Report to the Ranking Minority

Member, Energy and Commerce

Committee, House of Representatives

United States General Accounting Office

GAO

May 2001 SECURITIES

INVESTOR

PROTECTION

Steps Needed to

Better Disclose SIPC

Policies to Investors

GAO-01-653
Page i GAO-01-653 Securities Investor Protection

Letter 1

Executive Summary 3

Chapter 1 Introduction 14

SIPC’s Mission, Organization, Funding, and Oversight 15

SIPC Protection Versus Federal Deposit Insurance 17

How SIPC Liquidates a Member Firm and Protects Its Customers 18

SIPC Liquidation Proceedings Are Relatively Infrequent 21

Objectives, Scope, and Methodology 22

Chapter 2 Opportunities Exist to Improve the Disclosure of

SIPC’s Policies in Liquidations Involving

Unauthorized Trading 25

Unauthorized Trading Liquidations Accounted for Nearly TwoThirds of Liquidations Initiated From 1996 Through 2000 25

The Establishment of an Evidentiary Standard Is Authorized Under

SIPA 28

Bankruptcy Court Rejected the Stratton Oakmont Trustee’s

Procedure for Satisfying Certain Approved Unauthorized

Trading Claims 31

SIPC and SEC Have Missed Opportunities to Disclose Information

About the Evidentiary Standard to Investors 32

Conclusions 38

Recommendations 39

Agency Comments and Our Evaluation 40

Chapter 3 Disclosure of SIPC Policies in Liquidations

Involving Nonmember Affiliates Could Be

Improved 43

SIPC and Trustees Denied Nonmember Affiliates Claims on Several

Grounds 43

The Trustee and SIPC Concluded in the Most Recent Liquidation

That Customers of the Nonmember Affiliate Were Customers of

the SIPC Member 48

Information Available to Investors About Avoiding Risks That Can

Be Associated With Nonmember Affiliates Is Limited 49

Conclusions 50

Contents
Page ii GAO-01-653 Securities Investor Protection

Recommendations 52

Agency Comments and Our Evaluation 52

Chapter 4 Despite Positive Initiatives, SEC’s SIPC Oversight

Program Faces Some Challenges 53

SEC’s SIPC Oversight Examination Program Has Some Limitations 53

SEC Has Not Implemented SEC IG Recommendation on Sharing

Information About SIPC Issues 57

SEC OGC Has Established a Pilot Program to Monitor Ongoing

SIPC Liquidations 58

Conclusions 58

Recommendations 59

Agency Comments and Our Evaluation 59

Chapter 5 Investors May Confuse SIPC With Other Financial

Guarantee Programs as U.S. Financial Industries

Restructure 60

Some Investors May Confuse SIPC and State Insurance Guarantee

Associations With FDIC 60

Investor Confusion May Increase as Financial Services Industy

Consolidate 67

Conclusions 69

Recommendation 69

Agency Comments and Our Evaluation 69

Appendix I Comments From the Securities Investor Protection

Corporation 72

Appendix II Comments From the Securities and Exchange

Commission 83

Appendix III GAO Contacts and Acknowledgments 89
Page iii GAO-01-653 Securities Investor Protection

Tables

Table 1: Selected SIPC Liquidations Involving Nonmember

Affiliates. 45

Table 2: Protections and Disclosure Rules of SIPC, FDIC, and State

Life/Health Insurance Guarantee Associations 62

Figures

Figure 1: Sample Back Page of Confirmation Statement 37

Figure 2: Official Symbols of SIPC and FDIC 65

Abbreviations

FDIC Federal Deposit Insurance Corporation

GLBA Gramm-Leach-Bliley Act of 1999

IG Inspector General

NERO Northeast Regional Office

NYSE New York Stock Exchange

OCIE Office of Compliance Inspections and Examinations

OGC Office of General Counsel

SEC Securities and Exchange Commission

SIPA Securities Investor Protection Act of 1970

SIPC Securities Investor Protection Corporation

SRO Self-Regulatory Organization
Page 1 GAO-01-653 Securities Investor Protection

May 25, 2001

The Honorable John D. Dingell

Ranking Minority Member

Committee on Energy and Commerce

House of Representatives

Dear Mr. Dingell:

This report responds to your November 16, 1999, and April 13, 2000,

requests that we assess the operations of the Securities Investor

Protection Corporation (SIPC), which was established by the Securities

Investor Protection Act of 1970. As you requested, this report discusses

(1) the basis for SIPC policies involving unauthorized trading and the

extent that these policies are disclosed to investors; (2) the basis for SIPC

policies involving the affiliates of SIPC member firms and the extent that

these policies are disclosed to investors; (3) the Securities and Exchange

Commission’s (SEC) oversight of SIPC; and (4) the disclosure rules for

SIPC, the Federal Deposit Insurance Corporation, and state insurance

guarantee associations, as well as the related implications for consumers

as the financial services industry consolidates. This report includes

recommendations to the Chairman, SIPC, and the Chairman, SEC,

regarding disclosure of SIPC policies and SEC’s SIPC oversight.

As we 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. We will then send copies of this report to Senator

Phil Gramm, Chairman, Senate Committee on Banking, Housing and

Urban Affairs; Senator Paul Sarbanes, Ranking Member, Senate

Committee on Banking, Housing and Urban Affairs; Representative

W.J. “Billy” Tauzin, Chairman, House Committee on Energy and

Commerce; Representative Michael G. Oxley, Chairman, House Committee

on Financial Services; Representative John J. LaFalce, Ranking Minority

Member, House Committee on Financial Services; Debbie Dudley Branson,

Acting Chairman, SIPC; Michael Don, President, SIPC; the Honorable

Laura Unger, Acting Chairman, SEC; Mr. Robert R. Glauber, President and

CEO, National Association of Securities Dealers; Richard Grasso,

Chairman and CEO, New York Stock Exchange; and other interested

committees and organizations. Copies will be made available to others

upon request.

United States General Accounting Office

Washington, DC 20548
Page 2 GAO-01-653 Securities Investor Protection

Major contributors to this report are acknowledged in appendix III. If you

or your staff have any questions, please call me or Orice M. Williams at

(202) 512-8678.

Sincerely yours,

Richard J. Hillman

Director, Financial Markets

 and Community Investment
Executive Summary

Page 3 GAO-01-653 Securities Investor Protection

The Securities Investor Protection Act of 1970 (SIPA) created the

Securities Investor Protection Corporation (SIPC) to provide certain

protections against losses to customers from the failure of a securities

firm. However, the large number of claims denied in several recent SIPC

liquidation proceedings, has raised concerns that certain SIPC policies and

practices may unduly limit the actual protection afforded customers.

Critics assert that SIPC and court-appointed trustees, who carry out the

liquidation proceedings, interpret SIPA so rigidly that they act

inconsistently with, if not contrary to, the customer-protection purpose of

the act. SIPC’s handling of two types of claims has been most heavily

criticized. The first type involves claims of unauthorized trading, which is

the buying or selling of securities in an investor’s account without the

investor’s prior approval. The second type involves claims from investors

who were doing business with a nonmember affiliate but believed that

they were dealing with a SIPC-member firm and, therefore, covered by

SIPC.1

 These two types of claims were filed in 75 percent, or 28, of the 37

liquidation proceedings initiated by SIPC between 1996 and 2000.

The enactment of the Gramm-Leach-Bliley Act of 1999 (GLBA) eliminated

many legal barriers to affiliation among banks, securities firms, and

insurance companies, and other financial service providers. As the

financial services industry consolidates to provide one-stop shopping

mainly through affiliates, concerns have been raised about whether

consumers are adequately informed about the respective coverage

provided by SIPC, the Federal Deposit Insurance Corporation (FDIC), and

state insurance guarantee funds for various financial products. In light of

the concerns raised about SIPC’s implementation of SIPA and the

potential for increased investor confusion surrounding coverage, the

specific objectives of this report are to

• review the basis for SIPC’s policies and practices for validating and

satisfying claims involving unauthorized trading and the extent that these

policies were disclosed to investors;

• review the basis for SIPC’s policies and practices for determining claims in

liquidations of SIPC-member firms and their nonmember affiliates and the

extent that these policies were disclosed to investors;

• evaluate the Securities and Exchange Commission’s (SEC) oversight of

SIPC’s operations and compliance with SIPA; and

 1

Most registered securities firms automatically become members of SIPC. However,

affiliates of securities firms are not required to become members of SIPC.

Executive Summary
Executive Summary

Page 4 GAO-01-653 Securities Investor Protection

• compare the coverage provided by and disclosure rules for SIPC, FDIC,

and state insurance guarantee associations and the implications for

consumers as some banks, securities firms, and insurance companies

consolidate their operations.

GAO reviewed SIPA and its legislative history; reviewed legal briefs and

court decisions; and interviewed SIPC and SEC officials, SIPA trustees and

their attorneys, and claimants’ attorneys. GAO focused its review on

liquidations initiated between 1996 and 2000 involving introducing firms2

engaged in unauthorized trading and SIPC members with affiliates. GAO

also reviewed information relating to SEC’s oversight of SIPC and the

differences between SIPC and FDIC coverage and a summary of disclosure

policies typical of state insurance guarantee programs. A complete

discussion of GAO’s scope and methodology can be found in chapter 1.

SIPC’s policies and practices in liquidation proceedings involving certain

unauthorized trading claims have generated controversy because many

claims were denied or claimants received worthless securities instead of

cash.3

 Two practices are central to the controversy. The first practice

requires that claimants provide some form of objective evidence that they

complained about an unauthorized trade within a reasonable time after the

disputed trade. SIPC’s practice of requiring objective evidence, usually a

letter to the broker, is based on the authority that SIPA provides SIPC and

the trustees to establish standards to determine the validity of customer

claims. Although challenged by some claimants and critics as

unreasonable, courts have upheld this policy. The second practice involves

how SIPC and a trustee satisfied certain unauthorized trading claims.

Approved claims for substantial amounts of cash were satisfied with

worthless securities. Claimants have successfully challenged this practice

in a bankruptcy court, but the appeals process is ongoing.

SIPC and SEC, which plays an important role in investor education, have

not adequately disclosed to investors information about the policy on

 2

An introducing firm does not clear securities transactions or hold customer cash or

securities.

3

See “Many Holes Weaken Safety Net for Victims of Failed Brokerages,” The New York

Times, Sept. 25, 2000; “Group Assails Insurer of Investors,” The Washington Post, July 21,

1999; and “Many Unhappy Returns: Ex-Stratton customers still fighting to recoup $130m,”

Newsday, Dec. 20, 1998.

Results in Brief
Executive Summary

Page 5 GAO-01-653 Securities Investor Protection

providing objective evidence to prove unauthorized trading claims. For

example, SIPC’s informational brochure does not disclose information on

this policy to investors. For the claims we reviewed, investors seemed

unaware of the importance of documenting their complaints and were

more than twice as likely to telephone their broker to complain about an

unauthorized trade as to write a letter. GAO recommends that SIPC and

SEC take actions to better inform investors about this policy and the steps

investors can take to protect their interests.

SIPC’s position in liquidation proceedings involving SIPC members with

affiliates has also generated controversy because many claimants were

determined not to be customers of the failed member firm. SIPA

authorizes SIPC to liquidate only SIPC members. Therefore, only

customers of the member in liquidation are entitled to protection under

SIPA. In general, for a claim of a customer of the nonmember to be

approved, SIPC requires that the cash or securities involved has been

entrusted to the SIPC member firm.4 Several claimants, whose claims were

denied because SIPC and the trustee determined that they did not entrust

funds with the SIPC member firm, appealed the determination in Federal

Court. In 2000, a Federal Court of Appeals agreed, ruling that under the

circumstances of that case, a claimant’s reasonable belief that he or she

was dealing with the member can serve as the basis for a claim. However,

in other cases, courts have upheld SIPC’s position that a claimant’s belief

does not constitute evidence that funds in fact were entrusted to the

member. Although SIPC has been involved in several liquidation

proceedings involving nonmember affiliates since 1996, there is limited

information available to help investors avoid the potential risks associated

with the nonmember affiliates. GAO recommends that SIPC and SEC take

actions to increase the availability of this information.

SEC, which is responsible for oversight of SIPC, faces important

challenges in its oversight of SIPC. Since 1971, SEC has initiated only three

examinations. The first two examinations focused on the adequacy of the

SIPC fund and administrative issues. The scope of the most recent

examination initiated in May 2000 was expanded to include many of the

more controversial issues raised in this report. To date, SEC examiners

have focused on a limited number of liquidations involving unauthorized

trading and none of the liquidation proceedings involving the affiliate

 4

Claimants must also meet other requirements such as the products purchased must be

securities as defined by SIPA.
Executive Summary

Page 6 GAO-01-653 Securities Investor Protection

issue. SEC officials agreed and said that they would expand the number of

liquidations reviewed. In addition, in March 2000, SEC’s Inspector General

(IG) issued a report5 suggesting that SEC establish a formal mechanism to

share information about SIPC proceedings, but SEC has not implemented

the recommendation to date. A formal mechanism to share information

could enhance SEC’s ability to discuss staffs’ varying opinions on issues

relevant to SIPC and ensure a comprehensive oversight program. GAO

recommends that SEC expand its oversight of SIPC operations to include a

larger sample of proceedings involving unauthorized trading and

nonmember affiliates and establish a formal coordination mechanism to

share information about SIPC liquidation proceedings within SEC.

Consolidation in the financial services industry has raised concerns about

whether consumers are adequately informed about the respective

differences in coverage provided by SIPC; FDIC; and, to a lesser degree,

state insurance guarantee funds as more companies offer banking,

securities, and insurance products from a single location or through an

affiliated entity. Differences in the coverage largely stem from the

differences in the products offered and the nature of the relationship

between the financial institution (bank, securities firm, or insurance

company) and its customers. Many regulatory and securities industry

officials that GAO contacted said that consumers already confuse SIPC

with FDIC because of similarities in the amount of cash coverage and

misunderstandings about what that coverage entails. Without improved

investor education—especially that SIPC does not cover losses due to

changes in market prices—investor confusion is likely to increase as the

U.S. financial industry continues to consolidate and offer similar financial

products under a single corporate umbrella. GAO recommends that SIPC

improve the standard disclosure language it uses to describe its coverage.

By law, securities firms are to keep customer accounts separate from the

firms’ funds. For the firms that fail to do this and that are liquidated by

SIPC, SIPC’s statutory mission is to promptly replace missing cash and

securities in an investor’s account up to the statutory limits. Securities

firms registered with SEC automatically become members of SIPC and

must pay an annual assessment to the SIPC fund. The SIPC fund, valued at

$1.2 billion as of February 9, 2001, is used to replace the missing securities

 5

Oversight of Securities Investor Protection Corporation. Securities and Exchange

Commission Office of Inspector General. Audit Report No. 301. Mar. 31, 2000.

Background
Executive Summary

Page 7 GAO-01-653 Securities Investor Protection

and cash and to pay administrative costs of the liquidation proceeding.

However, SIPC does not protect against losses from declines in the market

value of securities.

In typical proceedings under SIPA, SEC or the Self-Regulatory

Organizations—such as the NASDR6

 and the New York Stock Exchange—

notify SIPC when a SIPC member firm is in financial trouble. Upon

receiving such information, SIPC may file a petition in a federal district

court to liquidate the firm.7

 The district court appoints a trustee at SIPC’s

recommendation. SIPC serves as the trustee in some cases. The liquidation

proceeding is then removed to a U.S. bankruptcy court. The trustee

notifies the firm’s customers of the liquidation proceeding. Typically, the

trustee tries to sell or otherwise transfer customer accounts to another

SIPC member. Customers must file claims to recover missing funds or

securities from the member in liquidation. The trustee and SIPC staffs

review submitted claims and related information and notify individuals

whether their claims are approved or denied. To the extent that the SIPC

member firm’s assets are insufficient, SIPC advances funds for the

payment of customer claims up to the statutory limits. Claimants may seek

review of the trustee’s decision on their claims by the bankruptcy court. If

the trustee’s fees and administrative expenses cannot be recovered from

the members’ assets, SIPC advances funds to cover them.

Pursuant to the authority provided under SIPA, SIPC and trustees

generally require claimants to provide objective evidence that they

complained within a reasonable time after the allegedly unauthorized

trade or their claims will be denied. However, SIPC and the trustees may

consider other forms of objective evidence, such as complaints to

regulators. SIPC and the trustees assert that objective evidence, such as

reliable and timely documentation showing a trade was unauthorized, is

necessary to ensure claim accuracy and to protect against fraudulent

claims. Although courts have upheld this policy, critics argue that the

standard is unreasonable and places an undue burden on claimants. For

 6

NASDR, Inc., is the regulatory arm the National Association of Securities Dealers.

7

In certain situations, SIPC may elect to use a direct payment procedure in lieu of

instituting a liquidation proceeding to pay customer claims.

