continue to review its publicly-disseminated information describing
SIPC to ensure that investors are not confused about the extent of SIPC
coverage. We believe these recommendations are important to enhance the
SIPA liquidation process for the benefit of public investors.
Thank you again for this opportunity to provide comments to the GAO as
it prepares its final draft of the Report.
Annette L. Nazareth
Director:
Signed by Annette L. Nazareth:
[End of section]
Appendix II Comments from the Securities Investor Protection
Corporation:
SECURITIES INVESTOR PROTECTION CORPORATION 805 FIFTEENTH STREET, N. W.,
SUITE 800 WASHINGTON, D. C. 20005-2215 (202) 371-8300 FAX (202) 371-6728
WWW.SIPC.ORG:
June 27, 2003:
HAND DELIVER:
Ms. Orice Williams
Assistant Director
Financial Markets and Community Investment
United States General Accounting Office 441 G Street, N. W.
Washington, D.C. 20548:
Dear Ms. Williams:
This letter is in response to the draft report entitled "Securities
Investor Protection: Update on Matters Related to the Securities
Investor Protection Corporation." (GAO-03-811).
We appreciate your acknowledgment (report page 33) "that SIPC has
substantially revamped and continues to be committed to improving its
investor education program to ensure that investors have access to
information about investing and the role and function of SIPC."[NOTE 1]
Likewise, you have recognized that "SIPC has shown a commitment to
making its operations more transparent." You have recommended that SIPC
revise its "brochure to provide links to specific pages on the relevant
Web sites to help investors access information about avoiding ratifying
potentially unauthorized trades in discussions with firm officials and
other potentially useful information about investing." Report page 34.
We believe that revising our brochure to add such links would result in
tens ofthousands of copies ofthe brochure becoming obsolete as the
various specific web pages are changed, a factor SIPC cannot control.
We believe that the
goals of your recommendation can be achieved by adding more specific
links to SIPC's web site so as to make it easier for customers to find
discussions concerning unauthorized trades or other investment fraud.
At the same time we will modify the brochure to tell customers that
they can utilize our web site to find specific discussions of
investment fraud. SIPC will then be in a position to periodically
review the links to specific pages, and update our web site
accordingly.
Very Truly Yours,
Michael E. Don President:
Signed by Michael E. Don
MED:ved:
NOTES:
[1] SIPC will not comment on those portions ofthe report that deal
with the Securities and Exchange Commission or what is referred to as
"excess SIPC insurance.":
[End of section]
Appendix III: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Richard J. Hillman (202) 512-8678 Orice M. Williams (202) 512-8678:
Acknowledgments:
In addition to those individuals named above, Amy Bevan, Emily
Chalmers, Carl Ramirez, La Sonya Roberts, and Paul Thompson made key
contributions to this report.
(250105):
FOOTNOTES
[1] U.S. General Accounting Office, Securities Investor Protection:
Steps Needed to Better Disclose SIPC Policies to Investors, GAO-01-653
(Washington, D.C.: May 25, 2001).
[2] Unauthorized trading occurs when a firm buys or sells securities
for a customer's accounts without the customer's approval.
[3] Most registered firms automatically become members of SIPC.
However, affiliates (firms that are formally tied within the same
financial holding company) of securities firms are not required to
become members of SIPC.
[4] SROs have an extensive role in regulating the U.S. securities
markets, including ensuring that members comply with federal securities
laws and SRO rules. SROs include all the registered U.S. securities
exchanges and clearing houses, the NASD (formerly known as National
Association of Securities Dealers) and the New York Stock Exchange
(NYSE).
[5] To evaluate and measure the impact of losses to a firm, maximum
potential loss and maximum probable loss must be determined. The
maximum potential loss, which is the absolute maximum dollar amount of
loss, could be significant because it is simply the aggregate of all
customer account balances over SIPC's $500,000 limit. Conversely, the
maximum probable loss is the likely dollar loss if a firm were to
become part of a SIPC liquidation proceeding. This type of calculation
is usually based on historical loss data for the particular event, but
unlike most other insurance products, actuaries have no historical loss
data for excess SIPC products because no claims-related losses have
been incurred.
