What to do if your broker fails

(Money Magazine) - As the credit crisis spreads throughout the financial sector, brokerages are suffering their own version of Chinese water torture.

Lehman Brothers filed for bankruptcy protection Monday after making bad mortgage-related bets. Bear Stearns was forced into the arms of rival J.P. Morgan Chase ( JPM, Fortune 500) earlier this year for much the same reason.

It's only natural that you'd start to wonder what would happen if your brokerage failed.

Last November, after a Wall Street analyst issued a negative report on E-Trade ( ETFC), the online broker's customers reacted by yanking a reported $2.5 billion in assets in a single day.

Some clients apparently weren't aware that brokerages adhere to the dry cleaner's code: That is, they handle your investments, but they don't borrow or use them for their own purposes. Nor did they realize that even if a broker shuts down, there's a safety net for your assets (well, most of them).

Catherine Hetrick, editor of InvesTech Portfolio Strategy, says when there's another bad headline about a broker, her newsletter gets calls from worried subscribers asking if their investments are safe.

"We all know what kind of protection banks provide," Hetrick says. "But brokerages are a completely different animal. It's nothing like FDIC insurance."

SIPC vs. FDIC

You probably know that the Federal Deposit Insurance Corporation covers up to $100,000 of your bank deposits per account. Up to $500,000 of your brokerage assets are also protected, but by a different entity: the Securities Investor Protection Corporation.

Unlike FDIC, which is a government agency, SIPC is a private nonprofit funded by member firms. And currently SIPC has only $1.5 billion in assets vs. $45 billion for FDIC. Seems like this wouldn't go very far if the holdings of a couple of big brokerages just up and disappeared.

But there's a good reason SIPC's coffers aren't that big: They don't have to be. Brokers function differently from banks. Banks are in the business of investing your deposits - lending out your savings to other customers, who might renege on those loans. Brokerages, on the other hand, aren't supposed to do anything with your securities other than hold them.

In fact, when you buy stocks or bonds, the broker must keep them segregated from its own. The same goes for the funds you've stuffed into your IRA. So even if your firm goes under because of, say, an ill-fated bet on frozen concentrated orange juice, your securities should still be there (though you may not be able to access them immediately).

"The vast majority of assets are recovered without our funds," says SIPC president Steve Harbeck.

Broker failures are rare

Truth is, despite all the bad news in this economy, few brokers have collapsed. Between the end of 2006 and mid-August, only two firms - a small outfit in Orlando and another in Madisonville, La. - have gone belly up. And in the case of the Louisiana firm, it was fraud: A principal misused customer funds, leading to as much as $2 million in losses, according to regulators.

Here's some more reassuring news: In its entire 38-year history, SIPC has had to spend only $508 million to recover customer assets. And just 349 customers total have failed to get their entire portfolios back. "It's increasingly rare for anyone to lose money," says Harbeck.

As for the major brokers you've read about in the headlines recently, like Bear Stearns, they made some horrible investments with their own cash, but client assets were never at risk.

How the system works

What would happen if your brokerage defied the odds and went out of business?

If there's no fraud involved - for instance, if it's just a case of the business going sour - SIPC might not even need to get involved. The broker itself might simply transfer your holdings to another firm, where you'd then have access to them.

If it is a case of fraud or if accounts are amiss because of bad record keeping, SIPC would help coordinate the transfer of your remaining assets (most transfers take one to three months). It would also be responsible for replacing missing securities.

When a broker fails, a court-appointed trustee will contact you to let you know how and when to file a claim. Even if you get a notice that your assets have been transferred to another broker, you should still file a claim.

That's just in case there's a problem during the transfer or there's a discrepancy in the records of what you held at the brokerage. And be sure to use registered mail with a return receipt, just in case any errors are made.

Here's a quick rundown of what else you should know:

What SIPC covers

• Stocks, bonds and funds SIPC will replace up to $500,000 of equities, fixed-income securities and funds for each account. If you held separate accounts at two different brokerages, each totaling $500,000, you'd be fully covered for both (though it would be unlikely that both of your brokers would fail).

• Cash Included in the $500,000 cap is coverage for up to $100,000 in cash. Note, however, that SIPC doesn't consider money-market mutual funds to be cash. They're treated like any other funds, so they would fall under the larger $500,000 limit. Brokered CDs are a special case. If your CDs have gone missing - for instance because of broker fraud - then SIPC would be responsible for replacing your holdings. But if you lost money on the CD because the bank behind it failed, it would be FDIC's responsibility to make you whole.

What SIPC doesn't cover

• Some alternative assets With a few exceptions, SIPC limits coverage to SEC-registered securities. So foreign currency, precious metals and commodity futures contracts aren't protected.

• Bad timing SIPC will replace your shares, not dollar values. So if you own 100 shares of Microsoft worth $3,000 and your broker runs off with them, SIPC will replace your 100 shares - even if they're worth only half as much now because of market gyrations.

• Some outstanding margin loans If your broker fails while you have a margin loan outstanding, SIPC will try to transfer the debt and collateral to another broker. But if no other firm takes on the loan, you'll be on the hook to pay it off to your broker or ultimately to its creditors.

What you need to do

• Check if your broker is an SIPC member Nearly all brokerages are. If yours isn't, consider moving to a more established firm. Also, if you invest through advisers, make sure they're working with SIPC members too. To verify, look for "Member SIPC" at the bottom of the broker's Web site or call SIPC at 202-371-8300.

• Look for excess SIPC coverage If you open a big account, make sure your broker has excess SIPC coverage. Many brokerages buy this insurance to cover stocks and bonds in excess of the $500,000 limit. Your broker or its Web site should be able to tell you if it carries the extra coverage. But remember: This excess insurance covers only those classes of assets SIPC does.

• Maintain good paperwork Check your statement every month to make sure it's accurate, and report any discrepancies in writing. If your brokerage goes bankrupt, SIPC will rely on the broker's records to replace your shares. That means the burden of proof will be on you if you think records are wrong.

Article courtesy of CNNMoney.com