Principal Findings

SIPC’s Policies and

Practices Involving

Unauthorized Trading

Need Additional

Disclosure
Executive Summary

Page 8 GAO-01-653 Securities Investor Protection

example, critics of the policy believe that it is unrealistic to expect

unsophisticated investors to complain about unauthorized trades in

writing within a specified period of time because securities orders and

related transactions routinely are conducted by telephone. Available

evidence lends support to the contention that investors are unaware of

SIPC’s practice. For example, GAO reviewed a random and representative

sample of 152 unauthorized trading claims from 2 of the larger liquidation

proceedings and found that about 87 percent of the claimants indicated

that they telephoned to complain about unauthorized trades compared

with 38 percent of the claimants who provided letters.

The second controversial practice in SIPC liquidations involving

unauthorized trading occurred in a case in which the trustee satisfied

certain claims for cash by unwinding all trades determined to be

unauthorized, including those not specified in the claims. As a

consequence of this process, the trustee treated the claims as claims for

securities. This practice resulted in some claimants receiving worthless

securities, rather than substantial amounts of cash for which they had filed

claims. In this case, claimants filed claims for cash that had been used to

make unauthorized purchases of securities. However, the trustee

determined that the securities had been purchased with proceeds from

prior unauthorized sales of securities. Therefore, SIPC and the trustee

determined that the claimants were entitled to the securities that were in

the account before the unauthorized sales, rather than the cash that was

received from the sales and placed in the account before the unauthorized

purchase. Claimants challenged the trustee’s practice, and a federal

bankruptcy court rejected the practice as not authorized by SIPA or any

other law. SIPC and the trustee maintained that SIPA requires the trustee’s

approach. The court determined that the claims for cash should be paid

because the statute does not authorize the trustee to consider trades not

disputed in a claim form and, therefore, treat a claim as if it were a claim

for securities. According to SIPC officials, SIPC and the trustee have filed

notices of appeal.

SIPC and SEC, which has an important role in investor education, have not

adequately disclosed information about the importance of documenting

unauthorized trading complaints. Although SIPC and SEC—through an

informational brochure and Web sites—provide much useful information,

they do not fully and consistently explain the need to complain in writing

about unauthorized trades within a reasonable time period of the

unauthorized trade. SEC’s Web site, for example, provided inconsistent

advice about when to telephone complaints and when to follow up in

writing. Limited disclosure may, in part, explain why many investors with
Executive Summary

Page 9 GAO-01-653 Securities Investor Protection

unauthorized trading complaints appear to have been unaware of the

importance of documenting their complaints about trades that were not

authorized in a timely manner.

Under SIPA, only customers of a SIPC member firm qualify for SIPA

protection and only securities defined in the act and determined to be in

the member’s custody are covered. In three SIPC liquidations involving

nonmember affiliates that GAO reviewed, trustees or SIPC denied claims

they determined were not covered by SIPA because one or more of these

requirements were not satisfied, as well as for other reasons. SIPC and the

trustees denied certain claims in these proceedings, for example, on the

grounds that persons who dealt with the affiliates were not customers of

the SIPC member firms. They said that certain evidence, including checks

made out to the affiliates or fund transfers to accounts with the affiliates,

demonstrated that the claimants were not the customers of the SIPC

members. In addition, SIPC and the trustees determined that the

investments purchased were not securities as defined in the act.

In 2000, claimants in one liquidation involving a nonmember affiliate

successfully challenged the trustee’s and SIPC’s denials of their claims.

The claimants believed that they qualified as customers of the SIPC

member because the SIPC member and its affiliates were presented to

them and operated as a single enterprise and that the investments at issue

were securities. Moreover, the common owner used the member and

nonmember in a scheme to defraud customers. In August 2000, the Federal

Court of Appeals for the Eleventh Circuit found that the claimants

reasonably believed that they were dealing with the SIPC member and that

the owner of both entities used funds raised through the nonmember

affiliate as if they were the funds of the SIPC member. The court also

found that the claimants deposited cash to purchase securities covered

under the act. However, other courts have supported SIPC’s and the

trustee’s position in similar cases.

Although disclosure alone would not resolve all of the issues surrounding

these types of liquidations, greater disclosure could help investors better

understand SIPC liquidation proceedings and what steps they could take

to protect their interests. SIPC’s informational brochure provides useful

information that tells investors that they should avoid writing checks to

anyone other than the firm, including affiliates. However, SEC does not

require SIPC member firms to routinely distribute the SIPC brochure to

investors. In addition, SEC’s Web site provides some information on

dealings with affiliates, but the information is generally limited.

Information Shared With

Investors About SIPC’s

Policies Involving

Nonmember Affiliates Is

Not Adequate
Executive Summary

Page 10 GAO-01-653 Securities Investor Protection

SEC has taken steps to improve its oversight of SIPC. However, the

oversight program faces ongoing challenges. SEC’s Division of Market

Regulation (Market Regulation) has primary responsibility for ensuring

SIPC’s compliance with SIPA. Market Regulation has engaged in several

important oversight activities, such as monitoring the size of the SIPC

customer-protection fund and maintaining regular communication with

SIPC. However, Market Regulation initiated only two SIPC examinations

between 1971 and 1999.

In 2000, SEC started a joint examination led by Market Regulation and the

Office of Compliance Inspections and Examinations (OCIE). Consistent

with observations made by SEC’s IG, the scope of this examination was

expanded. The examination guidelines include some of the issues raised

by the more recent controversial liquidations discussed in this report. As

of March 2001, the sample of liquidations reviewed by SEC included 4 of

the 28 liquidations involving the controversial policies and practices and

none of nonmember affiliate proceedings. In response to this observation,

SEC staff stated that they plan to review additional liquidations involving

unauthorized trading and the nonmember affiliate issue.

In September 2000, SEC also established a pilot program to monitor SIPC

liquidation proceedings. Although this program is a positive development,

it is too soon to determine its efficacy. The pilot program also highlights

the need for more formal information sharing among SEC units. The IG

report on SEC’s SIPC oversight found that communication among SEC

units could be improved and recommended that SEC units establish a

formal method for sharing information. GAO’s review found that SEC had

not yet implemented the IG recommendation. Given that different offices

and divisions receive different information about SIPC liquidations, more

formal communication among the groups that are involved in reviewing

these liquidations—such as Market Regulation, OCIE, and the Division of

Enforcement (Enforcement)—is important. Without a formal means to

share information across organizational lines, SEC’s ability to establish a

comprehensive SIPC oversight strategy could be hampered. SEC officials

said that they plan to begin holding quarterly meetings to share

information about SIPC.

The type of financial protection that SIPC provides is similar to that

provided by FDIC and, to some extent, state life and health insurance

guarantee associations, but important differences exist. Consumers may

confuse the coverage offered by these programs. When a member firm

fails, if customer accounts are not transferred to another institution, both

SIPC and FDIC return up to $100,000 of missing customer or depositor

SEC’s SIPC Oversight Has

Improved but Faces

Ongoing Challenges

Potential Exists for

Increased Investor

Confusion
Executive Summary

Page 11 GAO-01-653 Securities Investor Protection

cash; however, SIPC also replaces missing securities. The total amount of

coverage under SIPA is up to $500,000, of which no more than $100,000

can be a claim for cash. Customer securities held by a securities firm are

not assets of the firm, but are held in custody by the firm for its customers.

SIPA protects the firm’s obligation to return these assets. Because

securities, unlike cash, are subject to price fluctuations, the securities

returned to a customer can be worth less than their purchase price. In

contrast, FDIC protects deposits, which are obligations of the accepting

firm, which includes banks and thrifts. FDIC protects depositors against

the risk that the institution that accepted the deposit will fail and not have

assets sufficient to return a customer’s deposit. Unlike securities accounts,

cash deposits do not fluctuate in value. Therefore, in order to fulfill failed

member depository obligations, FDIC returns the amount in the account

up to the statutory limit. The state life/health insurance guarantee

associations also serve to preserve an insurance company’s obligation to

those insured. The state insurance associations guarantee that owners of

covered products will not lose their insurance coverage up to certain

limits and step in to fulfill the obligations of the policy when an insured

institution fails.

According to many regulatory and securities industry officials, some

consumers likely confuse SIPC with FDIC, given the similarities in

coverage amounts, misunderstandings between the nature of securities

investing versus making deposits, and the similarity in the SIPC and FDIC

logos. Yet, neither SIPC or SEC requires firms who are SIPC members to

disclose in advertising to the investing public a key fact that might help

consumers distinguish SIPC from FDIC: that SIPC does not protect against

losses due to declines in their securities’ market value.

GLBA allows banks, securities firms, and insurance companies, primarily

through affiliates, to underwrite and sell each other’s traditional financial

products to a degree not previously allowed. To the extent that financial

companies consolidate and begin to offer a full range of banking,

securities, and insurance products to the public, individuals will be more

likely to purchase financial products from the same corporate family that

are covered by different guarantee organizations. Any public confusion

that already exists between SIPC and FDIC or the state insurance

guarantee associations may increase. Given the limitations of SIPC’s

disclosure requirements, unsophisticated investors who do not fully

understand the difference between investing in securities and depositing

funds in a bank may not realize that SIPC will not protect their securities

investments from certain losses, such as declines in market value.
Executive Summary

Page 12 GAO-01-653 Securities Investor Protection

To improve investor awareness of SIPC’s policies, practices, and coverage,

GAO recommends that the Chairman, SIPC,

• as part of SIPC’s ongoing effort to revise the informational brochure and

Web site, include a full explanation of the steps necessary to document an

unauthorized trading claim and

• amend SIPC advertising bylaws to require that the official explanatory

statement about a firm’s membership in SIPC include a statement that

SIPC coverage does not protect investors against losses caused by changes

in the market value of their securities.

In addition, SEC can take steps to improve the information it provides to

investors and that investors receive about SIPC and about how to protect

investor interests. GAO recommends that the Chairman, 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 its existing customers more widely and

• review the sections of SEC’s Web site and, where appropriate, advise

customers to complain promptly in writing when they believe trades in

their account were not authorized and update the SEC Web site to include

a full explanation of SIPC’s policies and practices in liquidations involving

nonmember affiliates.

In chapter 2 of this report, GAO makes additional recommendations to the

SEC Chairman to improve disclosure.

Finally, to improve oversight of SIPC operations, GAO recommends that

the Chairman, SEC

• ensure that OCIE and Market Regulation include in their ongoing SIPC

examination a larger sample of liquidations involving unauthorized trading

and nonmember affiliates claims and

• require Market Regulation, OCIE, General Counsel, and Enforcement to

establish a formal procedure to share information about SIPC issues.

GAO received written comments on a draft of this report from SIPC and

SEC. These comments are discussed in greater detail at the end of

chapters 2 through 5. In addition, SIPC’s and SEC’s comments are printed

in appendixes I and II, respectively. SIPC and SEC also provided technical

comments, which have been incorporated into the report where

appropriate. Officials from SIPC and SEC agreed with most of the

Recommendations

Agency Comments

and Our Evaluation
Executive Summary

Page 13 GAO-01-653 Securities Investor Protection

conclusions and recommendations in the draft report and both have begun

to take steps to implement several of GAO’s recommendations.

For example, SIPC officials said that they have begun to implement

GAO’s recommendation concerning improving disclosure of SIPC’s

unauthorized trading policies and practices. Specifically, SIPC officials

said that changes they are making to the informational brochure would

urge investors to complain about unauthorized trading in writing. In

addition, SEC officials said that they would consider the appropriateness

of requiring firms to distribute the SIPC brochure to new customers and

existing customers more widely. In addition, SEC officials said that they

had already reviewed SEC’s Web site and made changes in response to

GAO’s recommendations where appropriate. SEC officials also agreed

with GAO’s recommendations concerning its oversight effort. Specifically,

SEC officials agreed to review additional liquidation proceedings during its

ongoing examination, and SEC officials stated that they would hold

quarterly meetings to discuss various issues related to SIPC.

SIPC disagreed with GAO’s recommendation that it amend its bylaws to

require that any statement about a firm’s membership include a statement

that SIPC coverage does not protect investors against losses caused by

changes in the market value of their securities. First, SIPC officials believe

SIPC lacks the authority to implement such a change in SIPC’s bylaws.

Second, they believe such a statement would be misleading. GAO has

revised the recommendation to make clear that it applies to only SIPC’s

“official explanatory statement.” On the basis of GAO’s conversation with

SEC officials concerning SIPC’s authority to amend its bylaws and GAO’s

review of the statute and legislative histories, GAO continues to believe

that SIPC has authority, with SEC approval, to determine what should be

disclosed in its official explanatory statement. GAO also does not share

SIPC’s concern that simply stating that SIPC does not protect against

losses caused by changes in the market value of securities would be

misleading. Such disclosure would be similar to information disclosed in

SIPC’s informational brochure, as well as information contained on the

Web sites of SEC and NASDR describing SIPC coverage.
Chapter 1: Introduction

Page 14 GAO-01-653 Securities Investor Protection

The Securities Investor Protection Act of 1970 (SIPA) established the

Securities Investor Protection Corporation (SIPC) to provide certain

financial protections to the customers of insolvent securities firms. As

required by SIPA, 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.1

 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 2000, SIPC

initiated a total of 287 liquidation proceedings and paid about $234 million

to satisfy such customer claims.

In the past 5 years, some SIPC liquidation proceedings have involved

controversial policies and practices because trustees denied large

numbers of investor claims.2

 One controversial practice involved the

trustees’ denials of many claims because claimants did not satisfy the

trustee’s requirement that the claimants reliably demonstrate that trading

in their accounts was unauthorized (i.e., the firm had bought or sold

securities for a customer’s account without approval). Another

controversial practice involved denials of claims of individuals who said

they believed that they were customers of a firm covered under SIPA but

actually had been dealing with an affiliated entity not covered by SIPA. In

these liquidations, critics argue that SIPC’s main goal has been to protect

its industry-supplied fund rather than to protect customers as

contemplated by SIPA. SIPC maintains that its policies are consistent with

SIPA. An additional issue related to SIPC coverage has emerged from

another source: consolidation in the financial services industry. As

securities firms, banks, and insurance companies begin to merge and sell

each others’ traditional products through affiliates, it raises important

implications about the extent of disclosure that SIPC should require its

member firms to make concerning the program’s coverage. In response to

a request from the Ranking Member of the House Energy and Commerce

Committee, we reviewed SIPC’s policies and practices in liquidations

involving unauthorized trading and affiliate issues, Securities and

 1

SIPA authorizes an alternative to liquidation under certain circumstances when all

customer claims aggregate to less than $250,000.

2

See “Many Holes Weaken Safety Net for Victims of Failed Brokerages,” The New York

Times, Sept. 25, 2000; “Group Assails Insurer of Investors,” The Washington Post, July 21,

1999; and “Many Unhappy Returns: Ex-Stratton customers still fighting to recoup $130m,”

Newsday, Dec. 20, 1998.

Chapter 1: Introduction
Chapter 1: Introduction

Page 15 GAO-01-653 Securities Investor Protection

Exchange Commission (SEC) oversight of SIPC, and the potential for

greater investor confusion as banks, securities firms, and insurance

companies offer financial products from the same corporate family that

are covered by different guarantee organizations.

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 did not have their

customers’ property on hand. 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 where 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.” SIPA

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.3

 SIPA sets

 3

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.

SIPC’s Mission,

Organization,

Funding, and

Oversight
Chapter 1: Introduction

Page 16 GAO-01-653 Securities Investor Protection

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 29 staff located in a Washington, D.C.,

office. 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, 2000, SIPC had 7,033 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,4 (2) selling

variable annuities,5

 (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.6

 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

 4

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.

5

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.

6

Typically, bank certificates of deposit are not securities under the Securities Exchange Act

of 1934, however, they are defined as securities in SIPA.
Chapter 1: Introduction

Page 17 GAO-01-653 Securities Investor Protection

cover situations where an individual has a debtor-creditor relationship—

such as a lending arrangement—with a SIPC member firm.

SIPC has a fund valued at $1.2 billion as of February 9, 2001, that it uses to

make advances to trustees for customer claims and to cover the

administrative expenses of a liquidation proceeding.7

 Administrative

expenses in a SIPC 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.8

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 re-lend them to SIPC). In addition, SIPC has a $1 billion

line of credit with a consortium of banks.

SIPA gives SEC oversight responsibility over SIPC. 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 may require SIPC to

adopt, amend, or repeal any bylaw or rule.9

 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.

SIPC and the Federal Deposit Insurance Corporation (FDIC) transfer or

return customer property in the event that a member fails; however, there

are important differences in the protection provided to investors. First,

while both protect cash left with the banks or securities firms, only SIPC

protects securities. Second, securities firms act as custodians for

customers’ securities; this property does not become an asset of the firm.

SEC rules prohibit securities firms from using customer securities or cash

 7

The SIPC board decided the fund balance should be raised to $1 billion to meet the longterm financial demands of a very large liquidation. The SIPC balance reached $1 billion in

1996.

8

As of February 2001, the annual assessment for SIPC members was $150.