[6] SIPA authorizes an alternative to liquidation under certain
circumstances when all customer claims aggregate to less than $250,000.
[7] Under SIPA, the filing date is the date on which SIPC files an
application for a protective decree with a federal district court,
except that the filing date can be an earlier date under certain
circumstances, such as the date on which a Title 11 bankruptcy petition
was filed.
[8] A unit investment trust is an SEC-registered investment company,
which purchases a fixed, unmanaged portfolio of income-producing
securities and then sells shares in the trust to investors.
[9] An annuity is a contract that offers tax-deferred accumulation of
earnings and various distribution options. A variable annuity has a
variety of investment options available to the owner of the annuity,
and the rate of return the annuity earns depends on the performance of
the investments chosen.
[10] Typically, bank certificates of deposit are not securities under
the Securities Exchange Act of 1934; however, they are defined as
securities in SIPA.
[11] The SIPC board decided the fund balance should be raised to $1
billion to meet the long-term financial demands of a very large
liquidation. The SIPC balance reached $1 billion in 1996.
[12] 15 U.S.C. 78ddd(c)(2). The assessments shall be a percentage of
each member's gross revenues if (1) the fund is below a level that the
Commission determines is in the public interest; (2) SIPC is obligated
on any outstanding borrowings; or (3) SIPC is required to phase out the
lines of credit it has established. Otherwise, SIPC shall impose an
annual assessment. 15 U.S.C. 78ddd(d)(1).
[13] 15 U.S.C. 78ddd(d)(1)(C). "The minimum assessment imposed upon
each member of SIPC shall be $25 per annum through the year ending
December 31, 1979, and thereafter shall be the amount from time to time
set by SIPC bylaw, but in no event shall the minimum assessment be
greater than $150 per annum." Id.
[14] A proposed rule change becomes effective 30 days after it is filed
with SEC, unless the period is extended by SIPC or SEC takes certain
actions. A proposed rule change may take effect immediately if it is a
type that SEC determines by rule does not require SEC approval.
[15] Travelers Bond is now Travelers Property Casualty Corp.
[16] Clearing firms clear customer transactions and hold customer cash
and securities.
[17] These PSAs may also be viewed at www.sipc.org/streaming.html.
[18] Firms are required to mention their SIPC membership in
advertisements, but are not required to use one of the explanatory
statements provided by SIPC.
[19] SIA is a trade group that represents broker-dealers of taxable
securities. SIA lobbies for its members' interests in Congress and
before SEC and educates its members and the public about the securities
industry.
[20] In general terms, a surety bond represents a contract in which one
party to the contract, the "surety," is obligated to pay third parties
if the other party to the contract fails to perform a duty owed to the
third parties. See REST 3d ~ 1.
[21] According to one insurer, while no claims have been filed, certain
attorney fees and a very small number of settlements have been paid to
a few investors.
[22] Two of the policies specified that it was the broker-dealer's
"responsibility" to notify its customers of discontinuance of the
coverage, but neither the insurer nor the firm was obligated to make
this disclosure.
[23] A similar policy contained a rider specifying coverage for lost
cash in excess of the $100,000 SIPA cap.
[24] See Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 434,
32 L. Ed. 2d 195, 92 S. Ct. 1678 (1972) (Bankruptcy trustee did not
have standing to assert debenture holders' claims of misconduct against
respondent indenture trustee where the cause of action belonged solely
to the debenture holders and not to the bankruptcy estate.)
[25] Credit ratings produced by credit rating agencies are widely
circulated; many investors rely on these ratings to make investment
decisions. These ratings include opinions about the creditworthiness of
certain public companies and their financial obligations, including
bonds, preferred stock, and commercial paper. The credit ratings that
result from analyses of this information can affect securities markets
in a number of important ways, including an issuer's access to and cost
of capital, the structure of financial transactions, and the ability of
certain entities to invest in certain rated obligations.
[26] A captive insurance company is a type of self-insurance whereby a
insurance company insures all or part of the risks of its parent. This
company is created when a business or group of businesses form a
corporation to insure or reinsure their own risk.
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