9

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 of a type that SEC determines by rule does not require SEC

approval.

SIPC Protection

Versus Federal

Deposit Insurance
Chapter 1: Introduction

Page 18 GAO-01-653 Securities Investor Protection

to finance their own operations, and require firms to maintain minimum

levels of liquid assets to meet obligations to customers and other market

participants. However, if a firm fails and is unable to return all customer

securities or cash, SIPA provides limited protection, namely, the return of

the securities or cash in a given customer’s account up to the statutory

limits. SIPC generally returns the securities or cash that should have been

in the investor’s account on the liquidation filing date. Therefore, if the

price of the securities declines, SIPC does not protect investors from that

loss. However, investors benefit from continuing to hold the securities if

the price increases. Deposits held by a bank or thrift are different from

investments held by securities firms. Unlike securities, cash deposits do

not fluctuate in value. In addition, deposits are obligations of the

institution that accepts them. Banks are free to use these customer

deposits to finance their own operations (e.g., make loans or other

investments). If a bank makes bad investment decisions and fails with

insufficient assets to meet its liabilities to depositors, FDIC will provide

coverage up to the $100,000 limit.

When SEC or a self regulatory organization (SRO), such as NASDR, Inc.,10

informs SIPC that one of its member firms is in or is approaching financial

difficulty, SEC, the SROs, and SIPC take steps to determine whether the

firm might fail and whether and to what extent customers, as that term is

defined in SIPA, may be exposed. SIPC initiates liquidation proceedings if

it determines that the member firm has failed or is in danger of failing to

meet its obligations to customers, among other factor(s).11 SIPC initiates

liquidation proceedings by applying for a protective order in a federal

district court or initiating a direct payment procedure.12 The firm has an

opportunity to challenge the ruling. If the court issues the order, the court

appoints a disinterested trustee selected by SIPC, or, in certain cases, SIPC

 10NASDR, Inc., is the regulatory arm of the National Association of Securities Dealers,

which was granted self-regulatory authority under the Securities Exchange Act of 1933.

11For SIPC to initiate a proceeding, at least one of the following other factors must exist (1)

the firm must be insolvent under the Bankruptcy Code or unable to meet its obligations as

they become due; (2) the firm is subject to a court or agency proceeding in which a

receiver, liquidator, or trustee has been appointed for the member; (3) the firm is not

compliant with applicable financial responsibility rules of the Commission or SROs; or (4)

the firm is unable to show compliance with such rules.

12In the smallest proceedings (in which, among other factors, the claims of all customers

are less than $250,000), SIPC directly pays customer claims without filing an application for

a protective order with a court and without the appointment of a trustee.

How SIPC Liquidates

a Member Firm and

Protects Its

Customers
Chapter 1: Introduction

Page 19 GAO-01-653 Securities Investor Protection

itself, to liquidate the firm.13 The district court orders removal of the entire

liquidation proceeding to the federal bankruptcy court for that district. To

the extent that it is consistent with SIPA, the proceeding is conducted

pursuant to pertinent provisions of the Bankruptcy Code. SIPA requires

that the trustee investigate facts and circumstances relating to the

liquidation; report to the court facts indicating fraud, misconduct,

mismanagement, or irregularities; and submit a final report to SIPC and

others designated by the court. Also, the trustee is to periodically report to

the court and SIPC on its progress in distributing cash and securities to

customers.

Promptly after being appointed, the trustee is to publish a notice of the

proceeding in one or more major newspapers, in a form and manner

determined by the court. The trustee also is to mail a copy of the notice to

existing and recent customers listed on the firm’s books and records, and

is to provide notice to creditors in the manner prescribed by the

Bankruptcy Code. Customers must file written statements of claims. The

notice typically informs customers how to file claims and explains the

deadlines for filing claims. Two deadlines apply. One is set by the

bankruptcy court supervising the proceeding and the other is set by SIPA.

The deadline set by the bankruptcy court for filing customer claims

applies to customer claims for net equity. Under SIPA, the deadline may

not exceed 60 days after the date that notice of the proceeding is

published. Failure to satisfy the deadline can affect what the customer

may be able to recover. The second deadline occurs 6 months after the

publication date. SIPA mandates that no customer or general creditor

claim received after the 6-month deadline can be allowed by the trustee,

except for claims filed by the United States, any state, infant, or certain

incompetent persons.

The trustee and SIPC staffs review each claim that the trustee receives. In

some cases, the trustee’s staff, SIPC staff, or both may write a brief

analysis of the claim, which recommends whether the claim should be

allowed or denied. If the trustee and SIPC staff initially disagree over

whether the claim is valid, they hold a discussion. Typically, if the claim

lacks sufficient supporting evidence, the trustee will write to the claimant

requesting additional information. Once a final decision is made, the

 13SIPC may decide to serve as a trustee in any case where it determines that the firm’s

liabilities to unsecured general creditors and subordinated lenders appear to aggregate to

less than $750,000 and it appears that there are less than 500 customers.
Chapter 1: Introduction

Page 20 GAO-01-653 Securities Investor Protection

trustee sends a determination letter to each claimant that informs him or

her of the decision and its basis. The letter also informs a claimant of his

or her right to object to the determination and how to do so. The

bankruptcy court judge overseeing the liquidation rules on customers’

objections after holding a hearing on the matter. Decisions of the

bankruptcy court may be appealed to the appropriate federal district

court, and then upward through the federal appellate process.

Under the typical SIPA property distribution process, SIPC customers are

to receive any securities that the firm holds that are registered in their

name or that are in the process of being registered in their name, subject

to the payment of any debt to the firm. Any other customer property in an

account is part of a customer’s net equity as calculated by the trustee. Net

equity claims are satisfied first by allowing customers to share on a pro

rata basis in the firm’s remaining customer property. The trustee may use

up to $500,000 advanced from the SIPC fund to satisfy a customer’s claim

remaining after the distribution; however, only $100,000 may be advanced

to satisfy a claim for cash.14 SIPA specifies that a customer claim for

securities must be satisfied with securities whenever feasible. That is, if

the firm being liquidated does not possess the securities, then the trustee

must purchase them in the open market and return them to the customer if

a fair and orderly market for the securities exists.

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. Moreover, the trustee may use advances from the SIPC fund up to

the $500,000/$100,000 limits to satisfy claims that cannot be fully satisfied

by the estate of customer property. In fact, since many bankrupt securities

firms have no assets left at all, SIPC customers may be the only parties

with claims against the firm to have any of their claims satisfied.

SIPC liquidates clearing and introducing firms, which are distinct entities.

Introducing firms do not clear securities transactions or hold customer

cash or securities. Instead, introducing firms contract with clearing firms

to clear their customers’ transactions and hold their customers’ cash and

 14SIPC may advance funds to the trustee to satisfy claims prior to the distribution of

customer property.
Chapter 1: Introduction

Page 21 GAO-01-653 Securities Investor Protection

securities. Introducing firms introduce their customers to a clearing firm

on a fully disclosed basis. This means that each introducing firm customer

has a securities account at the clearing firm in the customer’s name and in

which the customer’s securities transactions are cleared and securities

and cash are held. Under this scenario, the customers know their accounts

are at the clearing firm, and the clearing firm treats them as customers for

purposes of securities regulations governing custody of customer assets

and the financial responsibility of broker-dealers. In general, the clearing

firm, not the introducing firm, prepares and mails trade confirmations and

periodic account statements.15 Some SIPC liquidations have involved

introducing firms that stole or misplaced customer property intended to

go to a clearing firm.

SIPC has initiated a fairly small number of liquidations each year

compared with the number of securities firms that go out of business

annually. Between its inception in 1971 and the end of 2000, SIPC

commenced 287 liquidations of member securities firms. From 1996

through 2000, SIPC initiated a total of 37 liquidations of member firms or

about 7 per year. By contrast, SIPC data indicate that hundreds of SIPC

member firms go out of business each year without ever becoming SIPC

liquidations.16 For example, our 1992 report found that between 1971 and

1991, 20,344 SIPC members went out of business, but only 228 (about 1

percent) became SIPC liquidations. Similarly, in 1999, a total of 865 SIPC

members went out of business but SIPC initiated liquidation proceedings

against a total of 9 firms.

Many of the thousands of SIPC members that have gone out of business

without SIPC involvement were firms that traded solely for their own

accounts, did not hold customer property, and did not introduce customer

accounts to a clearing firm. Accordingly, there were no customers in need

of SIPC protection. In addition, because introducing firms are not

permitted to hold customer cash or securities, most go out of business

without any customer securities or cash to return to customers. (These

assets are at the clearing firm.) However, if an introducing firm improperly

holds, loses, or embezzles customer securities or cash, there may be a

need for a SIPA liquidation. Furthermore, SEC’s financial responsibility

 15According to SEC, in some cases, the introducing firm sends the confirmation or account

statement rather than the clearing firm.

16Although some firms fail financially, others go out of business for nonfinancial reasons,

such as mergers.

SIPC Liquidation

Proceedings Are

Relatively Infrequent
Chapter 1: Introduction

Page 22 GAO-01-653 Securities Investor Protection

and customer protection rules establish controls that securities firms must

follow, which promote firm solvency and the safekeeping of customer

assets. Regulators monitor compliance with these rules and intervene

when problems arise prior to a firm’s failure. SEC and SROs—such as

NASDR and the New York Stock Exchange (NYSE)—have primary

responsibility for overseeing and regulating SIPC member firms. SIPC does

not have any authority under SIPA to regulate or examine its membership.

In some cases, securities regulators may oversee the transfer of customer

accounts from a troubled firm to a healthy firm without the need for SIPC

involvement.

Our objectives were to (1) review the basis for SIPC’s policies and

practices for validating and satisfying claims involving unauthorized

trading and the extent that these policies were disclosed to investors; (2)

review the basis for SIPC’s policies and practices for determining claims in

liquidations involving SIPC-member firms and their nonmember affiliates,

and the extent that these policies were disclosed to investors; (3) evaluate

SEC’s oversight of SIPC’s operations and compliance with SIPA; and (4)

compare the coverage provided by and disclosure rules for SIPC, FDIC,

and state insurance guarantee associations; and identify the implications

for greater confusion among consumers as some banks, securities firms,

and insurance companies consolidate their operations.

To meet the first two objectives, we reviewed SIPA and its legislative

history, court decisions, legal briefs, and other documents that were

relevant to understanding SIPC’s or its critics’ views concerning the legal

aspects of SIPC positions. Consistent with our general policy, we have not

taken a position on issues involving ongoing litigation. To review the

implementation of SIPC’s policies and to assess investor awareness of

these policies, we also reviewed a total of 152 customer claim files from 2

recent liquidations in which many claimants alleged unauthorized trading.

For each of the two liquidations, we randomly selected a sample of claim

files and reviewed documents from the files. These documents included

affidavits and other supporting evidence provided by the claimants, if any

were supplied, and the determination letter sent by the trustee to the

claimant that explained the reason for allowing or denying the claim. We

interviewed officials from SIPC and SEC, individuals who are or who have

served as SIPC trustees and their attorneys, and attorneys who have

represented claimants who have disputed trustee claim decisions

concerning both the unauthorized trading and affiliate issues. In addition,

we reviewed SIPC and SEC informational sources—such as brochures and

Web sites—to determine what SIPC disclosed to investors regarding its

policies and practices.

Objectives, Scope,

and Methodology
Chapter 1: Introduction

Page 23 GAO-01-653 Securities Investor Protection

To fulfill our third objective, to evaluate SEC oversight of SIPC, we

reviewed past SEC inspections of SIPC, the work plan and other

documents relating to SEC’s ongoing inspection of SIPC, a recent report

by the SEC’s Office of the Inspector General that reviewed SEC’s oversight

of SIPC,17 our 1992 report on SIPC,18 and other SIPC and SEC documents.

We also interviewed officials in different organizational units of SEC,

including the divisions of Market Regulation (Market Regulation) and

Enforcement (Enforcement); the Office of General Counsel (OGC); the

Office of Compliance, Inspections, and Examinations (OCIE); and the

Northeast Regional Office (NERO) located in New York City.

To accomplish our fourth objective, to identify differences between SIPC

and other financial guarantee programs and the potential for increased

investor confusion as the financial services industry, we first compared

general characteristics of the coverage provided by SIPC, FDIC, and state

insurance guarantee associations. Then, we reviewed disclosure

requirements regarding firms’ participation in these organizations’

coverage. To compare SIPC to FDIC, we reviewed pertinent statutes,

regulations, and bylaws; and we interviewed officials from both

organizations. With respect to state insurance guarantee associations, we

focused on the 52 state life/health guarantee associations because the

policies they sell, such as annuities, more closely resemble investments

than do many of the types of insurance covered by property/casualty

insurance guarantee associations. For information on the life/health state

associations, we relied solely on information provided by the National

Organization of Life and Health Guarantee Associations, a group to which

all of the state associations belong. We did not verify the information this

organization gave us with individual state insurance laws.

 17Oversight of Securities Investor Protection Corporation. Securities and Exchange

Commission Office of Inspector General. Audit Report No. 301. Mar. 31, 2000.

18Securities Investor Protection: The Regulatory Framework Has Minimized SIPC’s Losses

(GAO/GGD-92-109, Sept. 22, 1992).
Chapter 1: Introduction

Page 24 GAO-01-653 Securities Investor Protection

We obtained written comments on a draft of our report from SIPC and

SEC, which are provided in full in appendixes I and II. We did our work in

Jacksonville and Tampa, Florida; New York, New York; and Washington,

D.C., between March 2000 and April 2001 in accordance with generally

accepted government auditing standards.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 25 GAO-01-653 Securities Investor Protection

SIPC liquidations involving unauthorized trading accounted for nearly twothirds of all liquidations initiated from 1996 through 2000. SIPC’s policies

and practices in these liquidation proceedings have generated controversy

primarily because of the large numbers of claims that were denied and the

methods used to satisfy certain approved claims. The first practice

generally requires that investors with unauthorized trading claims provide

some form of objective evidence that they complained within a reasonable

time after the disputed trade. Although establishment of such a practice is

authorized under SIPA and has been upheld in court, this practice has

been criticized as unfair. The second controversial practice occurred in

one proceeding. The practice, which was rejected by a bankruptcy court,

resulted in SIPC and the trustee treating certain approved unauthorized

trading claims for cash as claims for securities. Consequently, claims for

cash were paid with worthless securities. Claimants successfully

challenged this practice in a bankruptcy court, but SIPC and the trustee

have filed notices of appeal. Another issue involving SIPC’s practices is

that they are often not transparent to investors. Specifically, SIPC and

SEC, which has an important role in educating investors, have missed

opportunities to disclose information about SIPC’s practices for

determining unauthorized trading claims and to educate investors about

steps they can take to protect their interests.

From 1996 through 2000, 24 of the 37 proceedings initiated by SIPC, or 65

percent, involved introducing firms that, according to SIPC, engaged in

unauthorized trading.1

 SIPA provides customer status and coverage to

claimants who can demonstrate that the securities or cash in their

accounts was unlawfully converted. Unauthorized trading is recognized as

a form of unlawful conversion in which the firm or its representative take

control of a customer’s property and use it for the firm’s purposes without

the customer’s permission. For example, a firm representative might buy

or sell a customer’s securities without authorization. In February 1996,

SIPC, with SEC’s concurrence, began initiating liquidation proceedings

against failed introducing firms that had engaged in unauthorized trading

 1

SIPC officials listed an additional introducing firm—Old Naples Securities—as having

engaged in unauthorized trading. Old Naples also raised issues that occur when SIPC

liquidates member firms and their nonmember affiliates. This issue and the Old Naples

liquidation are discussed in chapter 3.

Chapter 2: Opportunities Exist to Improve

the Disclosure of SIPC’s Policies in

Liquidations Involving Unauthorized Trading

Unauthorized Trading

Liquidations

Accounted for Nearly

Two-Thirds of

Liquidations Initiated

From 1996 Through

2000
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 26 GAO-01-653 Securities Investor Protection

of customer accounts carried at clearing firms.2 According to SIPC

officials, SIPC initiated the policy to liquidate these firms and provide

protection to their customers because of the increase in the number of

customers who dealt with introducing firms and the apparent increase in

unauthorized trading activity by them.

According to SIPC officials, many of these firms marketed microcap

stocks3 to their customers, which had become virtually worthless by the

initiation of liquidation proceedings. For example, a firm called Stratton

Oakmont, Inc. (Stratton Oakmont) committed the most serious violations

and manipulated the prices of numerous microcap stocks through various

sales practice abuses, including unauthorized trading. Of the

approximately 3,400 claimants in the Stratton Oakmont liquidation

proceeding, the trustee either directed approximately 2,600 claimants to

pick up their generally worthless microcap securities at the clearing firm

or denied their claims because SIPA does not protect against market

losses.4

The fact that these introducing firms engaged in unauthorized trading

presents significant challenges to SIPA trustees in determining the validity

of customer claims. These introducing firms contract with clearing firms

to hold customer accounts and maintain records and these account

holders are treated as customers of the clearing firm. However, in SIPC

liquidation proceedings involving introducing firms, claimants may argue

that the records of both the introducing firms and the clearing firms are

incorrect because they show positions that were the result of

 2

Prior to 1996, SIPC did not initiate liquidation proceedings against introducing firms that

traded customer accounts without authorization by transmitting unauthorized trade orders

to clearing firms. SIPC took the position that claimants were customers of the firms that

cleared for the introducing firms and that their securities and cash were generally available

at those firms. See e.g., 17 C.F.R. § 300.200 (2000) (SIPC rule stating that persons having

accounts cleared by a clearing firm on a fully disclosed basis are customers of the clearing

firm). See also Arford v. Miller, 239 B. R. 698 (S.D. N.Y. 1999), aff’d Arford v. Miller, 210.

F3d 420 (2dCir. 2000).

3

Microcap stocks are normally not listed on national stock exchanges, have limited

financial reporting requirements, and represent interests in companies with speculative

business prospects.

4

The trustee determined these approximately 2,600 claims in a variety of ways. For

example, the trustee directed about 1,210 claimants to contact the clearing firm for their

securities. The trustee also denied 448 claims for market losses on securities and 342

claimed they were owed nothing. The remaining approximately 600 claims were rejected

for other reasons.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 27 GAO-01-653 Securities Investor Protection

unauthorized trades ordered by the introducing firm representatives. In

general, SIPC trustees do not have the ability to determine from the firms’

records whether the claimants’ assertions are true. As discussed later in

this chapter, SIPC and its trustees require claimants to provide some form

of objective evidence to substantiate their claims, although many

claimants have been unable to provide such evidence. For example, the

Stratton Oakmont trustee denied 656 of a total of 728 unauthorized trading

claims, or about 90 percent, largely for failing to provide objective

evidence.5

 For other unauthorized trading claims, the trustee approved the

claims and returned the microcap securities that he determined should

have been in the claimants’ account.

SIPC’s liquidations of introducing firms that engaged in unauthorized

trading involve relatively higher administrative costs than other

liquidations because determining the validity of unauthorized trading

claims involves the acquisition and evaluation of information that is not

usually contained in firm records. On average, SIPC’s administrative

expenses were 45 percent of the total funds advanced in liquidation

proceedings involving unauthorized trading initiated from 1996 through

1999.6

 By contrast, administrative expenses averaged 10 percent of SIPC

funds advanced for all other SIPC liquidations.7

 The Stratton Oakmont

liquidation provides a clear example of the high administrative costs that

may be associated with these liquidations. As of year-end 2000, SIPC had

advanced about $5.9 million for administrative expenses of the Stratton

Oakmont liquidation, as opposed to about $2.1 million to satisfy customer

claims. SIPC officials said that administrative expenses in proceedings

involving unauthorized trading tend to be higher than other proceedings

because, among other things, the trustee’s staff must engage in lengthy

investigations to determine the merits of each unauthorized trading claim.

In addition, many claimants whose unauthorized trading claims have been

 5

We reviewed a representative and random sample of about 98 approved and denied claims

in the Stratton Oakmont liquidation proceeding. The SIPA trustee generally approved

claims that met the standard and denied those that did not.

6

The percentage is calculated based on financial information from introducing firm

liquidation proceedings that were closed or had satisfied claims but had litigation pending

as of December 31, 1999. Proceedings in which the claims process was ongoing were

excluded.

7

The percentage is calculated based on the liquidation proceedings that where closed or

had satisfied claims but litigation was pending, excluding proceedings involving

introducing brokers engaged in unauthorized trading. Proceedings in which the claims

process was ongoing were excluded.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 28 GAO-01-653 Securities Investor Protection

denied often file objections in bankruptcy court, which further increases

litigation and related costs. About two-thirds of the Stratton Oakmont

claimants whose unauthorized trading claims were denied have filed such

objections.

Pursuant to the authority provided under SIPA, SIPC and trustees have

established a standard that requires claimants to produce objective

evidence to substantiate their unauthorized trading claims. To satisfy this

standard, SIPC and trustees typically require claimants to provide some

form of objective evidence that they complained, usually in writing, to the

SIPC member firm or to regulators within a reasonable time after the

disputed transactions. According to SIPC officials, the evidentiary

standard is necessary to verify unauthorized trading claims and to protect

against fraudulent claims. SIPC’s critics have complained that the

evidentiary standard is unfair and that most unsophisticated investors call

rather than write their securities firm to allege unauthorized trades.

However, the court decisions that we reviewed have supported the

evidentiary standard.

SIPA authorizes SIPC and trustees to establish the standards by which to

determine the failed firm’s obligations to its customers. Specifically, SIPA

directs the trustee to

“...discharge, in accordance with the provisions of this section, all obligations of the debtor

to a customer relating to, or net equity claims based upon, securities or cash, by the

delivery of securities or the making of payments to or for the account of such

customer...insofar as such obligations are ascertainable from the books and records of the

debtor or are otherwise established to the satisfaction of the trustee...” (italics added).8

Claimants have a right to challenge the appropriateness of the trustees’

standards for verifying claims in bankruptcy court.

Pursuant to this statutory authority, SIPC officials said that they and

trustees generally require some form of objective evidence to determine

the legitimacy of unauthorized trading claims. Typically, to satisfy this

standard, claimants must provide reliable, objective evidence that they

complained in writing to the failed firm or to a regulatory agency within a

 8

15 U.S.C. § 78fff-2(b).

The Establishment of

an Evidentiary

Standard Is

Authorized Under

SIPA

SIPA Authorizes SIPC and

Trustees to Establish

Standards to Verify Claims
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 29 GAO-01-653 Securities Investor Protection

reasonable period after allegedly unauthorized trades. In general, SIPC

staff and trustees reject claims where the individual could not provide

documentation of the complaint made to the firm or regulators within 90

days of the disputed transaction. However, we found that SIPC and the

trustees would consider alternative evidence or extenuating

circumstances. For example, one trustee used an NASDR investor

complaint log as evidence that claimants complained about allegedly

unauthorized trades within a reasonable time period. In another SIPC

proceeding, a claimant proved that he had not received any account

statements within the 90-day time period and the trustee approved his

unauthorized trading claim.

According to SIPC officials, the evidentiary standard is necessary to

determine the validity of unauthorized trading claims and to protect

against fraudulent claims. The officials said that without such a standard,

trustees would generally have no way of verifying these claims—other

than the testimony of the claimants—because the failed firms’ books and

records would not show that the trades were unauthorized. SIPC officials

said that one claimant in a SIPC liquidation proceeding had filed claims for

75 allegedly unauthorized trades totaling $10 million. The claimant did not

provide any evidence that the trades were unauthorized other than an

affidavit and trading records. After extensive investigation of the

claimant’s account history, SIPC officials said that staff determined that

the claimant had only identified trades that lost money as “unauthorized”

while ignoring trades that made money. Without the evidentiary standard,

SIPC officials said that they would not be able to reasonably determine the

credibility of such claims.

According to SIPC officials, the requirement that customers provide

evidence of having complained in writing generally within 90 days is

consistent with the notifications that firms send to account holders, such

as trade confirmations and quarterly statements, showing the activities

and positions in their accounts. Typically, clearing firms send trade

confirmations within days of each security transaction. Clearing firms are

also required to send quarterly statements to account holders holding

accounts carried on a fully disclosed basis and often send monthly

statements as well. These statements provide a record of the transactions

in each customer’s account. Provided investors review these statements,

SIPC officials said the statements would give investors ample notice of any

unauthorized trades within about 90 days of the trade.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 30 GAO-01-653 Securities Investor Protection

Critics have questioned the fairness of SIPC’s evidentiary standard, but

courts have upheld its use in liquidation proceedings.9

 An attorney who

represents Stratton Oakmont claimants said that the evidentiary standard

can be unfair and is unsupported by law or SIPC regulations. He said that

most unsophisticated investors simply call their securities firms when they

identify a problem in their account, and that only sophisticated investors

can be expected to complain in writing within a specified period. The

attorney said that Stratton Oakmont claimants plan to contest in the

bankruptcy court the evidentiary standard as the basis for rejecting

unauthorized trading claims. Critics of the policy also said that the policy

ignores that SEC had taken enforcement actions against Stratton Oakmont

for pervasive unauthorized trading before the liquidation proceeding.

Our review identified information to support the contention that many

investors may not be aware of SIPC’s evidentiary standard for

unauthorized trade claims. We reviewed a representative and random

sample of 152 claim files from the Stratton Oakmont and Euro-Atlantic

Securities, Inc., liquidation proceedings. We found that about 87 percent of

the claimants stated that they complained over the telephone about

allegedly unauthorized trades. By contrast, only about 38 percent

complained in writing within the 90-day time period.

Although investors may generally not be aware of SIPC’s evidentiary

standard, recent court decisions have upheld its application in SIPC

liquidation proceedings. We identified bankruptcy court orders in 2 of the

24 introducing firm liquidations—Hanover Sterling & Co., Ltd. and EuroAtlantic Securities, Inc.—relating to the evidentiary standard for

unauthorized trading claims in SIPC liquidations. In both cases, the

bankruptcy judges upheld the trustees’ determinations to deny

unauthorized trading claims on the grounds that the claimants did not

provide reliable, objective evidence that they complained of allegedly

unauthorized trades within a reasonable period.

 9

Also see “Investor Protection – NOT: SIPC and the Securities Investor Protection Act of

1970.” Securities Arbitration 2000, Practising Law Institute, August 2000.

Critics Question the

Fairness of SIPC’s

Evidentiary Standard but

Courts Have Upheld It
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 31 GAO-01-653 Securities Investor Protection

In a January 2001 decision, the bankruptcy court overseeing the Stratton

Oakmont liquidation concluded that the trustee’s procedure for satisfying

approved unauthorized trading claims was not authorized by SIPA or any

other law. Under the procedure, the trustee sometimes returned worthless

securities to claimants rather than the substantial amounts of cash that

they had sought.10 SIPC officials supported the trustee’s procedure and

said it was based on SIPA.

The Stratton Oakmont trustee sometimes satisfied approved unauthorized

trading claims with securities rather than the cash for which customers

had filed their claims. Typically, these customers (claimants) filed claims

with the trustee for the cash that would have been in their accounts had

Stratton Oakmont representatives not purchased microcap securities

without their authorization. In deciding how to satisfy these claims,

however, the trustee considered evidence that suggested earlier

transactions in the claimants’ accounts were also unauthorized.11 These

earlier transactions were typically unauthorized sales of securities, the

proceeds of which were used to make the unauthorized purchases that

were the basis for the claims for cash. To satisfy the claims, the trustee

reversed all transactions that he determined to be unauthorized and

returned the claimants to their positions prior to the unauthorized trades.

For some claimants, this procedure resulted in the trustee returning

securities that had become worthless, but which had value when they

were sold without authorization. As a result, the trustee did not return the

substantial amounts of cash that the claimants had initially sought by

unwinding only the unauthorized securities purchases.

SIPC officials support the trustee’s procedure for satisfying approved

unauthorized trading claims as mandated by SIPA. According to SIPC

officials, in determining a claimant’s net equity under SIPA, a trustee has

the responsibility to determine what securities or cash should have been in

each claimant’s account as of the liquidation filing date in the absence of

any unauthorized trading. SIPC officials added that a claim seeking to

unwind only some of the unauthorized trades would not preclude the

 10The Stratton Oakmont trustee approved 72 unauthorized trading claims. A total of 23

claimants filed objections to the trustees’ determinations of their claims, largely because

the trustee offered to return worthless microcap securities in satisfaction of their claims.

11For example, the claimants may have filed copies of complaint letters that they had sent

to the securities firms, which identified particular securities sales and purchases as

unauthorized.

Bankruptcy Court

Rejected the Stratton

Oakmont Trustee’s

Procedure for

Satisfying Certain

Approved

Unauthorized Trading

Claims
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 32 GAO-01-653 Securities Investor Protection

trustee from determining whether other transactions in the account were

also unauthorized. The trustee would return to the claimant the cash

and/or securities that should have been in the account had the

unauthorized trades not occurred.

In the January decision, the bankruptcy court in the Stratton Oakmont

proceeding stated that the trustee’s process, which in effect treated the

claims for cash as claims for securities, was not authorized by SIPA or any

other law. The court concluded that claims for the proceeds from the

unauthorized purchases were claims for cash and not, as the trustee and

SIPC argued, claims for securities. As stated by the court:

“{T}he real question herein is whether the Trustee was correct when he collapsed two

distinct wrongs: in one wrong, Stratton Oakmont sold stock without authority and turned

the stock into cash, thereby cashing the customer out; in the other wrong, the broker took

the cash and invested it in a stock whose purchase the customer did not authorize, thus

tying up the customer’s funds in an involuntary investment...

“Nothing in the (SIPA) definition of ‘net equities’ bears on the question of whether the two

wrongs here can be treated as if they were one...The statute does not specifically authorize

a trustee to search through earlier records to satisfy a net equity claim for cash as if it were

a net equity claim for securities...In short, there is nothing in either bankruptcy or nonbankruptcy law that would require that the two related but distinct wrongs can be merged

into one or that would prevent the complaining party from recovering only in respect to the

latter wrong.”

12

SIPC officials said that they disagreed with the bankruptcy court’s

decision and have filed a notice of appeal, as has the trustee.

Disclosure plays an important role in securities market regulation, and

given SIPC’s investor protection mission, we believe SIPC has a

responsibility to inform investors of actions that they can take to protect

their investments and help ensure that they are afforded the full

protections allowable under SIPA. Similarly, SEC plays a vital role in

ensuring that investors receive adequate disclosure about the securities

markets and programs, such as SIPC, that potentially affect their interests.

In our 1992 report on SIPC, we identified deficiencies in disclosure about

SIPC and recommended steps that SIPC and SEC could take to better

 12See SIPC v. Stratton Oakmont, No. 97-40501 (ALG), slip op. at 20, 23 (Bankr. S.D. N.Y.

filed Jan. 24, 2001).

SIPC and SEC Have

Missed Opportunities

to Disclose

Information About the

Evidentiary Standard

to Investors
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 33 GAO-01-653 Securities Investor Protection

educate investors about the SIPC coverage. In 1994, SIPC revised its

informational brochure to respond to our recommendations.

SIPC and SEC have missed opportunities to disclose information about the

evidentiary standard to investors. In particular, SIPC and SEC have not

updated informational resources, such as the SIPC brochure as well as the

SIPC and SEC Web sites, to provide information about the evidentiary

standard. We also identified additional and more proactive steps that

could also better serve to notify investors about the importance of

documenting unauthorized trading claims. These steps include (1)

establishing uniform disclosure statements on trade confirmations and

other account holder documents and (2) requiring firms that have engaged

in pervasive unauthorized trading to notify their customers about

documenting complaints.

SIPC and SEC have established informational resources that provide a

great deal of useful information to investors. SIPC has developed an

informational brochure called How SIPC Protects You that provides useful

information about SIPC and its coverage. For example, the SIPC brochure

provides the coverage limits for securities and cash claims, defines the

securities covered under SIPA, and explains the claims review process.

However, SIPC bylaws and SEC rules do not require SIPC members to

distribute the brochure to their customers. Although SIPC officials said

that a wider distribution of the brochure would be beneficial, they do not

believe SIPC has the authority to require member firms to provide the

brochure to their customers. This authority resides directly with SEC or

with the SROs. In addition, SIPC has established a Web site at

www.sipc.org that also provides useful information to investors. SIPC’s

Web site explains the SIPC program and provides much of the information

discussed in the informational brochure.

Although the SIPC brochure—which was last updated in October 1994—

provides useful information, it does not advise investors that SIPA covers

unauthorized trading and that they should promptly complain in writing

about allegedly unauthorized trades. In March 2000, the SEC IG issued a

report on SEC’s SIPC oversight, which found that the SIPC brochure did

not give information about notifying the securities firm in a timely manner

about improper account activity, such as unauthorized trading, and

SEC and SIPC Information

Resources Do Not Fully

and Consistently Explain

the Evidentiary Standard

for Unauthorized Trading

Claims
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 34 GAO-01-653 Securities Investor Protection

documenting the notice.13 The SEC IG report further recommended that

SEC review the current SIPC brochure for adequacy, and encourage SIPC

to make appropriate changes. As of March 2001, SIPC officials said that

they had hired an investor education firm to review the current brochure

and to recommend appropriate changes. SIPC officials anticipate that they

will revise the brochure in 2001.

In addition to the information that SIPC provides to investors, SEC has a

Web site at www.sec.gov, which includes useful investor information,

including information relevant to SIPC protection.14 For example, the SEC

Web site contains a section called Microcap Stock: A Guide for Investors.

The section discusses the high risks associated with microcap stocks and

the fact that the prices of microcap stocks may be manipulated through

fraudulent schemes, as has been the case in some of the firms involved in

SIPC liquidations since 1996. SEC’s Web site also contains a section

entitled Cold Calling that provides tips to investors on how to avoid highpressure telephone sales practices and advises investors to closely review

their statements for any unauthorized trading activity. Stratton Oakmont

used cold calling to attract investors. SEC’s Web site also includes a brief

discussion of SIPC and provides a link to the SIPC Web site.

However, we found that SEC’s Web site provides information to investors

that could be viewed as contradictory to the evidentiary standard.

Specifically, the SEC Web site section entitled Microcap Stock: A Guide

for Investors recommends that investors should first call their broker if

they have any problems in their accounts. 15 If the broker cannot resolve

the problems, SEC’s Web site recommends that investors talk to the

branch manager. Finally, SEC recommends that the investors (1) write to

the firm’s compliance department if the branch manager cannot solve the

problem, (2) ask that the compliance department respond to the problem

within 30 days, and (3) write to the state securities regulators or SEC if the

problem is not corrected.

 13Oversight of Securities Investor Protection Corporation. U.S. Securities and Exchange

Commission Office of Inspector General. Audit Report No. 301. Mar. 31, 2000.

14According to SEC, the Web site receives about 1 million visitors daily.

15An SEC-prescribed statement that it requires securities firms to send in connection with

penny stock advises customers to telephone SEC or NASDR with concerns about the

brokerage firm’s activities. It states that as an alternative, customers can write to SEC. 17

C.F.R. § 240.15g-100.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 35 GAO-01-653 Securities Investor Protection

Although the telephone-based complaint approach SEC recommends

appears reasonable if the securities firm acts in good faith to resolve

problem trades, fraudulently operated firms such as Stratton Oakmont

may not promptly reverse unauthorized trades within a reasonable period.

Moreover, SIPC officials and the trustees’ staffs told us that Stratton

Oakmont officials sometimes used high pressure and even fraudulent

tactics to convince persons who called to complain about potentially

unauthorized trades to “ratify” these trades. According to these officials,

persons who agreed to ratify trades over the telephone—even due to highpressure tactics and fraud—would generally not be able to sustain an

unauthorized trading claim in a SIPA proceeding.16 Therefore, SEC’s

recommendation that investors call their securities firm to complain

without simultaneously writing a complaint letter potentially jeopardizes

their ability to prove claims in SIPC liquidation proceedings.

In contrast, we note that other sections of SEC’s Web site recommend that

investors complain in writing immediately if they encounter problems with

their broker. Specifically, the SEC Web site section entitled Invest Wisely:

Advice From Your Securities Industry Regulators warns investors that “If

you have a problem with the sales representative on your account,

promptly talk to the sales representative’s manager or the compliance

department. Confirm your complaint to the firm in writing. Keep written

records of all your conversations. Ask for written explanations.” SEC’s

Web site also includes specific information on unauthorized trading in a

section entitled Fast Answers, which advises customers to send

complaints to SEC via its on line complaint system. SEC has since updated

various areas on its Web site to address many of the issues we raised.

We also reviewed NASDR’s Web site, which also plays an important role in

investor education, to determine what information it provides regarding

potentially illegal behavior by securities firms. NASDR’s Web site section

entitled Filing a Customer Complaint recommends that “If you believe you

have been subject to unfair or improper business conduct by your broker,

you should complain to the brokerage firm promptly in writing.” The Web

site further recommends that investors should write to NASDR if the firm

does not resolve the problem. NASDR also provides an electronic form to

file written complaints about brokerage firms.

 16Stratton Oakmont installed a taping system in 1995 to monitor telephone calls between

firm representatives and their customers. The trustee’s staff listened to taped conversations

between Stratton Oakmont representatives and the firm’s customers to determine if trades

were ratified.
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 36 GAO-01-653 Securities Investor Protection

SEC, NYSE, and NASDR have not established requirements that clearing

firms notify customers that they should immediately complain in writing

about allegedly unauthorized trades. We reviewed a judgmental sample of

trade confirmations and account statements and found that while many

firms voluntarily notify their customers to immediately complain if they

experience any problems with their trades, instructions about the next

course of action varied. Some firms notified their customers to “complain

in writing within 10 days,” while other firms inform customers to “notify

your broker immediately.” In the latter case, the firms did not inform

investors to complain in writing, which could result in the customer

telephoning rather than writing the securities firm.

Although standardizing the notices to investors about documenting

unauthorized trading claims would likely have some benefits, these

benefits may be limited. We note that questions can be raised about the

extent of investor awareness of the disclosures currently provided on

trade confirmations and other account statements. Clearing firms that

provide disclosures that investors immediately complain in writing

typically do so in small print on the back page of trade confirmations (see

fig. 1). This information is typically included with a substantial amount of

information in similar type that the clearing firms are required to provide

to their customers. For example, SEC Rule 10b-10 requires firms to

disclose, among other things, information identifying and describing a

securities transaction and the capacity in which the firm acted (e.g., as an

agent for the customer or as a principal for its own account). Some

regulatory officials we contacted questioned whether investors take the

time to read these small disclosures on their trade confirmations and other

account statements. Nevertheless, SIPC officials said that standardizing

the disclosures to investors on account statements would be useful.

Market Regulation officials also told us that it would take a new rule or

possibly an amendment to Rule 10b-10 to require firms to make a standard

disclosure on confirmations, which in turn would require SEC to consider

both the benefits and costs of such a rule. Although there would be some

costs associated with modifying the disclosure provided on the back of

account statements, the changes could be implemented in such a way as to

keep costs to a minimum. For example, in many cases the change would

be as simple as adding “in writing” to their current statements warning

people to notify the firms of any problems with the statements.

Clearing Firms Are Not

Required to Notify

Customers to Complain in

Writing About

Unauthorized Trades
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 37 GAO-01-653 Securities Investor Protection

Figure 1: Sample Back Page of Confirmation Statement

Source: A securities firm.

SEC may identify and impose sanctions on firms that have engaged in

pervasive unauthorized trading long before they ever become SIPC

liquidations, but it does not routinely require such firms to notify their

customers about documenting unauthorized trading claims. For example,

between 1992 and 1997, Stratton Oakmont operated under intensive SEC

and court supervision in connection with, among other violations,

pervasive unauthorized trading and stock price manipulation. However, in

Opportunities Exist to

Provide Disclosures to the

Customers of Firms That

Have Engaged in Pervasive

Unauthorized Trading

If you do not understand an entry on your statement or suspect an error, it is essential that you

immediately contact the manager of the office servicing your account. We will consider your statement

correct unless we receive a written inquiry from you about the suspected error within 10 calendar days

from the day on which you received your statement. It is your responsibility to review your statement

promptly and to seek immediate clarification about entries that you do not understand.

Securities in [company name deleted] accounts are protected by the Securities Investor Protection

Corporation (“SIPC”), a non-profit organization. The SIPC provides up to $500,000 in securities protection

per customer that includes protection for up to $100,000 in uninvested cash. Through a third party

insurance carrier, [company name deleted] provides additional coverage for securities of customers up to

their total net equity balance as well as unlimited protection for uninvested cash.

Assets held by custodians, including those held in money market funds, are not covered. If you would like

more information, ask your Financial Advisor for a detailed brochure.

All transaction dates on this statement are the transactions’ settlement dates. In the case of unsettled

trades, we list the trade date instead of settlement date with a notation that the trade is unsettled.

The prices of securities displayed on your statement are derived from various sources and in some cases

may be higher or lower than the price that you would actually receive in the market. For securities listed on

an exchange or trading continually in an active marketplace, the price reflects the market quotations at the

close of your statement period. The prices of securities not actively traded may not be available. These are

indicated by “N/A” (not available).

For bonds trading less frequently, we rely on outside pricing services or a computerized pricing model,

which cannot always give us actual market values. Similarly, some annuity values provided by outside

sponsors are estimates.

The amounts on this statement for limited partnerships are typically obtained from a third party or from the

investments’ general partners unless [company name deleted] has obtained other information such as an

independent appraisal. Since many partnership valuations are provided only annually, they do not always

represent current values.

Furthermore, limited partnerships and non-traded Real Estate Investment Trusts (REITs) are illiquid and

have no public markets, so the amounts shown on this statement may not equal the amounts you would

receive if you sold your investment.

The value of mutual fund shares is determined by multiplying the Net Asset Value (NAV) by the number of

shares or units held as reported to [company name deleted] by the correspondent custodian. If we cannot

obtain a price or estimate, “N/A” appears.

For more detailed current information on prices, speak to your Financial Advisor.

This figure represents the approximate value of your account on a settlement date basis and is computed by

adding (1) the market value of all priced positions and (2) market values provided by pricing services and

correspondent custodians for other positions: and by adding any credit or subtracting any debit to your

closing cash or money market balance. Please note, this valuation may be adjusted for the net change in

priced asset values for securities held or for the net change in money market balances in your account

during the statement period. Your closing cash and/or money market balance represents the cash and/or

money market funds available in your account and reflects the net month end balance of all deposits,

credits and debits (including checking and MasterCard activity in Active Assets accounts).

If you have applied for margin privileges and have been approved, you may borrow money from [company

name deleted] in exchange for pledging assets in your account as collateral for any outstanding margin

loan. The amount you may borrow is based on the value of the eligible securities in your margin account,

which are identified by an asterisk (*) on your statement.

Errors & Inquiries

Your [company name deleted] Account Statement

SIPC Protection

Transaction Dates

Pricing of Securities

Account Valuation

Margin Privileges

(not available for IRAs or

retirement accounts)

➭
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 38 GAO-01-653 Securities Investor Protection

Stratton Oakmont, there was no requirement that the firm notify

customers that they should document their complaints in writing. In

similar future cases, requiring such firms to prominently notify their

customers to complain in writing about potentially unauthorized trades

and to exercise caution in “ratifying” such trades in discussions with firm

officials could help investors protect their interests, including potential

unauthorized trading claims in a SIPC liquidation. Further, such prominent

disclosures could benefit unsophisticated investors who may not review

the SIPC brochure or review the disclosures on the back pages of trade

confirmations and other account statements.

We recognize that not all firms that engage in unauthorized trading

become SIPC liquidations, and that requiring firms to disclose the

procedures for documenting claims could result in a loss of customer

confidence in those firms. However, as discussed earlier, SIPC liquidations

involving unauthorized trading are increasing and represented nearly twothirds of all SIPC liquidations from 1996 through 2000. Concerning

customer confidence, an SEC official who was responsible for overseeing

Stratton Oakmont said that requiring firms to notify their customers about

documenting unauthorized trades would not necessarily result in the

immediate failure of the firms and that it may be sensible to provide such

disclosures.

SIPC’s evidentiary standard, although controversial, is based on

authorities afforded SIPC and the trustees under SIPA. Claimants may use

evidence to attempt to meet the burden of proof required to prove their

claims, and it is up to the trustee and ultimately the courts to decide

whether the evidence provided is sufficient. SIPC officials have concluded,

and courts have agreed, that an objective evidence standard is necessary

to protect the SIPC fund from fraudulent claims. However, some critics of

SIPC’s evidentiary standard believe the standard is unfair because many

unsophisticated investors call rather than write their securities firm, and

available evidence supports this argument. In the Stratton Oakmont

liquidation proceeding, for example, the trustee denied 90 percent of the

unauthorized trading claims, largely because claimants were not able to

provide objective evidence to support their claim. In the two liquidation

proceedings reviewed, we found that investors appeared unaware that

failure to provide objective evidence could jeopardize their claims.

Claimants in these liquidation proceedings were twice as likely to

telephone complaints about unauthorized trading activity than to write a

letter to their broker.

Conclusions
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 39 GAO-01-653 Securities Investor Protection

Disclosure has an important role in securities market regulation, and 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. SIPC and SEC, which plays a vital role

in investor education, have missed opportunities to disclose the

evidentiary standard to investors. Many investors appeared unaware of the

steps they should take to protect their interests. SIPC’s brochure provided

no information on handling unauthorized trading complaints, and there is

no requirement that securities firms provide customers with the SIPC

brochure. In addition, SEC’s Web site offers potentially contradictory

guidance by, sometimes telling investors to call first and write if the

problem is not resolved, and other times telling them to call and confirm

the complaint in writing. SEC guidance, such as steps for dealing with

microcap fraud, generally tells investors to first call their securities firms

when they have problems with their accounts. In certain instances, such

advice could result in unscrupulous brokers pressuring investors into

increasing their investments or ratifying the trades, which would

compromise their SIPC protection.

Moreover, we identified additional limitations in the information disclosed

to investors about the evidentiary standard. First, SEC, NYSE, and NASDR

have not required that clearing firms uniformly inform investors on the

back of trade confirmations and other statements to complain in writing if

they have complaints about trades that were not authorized. Second, SEC

does not routinely require firms that are subject to enforcement actions

for pervasive unauthorized trading to advise their customers that they

should document complaints about unauthorized trades in a timely

manner.

In contrast to judicial acceptance of SIPC’s and the trustees’ policy of

requiring objective evidence to support unauthorized trading claims,

which is based on SIPA, a bankruptcy court rejected the Stratton Oakmont

trustee’s procedure for satisfying approved unauthorized trading claims as

not authorized by SIPA or any other law. However, SIPC and the trustee

have filed notices of appeal.

To improve investor awareness of SIPC’s policies, practices, and coverage,

we recommend that the SIPC Chairman, as part of SIPC’s ongoing effort to

revise the informational brochure and Web site, include a full explanation

of the steps necessary to document an unauthorized trading claim. We also

recommend that SIPC revise the brochure to warn investors to exercise

Recommendations
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 40 GAO-01-653 Securities Investor Protection

caution in “ratifying” potentially unauthorized trades in discussions with

firm officials.

In addition, SEC can take steps to improve the information it provides to

investors about SIPC and about how to protect investor interests.

Moreover, it can help ensure that more investors receive the SIPC

brochure. To improve investor awareness and education, we recommend

that the SEC Chairman

• require SIPC member firms to provide the SIPC brochure to their

customers when they open an account and encourage firms to distribute it

to its existing customers more widely;

• review the sections of SEC’s Web site and, where appropriate, advise

customers to promptly complain in writing when they believe trades in

their account were not authorized, including an explanation of SIPC’s

policies and practices and warnings about how to avoid ratifying

potentially unauthorized trades during telephone conversations;

• in conjunction with the SROs, establish a uniform disclosure rule to

require that clearing firms disclose on trade confirmations and/or other

account statements that investors should complain in writing about

unauthorized trades in a timely manner; and

• require firms that SEC determines to have engaged or are engaging in

systematic or pervasive unauthorized trading to prominently notify their

customers about the importance of documenting disputed transactions in

writing.

Overall, SIPC and SEC officials agreed with the report's conclusions and

recommendations regarding liquidations involving unauthorized trading.

However, SIPC’s written response clarified their positions on expanding

SIPC coverage to include customers of introducing firms, the

establishment of an evidentiary standard, and the 2001 bankruptcy court

decision regarding certain Stratton Oakmont claimants.

In response to our recommendation that SIPC revise its informational

brochure and Web site to explain the steps for documenting an

unauthorized trading claim, SIPC officials agreed “wholeheartedly” with

the recommendation. SIPC officials stated that the planned changes will

urge customers to complain in writing and thus make oral ratification of

unauthorized trades less likely. SIPC officials stated that its revised Web

site and brochure would refer investors to other Web sites—such as those

maintained by SEC and NASDR—that warn investors against securities

fraud.

Agency Comments

and Our Evaluation
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 41 GAO-01-653 Securities Investor Protection

SEC officials agreed that investors can best ensure that SIPC trustees will

recognize their claims resulting from unauthorized trades if they send

written complaints to their brokerage firm soon after the trade occurs.

SEC officials also agree that SEC should help educate investors about the

need to send written complaints. SEC officials stated that Commission

staff have reviewed SEC’s Web site and where appropriate added

information advising investors to complain promptly in writing when they

believe they are victims of unauthorized trading. However, SEC officials

said that it would not be appropriate to advise investors to put all

complaints in writing because most complaints can be resolved via

telephone calls, and some investors may abandon their complaints if

advised to put them in writing. We agree that all complaints do not have to

be in writing, but in instances of unauthorized trading SIPC and SEC

should advise investors to document their complaints in writing to ensure

that their interests are protected. In addition, we believe that SIPC and

SEC should advise investors to exercise caution in ratifying allegedly

unauthorized trades in conversations with firm representatives.

SEC officials stated that they supported improving disclosures to

customers. Moreover, they said that they would consider our

recommendations that SEC issue rules that would require (1) securities

firms to distribute the SIPC brochure to new customers and to encourage

the distribution of the brochure more widely to existing customers and (2)

clearing firms to provide uniform disclosures on account statements to

complain in writing about allegedly unauthorized trades. SEC staff

asserted, however, that most firms distribute the SIPC informational

brochure when customers open an account and that most statements have

language telling customers to write or notify the firm at an address if they

believe the statement is in error. SIPC officials supported the

recommendation that SEC require securities firms to provide the SIPC

brochure to new customers and stated that it would assist in the

dissemination of this information to unsophisticated investors. Relating to

the second issue raised by SEC, the intent of our recommendation

concerning information disclosures on the back of account statements is

to ensure that all clearing firms provide uniform disclosures. For the

account statements we reviewed, we did not find that firms routinely

provide an address when they instruct customers to write or notify the

firm.

SEC officials also said that they would consider our recommendation that

firms that have engaged in systematic unauthorized trading prominently

notify their customers to complain in writing about allegedly unauthorized

trades. Specifically, officials said that they would consider imposing the
Chapter 2: Opportunities Exist to Improve the

Disclosure of SIPC’s Policies in Liquidations

Involving Unauthorized Trading

Page 42 GAO-01-653 Securities Investor Protection

requirement on a case-by-case basis as part of settlement proceedings with

firms found to have engaged in systematic unauthorized trading. However,

SEC officials said that many issues arise in settling cases and that the

requirement may not be the best way to address all unauthorized trading

cases.
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 43 GAO-01-653 Securities Investor Protection

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 three

such liquidations, SIPC and the trustees denied claims by individuals who

had purchased financial products from the nonmember affiliates on

several grounds, including the determination that they were not customers

of the SIPC member firms. Although some courts had upheld the position

taken by SIPC and trustees that a claimant who places funds with an

affiliate does not qualify the claimant as a customer under SIPA, in August

2000, a federal appellate court rejected SIPC and the trustee’s arguments

on this point and others. In the fourth and most recent liquidation that we

reviewed, the trustee requested, with SIPC’s endorsement, that the

bankruptcy court consolidate the estates of the SIPC member and its

nonmember affiliate, which potentially extended SIPA coverage to

claimants who dealt with the affiliate. SIPC maintains that the factual

circumstances in the most recent proceeding warranted consolidation,

while similar circumstances were not present to the same degree, if at all,

in the other three proceedings.

SIPC and SEC have missed opportunities to educate investors about the

potential risks associated with certain nonmember affiliates. Although

SIPC’s informational brochure provides useful information, there is no

SEC requirement that SIPC members distribute the brochure to their

customers. Moreover, SEC’s Web site provides limited information about

dealing with nonmember affiliates. Given the limited information that is

available, investors may not be fully aware of the risks that can be

associated with certain nonmember affiliates.

Among other things, claimants seeking SIPA protection must be customers

of the SIPC member in liquidation, must purchase financial products that

qualify as securities under the Act, and the property they seek to have

returned must have been in the member’s custody. In three of the four

SIPC liquidations involving nonmember affiliates initiated from 1996

Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

SIPC and Trustees

Denied Nonmember

Affiliates Claims on

Several Grounds
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 44 GAO-01-653 Securities Investor Protection

through 2000 (see table 1),1 SIPC or trustees denied claims on one or more

of these grounds.2

 In determining whether a claimant qualified as a

customer of the SIPC member firm, for example, SIPC and the trustees

followed what has been referred to as the “bright-line” rule.3

 Under the

bright-line rule, SIPC and the trustees deny claims unless the cash or

securities involved had been entrusted to the SIPC member firm because

entrustment creates the custodial relationship with the member that is

protected under SIPA. However, in an August 2000 decision regarding Old

Naples Securities, a federal appellate court rejected SIPC’s and the

trustee’s application of the rule in denying customer claims, as well as

their determination that the claimants had not purchased protected

securities.

 1

In this chapter, we discuss four SIPC liquidations that involved affiliate issues, including

the New Times Securities. However, a fifth SIPC liquidation, Primeline Securities, also

raised affiliate issues. In the four liquidation proceedings discussed in this chapter,

customers were directly or indirectly induced by the principal to deposit their funds with

the nonmember affiliates. The principal used the funds to operate a fraudulent scheme. In

Primeline, by contrast, a registered representative employed by the SIPC member

apparently acted on his own to defraud customers by directing them to place their funds

with bank accounts he maintained for fraudulent purposes. Because of these differences,

we decided to exclude the Primeline liquidation from the discussion in this chapter.

2

SIPC and the trustees denied claims in the Old Naples and First Interregional liquidations

on one or more of the following grounds: (1) claimants must be customers of the SIPC

member in liquidation, (2) claimants must purchase financial products that qualify as

securities under the act, and (3) the property claimants seek to have returned must have

been in the member’s custody. SIPC opposed initiating liquidation proceedings against

Churchill Securities, primarily on grounds that the investments at issue were not securities

under SIPA. However, SIPC did not concede its position that persons who dealt with

affiliates were not customers of the SIPC member. Subsequently, SIPC initiated liquidation

proceedings against Churchill and as of January 2001, the trustee was reviewing claims.

3

See, for example, In re Stalvey & Associates, Inc., 750 F.2d 464, 469 (5th Cir. 1985)

(referring to “the bright line rule that ‘in the absence of actual receipt, acquisition, or

possession of the property of a claimant by the brokerage firm under liquidation,’ a

claimant (is) not entitled to the protection of SIPA.” (citing SEC v. Bove & Co., 378 F. Supp.

697, 699-700 (S.D.N.Y. 1974)).
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 45 GAO-01-653 Securities Investor Protection

Table 1: Selected SIPC Liquidations Involving Nonmember Affiliates.

SIPC member Nonmember affiliate(s) Filing date

Old Naples Securities Old Naples Financial Services Aug. 28, 1996

First Interregional Equity

Corporation

First Interregional Advisors

Corporation

Mar. 6, 1997

Churchill Securities CD Investment Group

Churchill Mortgage Investment

Corporation

Nov. 30, 1999

Sources: SIPC and SEC.

In each of the three cases identified in table 1, the SIPC member firms and

their nonmember affiliates were involved in schemes to defraud investors.

Claimants, victimized by these schemes, asserted that in their dealings

with the nonmember affiliate they reasonably believed that either they

were dealing with the SIPC member, or that any distinctions between the

firms were meaningless, and that both firms were treated as a single entity

by their common owners. 4

 For example, claimants maintained that

representatives of the SIPC member firms solicited investments in

products offered by the affiliate, directed or guided them toward dealing

with the affiliate, or promoted the member and the affiliate in such a way

that the claimants reasonably believed both enterprises were part of the

same entity. In some cases, claimants also provided other evidence

indicating a close relationship between the two entities, such as the use of

similar names (e.g., First Interregional Equity Corporation and First

Interregional Advisors Corporation) and locations of the SIPC member

and its affiliate on the same premises. Claimants also pointed out that in

each case one person owned or controlled the SIPC member and its

affiliate and that funds and assets held by the nonmember were used in

varying degrees to benefit either the member or the common owner.

Finally, claimants argued that they purchased financial products—such as

certificates of deposit—that qualified as securities under SIPA.

However, SIPC and trustees concluded that this evidence did not establish

that the claimants were customers of the SIPC member firms. In applying

the bright-line rule, SIPC and the trustees relied on checks or wire

transfers the claimants paid directly to the nonmembers to show that the

customers had not entrusted their investments to the member as required

 4

Typically, a trustee liquidates nonmember affiliates of SIPC members in liquidation

proceedings separate from the SIPC members. Moreover, the affiliates typically have no

assets to satisfy the claims of former customers.

SIPC’s Basis for Denying

Claims Associated With

Nonmember Affiliates
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 46 GAO-01-653 Securities Investor Protection

under SIPA. SIPC and the trustees concluded that this evidence spoke for

itself, that is, the property the claimants sought to recover was placed in

accounts somewhere else and had not been entrusted to the member. SIPC

and the trustees did not accept claims by persons who presented evidence

to show that they reasonably believed they were dealing with the SIPC

member. To the extent that claimants produced evidence to show that the

two entities actually were one or that they were used by their common

owners in such a way that they were legally indistinct, SIPC and the

trustees either considered the evidence unpersuasive or determined for

other reasons that treating the two entities as one would not be

appropriate.

In applying the bright-line rule, SIPC and the trustees focused exclusively

on whether the claimant’s property had been placed with the member.

Consequently, even if the claimant believed that he or she was dealing

with the member when placing funds with the affiliate, this belief would

not establish that the claimant was a customer of the member.5 An

example of this position is set forth in a brief SIPC and the trustee filed

with the Federal Court of Appeals for the Eleventh Circuit in In re Old

Naples Securities, Inc. v. Heebner.6

 There, SIPC and the trustee contended

that a claimant was not a customer under SIPA if he or she wrote checks

payable to an entity other than the member regardless of what the

claimant believed concerning the recipient’s status as a registered brokerdealer. 7

SIPC and trustees also denied claims in these proceedings because, in

their view, the claimants did not purchase securities as defined under

 5

SIPC refers to a decision by the United States Court of Appeals for the Ninth Circuit, In re

Brentwood Securities, Inc., 925 F.2d 325 (9th Cir. 1991), as authority for the proposition

that a claimant’s reasonable belief that he or she was dealing with the member is not the

proper basis for determining whether the claimant is a customer. Stating that an investor is

entitled to compensation from SIPC only if he or she has “entrusted” cash or securities to

the member, the court in Brentwood, rejected claims where the claimants asserted that

they had assumed or believed they had been dealing with the member. The court observed

that nothing in the record established that the broker had any role in the disputed

transactions. The claimants effectively bypassed the broker to deal directly with the

entities issuing the securities; no brokerage service was performed by either Brentwood or

an affiliate in connection with making the investments.

6

223 F.3d 1296 (11th Cir. 2000).

7

Joint Appellate Brief of SIPA and Trustee at 20-22, In re Old Naples Securities, Inc. v.

Heebner 223 F.3d 1296 (11th Cir. 2000).
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 47 GAO-01-653 Securities Investor Protection

SIPA.8 For example, in Old Naples, SIPC and the trustee determined that

claimants who allegedly purchased bonds from Old Naples Financial

Services—the affiliate of Old Naples Securities—actually made loans to

Old Naples Financial Services, which are not securities under SIPA. In a

similar situation, Churchill Securities, SIPC officials said that individuals

who allegedly purchased certificates of deposit from the nonmember

affiliates actually made loans to the affiliates or invested in unregistered

investment contracts, which also do not qualify for protection under SIPA.

In addition, SIPC and the trustees argued in some situations that claimants

already had their so-called securities in their possession, and therefore,

SIPC had no obligation to the claimants. For example, SIPC and the

trustee argued that claimants, who purchased “lease assignments” from

First Interregional Equity Corporation, or its affiliate First Interregional

Advisors Corporation, had possession of the instruments at issue because

they held the paper that recorded the assignments.

In an August 2000 decision in the Old Naples litigation, the Eleventh

Circuit rejected SIPC’s application of the bright-line rule as well as the

determination that the instruments at issue were not SIPA securities. On

the issue of dealing with an affiliate, the court recognized that “[a]

claimant is only a ‘customer’ protected by SIPA in regard to a claim for

cash entrusted to a brokerage if he of she ‘deposited [the] cash with the

debtor [or SIPC member firm]." The court further observed, however, that

determining customer status “does . . . not depend simply on to whom the

claimant handed her cash or made her check payable, or even where the

funds were initially deposited.”

9

 The court held that the claimants in that

case were customers of the SIPC member because (1) they reasonably

believed that they were dealing with the member through their dealings

with the nonmember affiliate and (2) the owner of both firms had acquired

control over customer funds held by the affiliate and used them as if they

were funds of the member firm. In addition, the court concluded that the

claimants had deposited cash that was intended to purchase bonds, which

qualify as securities under SIPA.

In November 2000, the trustee settled claims in the First Interregional

liquidation for $25 million out of a possible SIPC fund exposure of $100

 8

The issue as to whether financial products qualify as securities is not unique to cases

involving nonmember affiliates.

9

Old Naples Lexis at *11.

The Eleventh Circuit Court

of Appeals Rejected SIPC’s

and the Trustee’s Positions

in the Old Naples

Liquidation
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 48 GAO-01-653 Securities Investor Protection

million. As of January 2001, the trustee for the SIPC liquidation of

Churchill Securities continued to review claims.

In May 2000, SIPC initiated liquidation proceedings against New Times

Securities Services (New Times), which had a nonmember affiliate called

New Age Securities (New Age). Similar to the previous three liquidations,

the New Times case involved an apparently fraudulent scheme by the

controlling principal of both New Times and New Age that involved both

firms. However, in November 2000, the trustee, with SIPC’s approval,

requested that the bankruptcy court consolidate the New Times and New

Age estates for purposes of the liquidation. According to the trustee,

claimants who dealt with New Age should be considered as customers of

New Times and could qualify for SIPA protection.

Among the many reasons the trustee discussed in support of the request,

he pointed out that although New Times and New Age in many respects

operated separately, generally did not commingle their assets, and

distributed account statements under their respective names, their owner

had promoted them to investors as being indistinguishable. Because the

distinctions between New Times and New Age were unclear, claimants

either had believed that they were dealing with the member or that any

distinction between the firms was meaningless. Accordingly, the trustee

stated that the principal benefit of consolidating the firms is to

“...ease the burden upon ponzi scheme victims (the claimants) who are asserting claims for

customer status in this proceeding so that they may, in many cases, be eligible for SIPC

advances. Under the proposed consolidation order, those claims for “customer” status

(arising after the member became a SIPC member in 1995) will be determined as if New

Age and (New Times) were a single broker-dealer.” 10

As the New Times proceeding demonstrates, SIPC recognizes that under

certain circumstances a member firm and its nonmember affiliate can be

consolidated, which may benefit claimants who dealt with the affiliate.

 10In a ponzi scheme, an individual raises investment funds under fraudulent promises of

above market and typically risk-free returns. The perpetrator uses funds raised through the

scheme to pay off the investments of early participants in the scheme or for personal

expenses. Such schemes depend upon attracting an ever-increasing number of investors to

continue paying promised returns. Ultimately, ponzi schemes collapse when the

perpetrator can no longer raise funds to pay off the promised returns. The bankruptcy

court granted the trustee’s petition in November 2000.

The Trustee and SIPC

Concluded in the

Most Recent

Liquidation That

Customers of the

Nonmember Affiliate

Were Customers of

the SIPC Member
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 49 GAO-01-653 Securities Investor Protection

According to SIPC officials, the “facts and circumstances” of the New

Times proceeding differed from the facts and circumstances in the three

liquidation proceedings discussed earlier in this chapter. Because of the

facts and circumstances analysis, SIPC officials said that standard criteria

could not be developed to determine whether claimants who dealt with an

affiliate qualified as customers of the member. SIPC officials explained

SIPC’s denials of claims in the first three proceedings as cases in which

they did not believe that consolidating the estates of the SIPC members

and their nonmember affiliates was warranted.

As discussed in chapter 2, SIPC and SEC have a responsibility to disclose

information about SIPC’s policies and procedures to investors. However,

the information that investors would need to avoid the type of problems

that can be associated with fraudulent schemes conducted by certain SIPC

member firms and their affiliates is limited. SIPC’s brochure does provide

very useful information, but as also discussed in chapter 2, the SIPC

brochure is not routinely distributed to investors. In addition, SEC’s Web

site provides useful information about affiliates; however, opportunities

exist to educate investors about the potential problems that can be

associated with SIPC members that have nonmember affiliates.

SIPC’s investor informational brochure advises investors to be sure that

they are customers of a SIPC member firm and contains helpful

information that could assist investors in avoiding fraud when dealing with

certain nonmember affiliates. The SIPC brochure has a section entitled

How Can I Be Sure I am Dealing With a SIPC Member, which explains that

all SIPC members are required to display the SIPC logo. The section also

advises investors that

“Some SIPC members have affiliated or related companies or persons who conduct

investment business but who are not members of SIPC. Some of these affiliates may have

names which are similar to the name of the SIPC member, or which operate from the same

offices or with the same employees. Be sure that you receive written confirmation of each

securities transaction in your account and that each confirmation statement and each

statement of account is issued by the SIPC member and not by a SIPC member affiliate.

Deposits for credit for your securities account, by check or otherwise, should not be made

payable to your account executive, registered representative, or to any other individual, but

generally only to your SIPC member broker-dealer or, if your account is carried at another

SIPC member who provides clearing services for your SIPC member broker-dealer, then to

that other SIPC member...”

Information Available

to Investors About

Avoiding Risks That

Can Be Associated

With Nonmember

Affiliates Is Limited
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 50 GAO-01-653 Securities Investor Protection

However, investor access to this information is uncertain because there is

no requirement that SIPC members distribute the informational brochure

and many unsophisticated investors may not access the SIPC Web site.11

While SEC officials agreed that wider distribution of the brochure would

be useful, they were concerned about the costs of distributing the

brochure to 82 million account holders. Costs could be mitigated through

a variety of methods, from distributing it to only new account holders to

creating hyperlinks between SIPC and the firms’ Web sites, which

customers could access.

SEC’s Web site contains sections that generally advise investors about

risks that can be involved with affiliated entities of broker-dealers. The

SEC Web site includes a section entitled Invest Wisely: Advice From Your

Securities Industry Regulators. The section warns investors to “Never

make a check out to a sales representative” and to “Never send checks to

an address different from the business address of the brokerage or a

designated address listed in the prospectus.” SEC’s Web site also contains

a link to the SIPC Web site, which advises customers on affiliate-related

issues.

However, there are other prominent sections of the SEC Web site that

investors may access for advice that do not include specific information

about avoiding the frauds that may be associated with certain SIPC

member affiliates. Specifically, the SEC Web site has a section entitled

SEC: Protect Your Money that includes a subsection called Investor Alerts.

The purpose of the subsection is to advise investors on how to avoid

frauds that could result in substantial losses. The subsection contains links

to other Web sites as well as other sections of the SEC Web site that

discuss common frauds. These frauds include pump and dump schemes,

promissory note fraud, fraudulent telemarketers, and Internet securities

fraud. However, the subsection does not include any information the

means by which broker-dealers may set-up affiliates to perpetrate

fraudulent schemes, and the steps that investors could take to avoid these

scams.

Although SIPC’s policies and practices in liquidation proceedings involving

SIPC members that had nonmember affiliates are based on SIPA and

relevant case law, it has had mixed success defending its position in court.

 11SIPC’s Web site contractor does not keep data on the number of “hits” that the Web site

receives.

Conclusions
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 51 GAO-01-653 Securities Investor Protection

The position taken by SIPC and the trustees regarding who is a customer

and whether they purchased securities depends largely on the facts of

each liquidation proceeding. In three of the four liquidations we reviewed

involving nonmember affiliates, SIPC and SIPA trustees denied SIPC

coverage to certain claimants, in part, on the grounds that they were not

customers as defined in SIPA. SIPC and the trustees generally determined

that to qualify for customer status, SIPC and the trustee must determine

that the SIPC member firm actually received cash or securities directly

from the claimant(s). In all three of these liquidations, SIPC also denied

claims on other grounds, including that the claimants did not purchase

financial products that qualify as securities under SIPA. In August 2000, a

federal appellate court rejected SIPC and the trustee’s positions in one of

these three liquidations. The court concluded that (1) customer status

does not depend simply upon to whom the claimant writes a check to

purchase securities, (2) the SIPC member firm acquired control of

customer funds deposited with the nonmember affiliate, and (3) claimants

purchased products that qualify as securities under SIPA. Although SIPC

continues to believe that its positions were correct in this case, this court

decision establishes a precedent that other claimants can consider,

together with cases in which SIPC’s positions have been upheld, in

deciding whether to file claims that involve dealings with affiliates.

In the fourth and most recent liquidation involving a nonmember affiliate,

SIPC supported the trustee’s decision to consolidate the estates of the

member and nonmember, which would extend customer protection to

claimants, who purchased financial products from a nonmember affiliate.

Although the trustee may still deny certain claims on other grounds, these

claimants will not have their claims denied because they had accounts or

other dealings with the nonmember.

As with SIPC’s evidentiary standard regarding unauthorized trading,

opportunities exist to improve disclosure to investors about the risks that

may be associated with certain SIPC member and their nonmember

affiliates. Although SIPC’s informational brochure provides useful

information, such as writing checks to the SIPC member rather than

affiliates, there is no requirement that SIPC members distribute the

brochure to their customers. In addition, SEC’s Web site does not

prominently warn investors about how SIPC members and their affiliates

may conduct schemes to defraud their customers. We recognize that

investor education, although beneficial, has its limitations and even with

improved investor education, many investors may continue to fall victim

to fraudulent schemes perpetrated by certain SIPC member firms and their

nonmember affiliates.
Chapter 3: Disclosure of SIPC Policies in

Liquidations Involving Nonmember Affiliates

Could Be Improved

Page 52 GAO-01-653 Securities Investor Protection

We recommend that the SEC Chairman, as discussed in chapter 2, require

SIPC member firms to provide the SIPC brochure to their customers when

they open an account and encourage firms to distribute it to its existing

customers more widely. We also recommend 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 and SEC officials generally agreed with our conclusions and

recommendation pertaining to liquidations involving nonmember affiliates.

In particular, SEC agreed to implement our recommendation by updating

relevant on-line publications about the danger of sending funds to

affiliates. SIPC officials commented that the draft report's

recommendation that SEC require securities firms to provide the SIPC

brochure, which includes useful cautionary information about dealing with

nonmember affiliates, to new customers should also assist in the

dissemination of this information to unsophisticated investors.

SIPC officials also provided additional explanatory remarks about their

positions concerning liquidations involving nonmember affiliates. First,

SIPC officials restated that several courts have upheld SIPC's positions in

liquidations involving nonmember affiliates. We acknowledge this fact in

the draft by discussing one of the federal appellate court cases and citing

two others. Second, SIPC officials provided background information on

the origin and significance of the rule SIPC and the trustees base their

positions on in cases involving nonmember affiliates. SIPC officials stated

that “SIPC protection is not simply about getting money from SIPC.” They

also stated that it is a question of whether it is equitable and fair to allow

persons whom had not contributed to the assets of a firm in liquidation

proceedings to share in the assets of such firms. Finally, SIPC officials

wanted to clarify that the New Times liquidation proceeding was not the

only case in which SIPC supported the consolidation of a SIPC member

and its affiliates. SIPC stated that the New Times case is the fifth such

circumstance where SIPC supported consolidation. As we stated

throughout the draft report, the report addresses only four nonmember

affiliate liquidations, which were initiated in 1996, 1997, 1999, and 2000.

Recommendations

Agency Comments

and Our Evaluation
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 53 GAO-01-653 Securities Investor Protection

As provided in SIPA, SEC has the responsibility to oversee SIPC’s

operations and to ensure compliance with the act. During 2000, SEC

initiated several programs, which have the potential to strengthen its SIPC

oversight as provided for under SIPA. In particular, SEC initiated an

examination of SIPC, and OGC established a 1-year pilot program to

monitor ongoing SIPC liquidations and to assist investors who disagree

with SIPC trustee claim decisions. Our review found that SEC’s oversight

program faces challenges in meeting its potential goal of developing a

comprehensive assessment of SIPC’s operations. For example, to date the

SIPC examination that SEC initiated in 2000 has focused on a limited

sample of SIPC liquidations that involve unauthorized trading. Moreover,

none of these proceedings involve the affiliate issue. However, SEC

officials said that they would expand the sample to include more

liquidations that involve unauthorized trading and the affiliate issue. In

addition, SEC has not established a formal procedure to share information

about SIPC issues as recommended by the IG report. According to SEC

officials, the various groups plan to begin holding quarterly meetings to

discuss SIPC.

Market Regulation is the SEC division responsible for reviewing SIPC’s

day-to-day operations, including the review and approval of SIPC rules,

and monitoring the size and adequacy of the SIPC customer protection

fund. Although these efforts are important, in the 28-year period between

1971 and 1999, Market Regulation completed only two SIPC examinations,

the most recent of which focused on four liquidations.

In May 2000, Market Regulation and OCIE initiated a joint SEC oversight

examination. Although the ongoing SEC examination will likely provide

important information about SIPC’s operations, as of March 2001, the SEC

examination sample included a limited sample of liquidations that involved

unauthorized trading and none of the SIPC liquidations that involve

nonmember affiliates, which were discussed in chapter 3. SEC staff said

that they would include additional liquidations involving unauthorized

trading and the affiliate issue as part of the ongoing inspection.

Market Regulation has implemented its oversight responsibility for SIPC in

several ways. In particular, Market Regulation staff occasionally attend

SIPC board meetings and routinely monitor the size and adequacy of the

SIPC fund and discuss this issue with SIPC on an ongoing basis. In 1991, a

Market Regulation official served on a SIPC task force formed to make

recommendations regarding SIPC assessments on member firms. Market

Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

SEC’s SIPC Oversight

Examination Program

Has Some Limitations

Market Regulation’s

Ongoing Responsibility for

SIPC Oversight
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 54 GAO-01-653 Securities Investor Protection

Regulation and SIPC officials also communicate frequently in person and

via telephone over relevant issues and ongoing liquidations. As provided

by SIPA, SIPC also submits any proposed rule changes to SEC for review

and comment, and Market Regulation has lead responsibility for reviewing

and approving the proposed rules. In addition, SIPC regularly submits its

annual reports and audited financial statements to SEC.

However, Market Regulation’s on-site SIPC examinations have been

infrequent and limited in scope. In general, on-site examinations are a

crucial component of an effective oversight program because they provide

a comprehensive, independent, and in-depth look into the operations and

practices of the regulated entity. To provide useful and meaningful

information, examination guidelines must address relevant issues and

examination staff must review a sufficient number of items to fully

understand the regulated entity’s operations. Although contacts between

the regulator and regulated entity are important oversight tools, they

cannot substitute for an effective on-site examination program.

Despite the need for a comprehensive examination program, our 1992

report1

 found that Market Regulation had only initiated one SIPC

examination in the 21-year period between 1971 and 1992. Market

Regulation’s limited scope 1985 examination found that SIPC was doing a

good job in selecting trustees and overseeing the liquidation process.

However, our 1992 report also noted that the examination identified

actions that could speed the payment of customer claims, such as the

development of an automated liquidation system. Our report also found

that SEC did not follow-up on the 1985 examination recommendations

regarding SIPC’s automated systems. Consequently, our report

recommended that SEC periodically review SIPC’s operations and its

efforts to ensure timely and cost-effective liquidations. Market Regulation

agreed to implement this recommendation and subsequently established a

program to examine SIPC’s operations every 4 to 5 years.

In 1994, Market Regulation completed a 2-year SIPC examination that

focused on four liquidation proceedings. The examination assessed SIPC’s

efforts to maintain the size of the SIPC fund and reviewed the mechanics

of the four liquidations. In general, the SEC examination found that SIPC

and its trustees efficiently managed these four liquidations. However, the

Market Regulation examination also made several technical

 1

GAO/GGD-92-109.
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 55 GAO-01-653 Securities Investor Protection

recommendations to SIPC to improve liquidation proceedings and to

better serve individuals who file claims.

According to the SEC IG report on SEC’s SIPC oversight,2

 the 1994 SIPC

examination took 2 years to complete because Market Regulation assigned

staff to the project on a part-time basis. The SEC IG report stated that the

five staff assigned to the examination had other responsibilities, which

contributed to the length of time necessary to complete the project.

According to the IG report, SIPC staff said that, although the SEC

examination was not disruptive, they would have preferred a more timely

examination.

In May 2000, Market Regulation and OCIE initiated a joint examination of

SIPC. SEC created OCIE in 1995 to consolidate SEC’s inspection and

examination program. At that time, SEC transferred most of the

examination responsibilities of Market Regulation and the Division of

Investment Management to OCIE. Despite the transfer of most SEC

examination functions to OCIE in 1995, Market Regulation remained

involved in SIPC examinations. The IG report stated that Market

Regulation retained expertise in SIPC issues and has a constructive

relationship with SIPC staff while OCIE has valuable examination

expertise. The IG report commended Market Regulation and OCIE on

agreeing to initiate a joint SIPC examination in 2000, and, upon completion

of that examination, recommended that both SEC units continue to

conduct joint examinations and to agree on a periodic examination

schedule.

The SEC IG report identified several areas not addressed in the 1985 and

1994 inspections that could improve SEC’s oversight effectiveness. These

issues are as follows:

1. adequacy of SIPC policies, procedures, and/or standards used to

determine whether a customer request to bring a liquidation

proceeding has merit under SIPA;

2. sufficiency of SIPC guidance given to trustees regarding (a) evidence

(such as type and amount) necessary to establish a valid customer

 2

Oversight of Securities Investor Protection Corporation, Audit Report No. 301.

SEC’s 2000 Examination

Is Ongoing
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 56 GAO-01-653 Securities Investor Protection

claim and (b) recognition of legal precedents in liquidation

proceedings;

3. propriety of SIPC decisions made regarding claims submitted to the

trustee, during a proceeding, given SIPA’s requirements;

4. consistency of trustee actions in acting as a fiduciary to investors;

5. comparison of the timeliness of each stage of claim processing during

a liquidation compared with results from past inspections; and

6. reasonableness of SIPC administrative expenses, including a

comparison to amounts paid out in satisfaction of claims.

SEC Market Regulation and OCIE officials agreed that the 2000 inspection

would cover all the issues the IG report identified. The expanded scope

would allow SEC to address many of the controversies surrounding SIPC.

For example, item 2—SIPC guidance regarding evidence (type and

amount)—addresses the issues raised in SIPC’s liquidations of introducing

firms engaged in unauthorized trading. In particular, the guidance that

SIPC provided to trustees who implemented the documentation standard

for unauthorized trading claims would likely be a relevant issue for SEC’s

ongoing SIPC examination. In addition, item 6—cost of liquidation

administrative expenses—has primarily been a source of controversy in

some SIPC liquidations involving unauthorized trading claims. The

examination is to also include other areas, such as SIPC’s appointment of

trustees in larger liquidations, the scope of SIPA’s coverage, the public’s

understanding of the type of coverage SIPA provides, and the adequacy of

the SIPC fund.

As of March 2001, SEC had included four SIPC liquidations involving

unauthorized trading in its examination sample but had not included any

liquidations involving nonmember affiliates. OCIE officials told us that as

of March 2001, SEC staff had reviewed 21 SIPC liquidation proceedings.3

 In

March 2001, the sample included 4 of the 24 liquidations that involved

unauthorized trading. However, Market Regulation and OCIE staff had not

included in the examination sample any of the four liquidations involving

 3

The SEC sample of 21 liquidations includes 5 liquidations SIPC initiated from 1996 through

1999. Four of these were introducing firms that engaged in unauthorized trading. Of the

remaining 16 liquidations in the SEC sample, SIPC initiated 2 in 1995, 2 in 1994, 1 in 1993, 7

in 1992, 1 in 1991, 1 in 1989, and 2 in 1988.
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 57 GAO-01-653 Securities Investor Protection

nonmember affiliates. SEC officials told us that they were mindful of the

issues concerning unauthorized trading and nonmember affiliate claims.

They also said that the SIPC examination remained ongoing and that a

final determination on the number of liquidations to include in the final

sample had not yet been decided. However, they agreed that the sample

should be expanded to include additional liquidations involving

unauthorized trading and the nonmember affiliate issue. They said that

they planned to expand the sample of liquidations accordingly.

Given the controversies involving SIPC’s liquidations involving

unauthorized trading and nonmember affiliates, including a large number

of liquidations involving unauthorized trading and the affiliate issue, an

expanded sample size is warranted. As discussed in chapters 2 and 3,

liquidations involving unauthorized trading and affiliates comprise 75

percent of the SIPC proceedings initiated since 1996. In three of the four

SIPC liquidations involving nonmember affiliates, SIPC or trustees denied

large numbers of claims where customers purchased financial products

from the affiliates. In the Old Naples Securities liquidation proceeding, a

federal appellate court rejected SIPC and the trustee’s basis for denying

some of these customer claims. SIPC officials and trustees also

determined that consolidating the estates of the SIPC member firms and

their nonmember affiliates was not warranted in these three cases because

the members generally operated independently from their affiliates. By

contrast, SIPC and the trustee concluded in the New Times/New Age

proceeding that consolidation of the estates was warranted. Without a

review of the issues involved in these controversial SIPC liquidation

proceedings, SEC’s ongoing examination will not provide a complete basis

for understanding SIPC’s operations.

In 2000, the SEC IG found that communication among SEC’s internal units

regarding SIPC could be improved. To achieve this objective, the IG

recommended that Market Regulation, Enforcement, NERO, and OCIE

conduct periodic briefings to share information related to SIPC. 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. According to SEC officials that we contacted, they have not yet

established a regular procedure to ensure the dissemination of information

about SIPC. Subsequently, SEC officials stated that they will begin holding

quarterly meetings to discuss SIPC.

As the IG report found, periodic briefings among SEC units would help

ensure that information about issues such as investor complaints, the

SEC Has Not

Implemented SEC IG

Recommendation on

Sharing Information

About SIPC Issues
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 58 GAO-01-653 Securities Investor Protection

status of current liquidations, and securities firms that may be candidates

for SIPC liquidations are discussed in a timely manner. Moreover, the SEC

IG report also found that SEC staff in offices responsible for SIPC

oversight have expressed differing opinions on issues relevant to SIPC. By

establishing periodic briefings, SEC staff would have the opportunity to

discuss such differing opinions over SIPC and ensure a comprehensive

oversight program. SEC officials stated that they plan to begin holding

quarterly meetings.

In September 2000, SEC, at the request of OGC, Market Regulation, and

Enforcement, authorized a 1-year pilot program to monitor ongoing SIPC

liquidations. OGC requested authorization of the program after SEC

received numerous inquiries from investors and their attorneys regarding

SIPC liquidations. Under the pilot program, SEC will enter notices of

appearance in all SIPC liquidation proceedings. This will enable staff in

OGC and in SEC regional offices, which include about a dozen attorneys

specializing in bankruptcy, to monitor ongoing SIPC liquidations. The

bankruptcy staff already monitors corporate bankruptcy reorganizations

affecting public investors, pursuant to authority in the Bankruptcy Code to

take positions in reorganization proceedings. SIPA likewise authorizes

SEC to file notices of appearance and to participate as a party in

liquidations initiated under the act.

OGC staff said that the primary objective of the pilot program is to provide

oversight of claims determinations in SIPC liquidation proceedings in

order to make certain that the determinations are consistent with SIPA.

OGC staff will not be involved in evaluating investor claims until after the

trustee has made the initial determination because SEC does not want to

circumvent the claims determination process as established by SIPA. By

entering notices of appearances, SEC will receive investor objections to

adverse claims determinations and can seek authorization from SEC to

take positions in court if the staff disagrees with the determinations.

Despite SEC’s initiatives to strengthen its SIPC oversight efforts such as

the OGC pilot program, SEC faces several important challenges. The joint

Market Regulation and OCIE examination initiated in 2000 will likely

provide important information about SIPC’s operations and was expanded

to include a much larger sample of cases than the 1994 examination.

However, the sample of liquidations selected as of March 2001 included a

limited number of liquidations involving unauthorized trading claims and

did not include any SIPC liquidations that involved nonmember affiliates.

These liquidations are among the most controversial that SIPC has

SEC OGC Has

Established a Pilot

Program to Monitor

Ongoing SIPC

Liquidations

Conclusions
Chapter 4: Despite Positive Initiatives, SEC’s

SIPC Oversight Program Faces Some

Challenges

Page 59 GAO-01-653 Securities Investor Protection

initiated over the past 5 years. SEC’s plan to expand the sample of

liquidations involving unauthorized trading and nonmember affiliates

should strengthen its ongoing review.

Given the number of units involved in SIPC’s oversight, it is essential that

these units communicate across organizational lines, share information,

and take coordinated steps to resolve any critical issues that are identified.

Although SEC units share information on an informal basis, the lack of a

formal means of communication could hinder SEC’s overall SIPC

oversight efforts. In addition, the pilot program implemented in September

2000 could enhance SEC’s oversight of SIPC and provide useful timely

information about ongoing proceedings, but it is too soon to assess its

efficacy.

To improve SEC’s oversight of SIPC operations, we recommend that the

Chairman, SEC

• ensure that OCIE and Market Regulation include in their ongoing SIPC

examination a larger sample of liquidations involving unauthorized trading

and nonmember affiliate claims and

• require that Market Regulation, OCIE, OGC, and Enforcement establish a

formal procedure to share information about SIPC issues.

In general, SEC officials agreed with our conclusions and

recommendations dealing with its SIPC oversight program. Specifically,

regarding our recommendation that SEC sample a larger number of

liquidations in its ongoing SIPC inspection, SEC officials stated that they

will include additional liquidations involving unauthorized trading and

nonmember affiliates as we recommended. Regarding our second

recommendation on the need for a formal mechanism to share information

about SIPC issues, SEC officials stated that they plan to hold quarterly

meetings to discuss issues regarding SIPC. SEC said that the primary

purpose of the formal meetings will be to ensure that factual information

about investor complaints, the status of current liquidations, and other

similar matters are shared with all interested persons.

Recommendations

Agency Comments

and Our Evaluation
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 60 GAO-01-653 Securities Investor Protection

Investors that do not fully appreciate the differences in how banks and

securities firms operate may confuse SIPC with FDIC and, to a lessor

extent, state insurance guarantee associations. Although SIPC and FDIC

offer similar coverage for cash, only SIPC protects securities, whose

market value fluctuates. The market losses generated from such

fluctuations in the price of securities are not covered by SIPC. However,

securities firms are not required to disclose this information when

referring to SIPC in advertising statements. Conversely, FDIC insures

deposits, which do not fluctuate in value, and state guarantee associations

guarantee that owners of covered policies and contracts will not lose their

coverage if their insurer fails. According to industry officials, investor

confusion may increase as banking, securities, and insurance industries

consolidate.

Like FDIC, SIPC and state government life and health1

 insurance guarantee

associations protect owners of financial products when, respectively, their

securities firm or insurer fails. However, there are important differences

that customers may not fully understand and SIPC rules do not require its

members to disclose in advertising an important detail of coverage that

might help investors distinguish SIPC from the other programs.

SIPC, FDIC, and the life/health state insurance guarantee associations are

broadly similar in the main functions they perform but with important

differences. Each organization protects the owners of certain financial

products when their securities firm, bank, thrift, or insurer becomes

insolvent, subject to various statutory limitations. In a SIPC liquidation,

SIPC pays customer claims against the failed firm to the extent they

cannot be satisfied by customer cash and securities still in the firm’s

possession, and also pays the administrative expenses of a courtappointed trustee. FDIC liquidates failed members itself, as does SIPC in

 1

According to the National Organization of Life and Health Guarantee Associations, each

state has at least two guarantee associations to protect policyholders of financially

troubled insurers: one for life and health insurance and another for property and casualty

insurance. We focused on the 52 state life/health guarantee associations because the

policies their member firms sell, such as annuities, more closely resemble investments than

do many of the types of insurance sold by property/casualty insurers. The life/health

associations exist in every state, the District of Columbia, and Puerto Rico.

Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Some Investors May

Confuse SIPC and

State Insurance

Guarantee

Associations With

FDIC

SIPC’s Protection Is

Similar to FDIC and State

Life/Health Association

Guarantees, but Also

Differs in Some Important

Respects
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 61 GAO-01-653 Securities Investor Protection

some cases, and FDIC pays depositors if the firm cannot do so and pays

administrative expenses. State life/health insurance guarantee associations

assist the state insurance commissioners in liquidating failed insurers and

assume responsibility for covered policies that cannot be transferred to

another insurer. Each organization covers a broad range of their members’

traditional business. SIPC protects most types of securities and cash

deposited at the firm. FDIC insures all deposits made in the normal course

of an insured bank’s business. A state association typically covers most

types of life and health insurance sold in the state.

Despite these basic similarities, public confusion over the programs—

particularly between SIPC and FDIC—may lead to misconceptions about

coverage. Table 2 shows the different products the organizations cover

and the types of protection they offer. One key distinction is that FDIC

insures only cash deposits and SIPC protects cash and securities. Banks

can use deposits to make loans or other investments. FDIC protects

depositors against the possibility that their bank will not be able to repay

the deposit amount because it has insufficient assets. When an FDICinsured institution fails, depositors receive back all of the funds that they

deposited in (and had not withdrawn from) the institution, plus interest

that accrued prior to the insolvency, up to a statutory limit of $100,000 per

depositor.2

 Unlike deposits at a bank, securities left with a securities firm

do not become assets of the firm. Instead, the firm holds this property as a

custodian. In the event of a failure, SIPC returns missing customer

property: securities, the value of which is based on market pricing and not

the firm’s financial health, and cash held in customer accounts for the

purpose of buying securities. SIPC’s per-customer limit is $500,000, of

which no more than $100,000 may be for cash. SIPC’s statute requires it to

value securities as of the filing date. This requirement protects the filing

date value of securities in that, if the securities claimed by customers

cannot be purchased by the SIPC trustee in a fair and orderly market, the

claimant would receive their value as of the filing date. Losses caused by a

decline in the price of the securities due to market fluctuations between

the filing date and the date the investor originally purchased them would

not be covered.

 2

Multiple accounts held in different capacities (such as an individual and a corporate

account) are covered separately by both FDIC and SIPC.
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 62 GAO-01-653 Securities Investor Protection

Table 2: Protections and Disclosure Rules of SIPC, FDIC, and State Life/Health

Insurance Guarantee Associations

Guarantee

organization Nature of guarantee Disclosure rules

SIPC Returns missing securities valued

as of the filing date and investment

cash. The securities’ filing date

value may be more or less than

their original purchase price, and

the cash must have been intended

to purchase securities or result

from the sale of securities.

$500,000 per customerb

 limit, of

which no more than $100,000 may

be a claim for cash.

Official symbol must be displayed

in member firms’ offices.

Providing more information in

advertising through use of SIPC

official advertising statement, or

an official explanatory statement,

is optional.b

FDIC Returns deposits unconditionally

credited to deposit accounts as of

the date of default, plus interest

accrued as if the deposit had

matured on that date.

$100,000 per depositora

 limit.

Display and advertising rules are

similar to SIPC’s rules.

Insured institutions must disclose

that uninsured products are

neither FDIC-insured nor

obligations of the bank, and carry

market risk (if appropriate).

State Life and

Health

Insurance

Guarantee

Associations

Continuous coverage is guaranteed

if the association covers the

product. Another insurer or the

association takes over all policies

of the failed insurer.

$300,000 per policy limit in most

states.c

Twenty-four states and

Washington, D.C., require insurers

to explain the association’s

coverage and limits to new

policyholders. However, 48 states,

Washington, D.C., and Puerto

Rico prohibit insurers from

advertising membership in the

association to induce the sale of

insurance.

a

Multiple accounts held in different capacities (such as an individual and a corporate account) are

covered separately by both SIPC and FDIC.

b

The SIPC official advertising statement is “Member of the Securities Investor Protection Corporation”

or an abbreviated variant, such as “Member SIPC.” The official explanatory statement may either be

(1) “Member of SIPC. Securities in your account protected up to $500,000;” or (2) “Member of SIPC,

which protects customers of its members up to $500,000 (including up to $100,000 for claims for cash).

Explanatory brochure available on request.”

c

The state associations also have sub-limits on certain types of insurance, such as a typical $100,000

limit on health insurance benefits.

Sources: SIPA and SIPC rules, FDIC regulations, and National Organization of Life and Health

Guaranty Association documents.

Some investors in securities who erroneously believe that SIPC protects

against market losses may not fully understand the difference between

SIPC and FDIC coverage. The data on the extent that investors already

confuse SIPC with FDIC or any other organization are anecdotal. We are
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 63 GAO-01-653 Securities Investor Protection

not aware of any recent nationwide survey of investors that explored their

understanding of FDIC, SIPC, and the state insurance guarantee

associations or the differences between them. Bank regulator guidance on

investment products emphasizes the differences between the two

programs.3

 However, a recent SEC IG report4 and many securities industry

and regulatory officials we spoke with said that some customers probably

confuse SIPC and FDIC coverage. For example, FDIC officials said that

some investors do not understand the differences between FDIC and SIPC.

The main reason they cited was that both organizations have similar logos.

Another reason might be that both SIPC and FDIC protect cash up to

$100,000 per customer (SIPC) or per depositor (FDIC). The officials also

cited similarities in coverage and advertising as reasons for any confusion.

Our review of claim files in one recent SIPC liquidation suggested that

many claimants did not understand that SIPC returns securities that

should have been in the account or their value as of the date the

liquidation began, rather than the securities’ value at the time they were

purchased. The trustee in the Stratton Oakmont liquidation denied almost

450 claims for redemption of market losses.

The coverage provided by the state life/health insurance guarantee

associations resembles that of FDIC and SIPC in some ways, but they offer

another degree of protection that neither of the other two organizations

provide. Like SIPC and FDIC, the state associations may transfer customer

policies to another, healthy firm. However, the state associations

guarantee that holders of covered policies or contracts will not lose all of

their policy coverage if the company fails. An association directly takes

over policies that cannot be transferred to another insurer, as long as the

policyholders continue to pay their premiums and the policies do not

terminate on their own terms. SIPC and FDIC both may transfer customer

accounts to other firms, but when that does not occur, positions in

customer accounts are distributed subject to statutory coverage

limitations. The protection that state life/health insurance guarantee

associations provide differ from that of SIPC and FDIC in other ways, as

well. For example, most of the associations limit protection to $300,000

per policy, unlike FDIC’s $100,000 cap or SIPC’s $500,000 limit.

 3

Interagency Statement on Sales of Nondeposit Investment Products, Fed. 15, 1994. See

e.g., FDIC Interpretive Letter FIL-9-94 at 13.

4

Oversight of Securities Investor Protection Corporation. Securities and Exchange

Commission Office of Inspector General. Audit Report No. 301. Mar. 31, 2000.
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 64 GAO-01-653 Securities Investor Protection

Table 2 also compares the extent to which FDIC, SIPC, and life/health

state insurance guarantee associations require their members to inform

customers of the coverage provided by these organizations. The disclosure

requirements, or the lack thereof, may contribute to any confusion

between SIPC and FDIC, and perhaps with the state associations.

SIPC and FDIC disclosure requirements are minimal. SIPC only requires

that members display the official SIPC symbol prominently in their offices.

Advertisements, unless exempted, must include the SIPC symbol, the

official advertising statement, or the official explanatory statement, which

are discussed below. SIPC does not require that its members disclose that

SIPC does not protect against losses from changes in market value. When

asked about disclosing this information, SIPC expressed concern about

their authority to require additional disclosure in advertisements.

Specifically, officials stated that they thought the SIPA provision

authorizing SIPC to establish advertising bylaws restricted their authority

to require additional disclosure. The provision states as follows:

“SIPC shall by bylaw prescribe the manner in which a member of SIPC may display any

sign or signs (or include in any advertisement a statement) relating to the protection to

customers and their accounts, or any other protections, afforded under this chapter. No

member may display any such sign, or include in any advertisement any such statement,

except in accordance with such bylaws. SIPC may also by bylaw prescribe such minimal

requirements as it considers necessary and appropriate to require a member of SIPC to

provide public notice of its membership in SIPC.”

5

We spoke with SEC staff about SIPC’s concern regarding its statutory

authority and they do not appear to share this concern. From the face of

the statute, we also believe that the SIPA provision does not bar SIPC from

requiring the additional disclosure in the optional disclosure statement.

FDIC generally requires insured institutions to display the appropriate

official seal (FDIC has two seals, one for thrifts and one for banks) at each

station or window where deposits are normally taken. Advertisements

must include either the appropriate seal or the advertising statement,

which says only that an institution is an FDIC member. Certain

advertisements may be exempt from this requirement.

As figure 2 shows, SIPC’s official symbol resembles FDIC’s official seal.

 5

15 U.S.C. § 78kkk(d).

SIPC Does Not Require

Members to Disclose

Important Coverage Issues

SIPC and FDIC Disclosure
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 65 GAO-01-653 Securities Investor Protection

Figure 2: Official Symbols of SIPC and FDIC

Both SIPC and FDIC allow but do not require member firms to disclose

more information than can be gleaned from these logos. SIPC’s

Advertising Bylaw permits members to advertise their membership using a

“SIPC official explanatory statement.”

The explanatory statement, which has two variants, discloses somewhat

more information about SIPC coverage. The statement may either be (1)

“Member of SIPC, which protects customers of its members up to $500,000

(including up to $100,000 for claims for cash). Explanatory brochure

available on request;” or (2) “Member of SIPC. Securities in your account

protected up to $500,000.” As we discussed in chapter 3, SIPC’s brochure

describes SIPA coverage in more detail. However, SIPC does not allow

member firms to use any other language to describe its coverage in

advertisements, out of concern that they might mischaracterize SIPC

protections. For example, some firms have described the coverage as

“insurance.”

SIPC also allows members to use an official advertising statement. Yet,

this statement (“This firm is a member of the Securities Investor

Protection Corporation” or an abbreviated version such as “member

SIPC”) provides no more information to investors than the official symbol

does. FDIC also requires insured institutions to use an official advertising
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 66 GAO-01-653 Securities Investor Protection

statement in most advertising. The statement (Member of the Federal

Deposit Insurance Corporation” or an abbreviated version), like SIPC’s

official advertising statement, discloses few details about the

organization’s coverage.

Although FDIC only mandates use of its official seals or the official

advertisement statement in advertising, there may be no need for

additional disclosure. Arguably, FDIC protection is easier for consumers

to understand, because it generally guarantees deposits placed in a failed

insured institution. Unlike securities prices, cash deposits do not fluctuate

in value. As explained above, SIPC protects the filing date value of

securities, but not their original purchase price. Also, FDIC-insured

institutions must disclose to their retail customers which of their products

are not FDIC insured. As table 2 shows, they must inform customers, in

writing and orally at the time of sale, that the uninsured product they are

selling is not FDIC insured nor an obligation of the bank, and that the

product carries market risk if that is appropriate. Further, according to

FDIC officials, FDIC encourages insured institutions to disclose as much

information as possible about the organization’s insurance. In contrast,

SIPC member firms are not required to disclose which products they sell

are not protected by SIPC (such as commodity-based investments),

although they are prohibited from displaying or advertising SIPC

membership if doing so would mislead the public into believing that

products they sell that do not meet SIPA’s definition of a security are

protected.

SIPC’s disclosure rules differ from many states’ requirements that

members of a life/health insurance guarantee association must

prominently disclose the limitations to the association’s protections. Most

of the associations are based on a “model act” drafted by the National

Association of Insurance Commissioners (NAIC). The NAIC model act

reflects the consensus of state insurance commissioners on how states

should write their insurance laws. The model act for life/health insurance

guarantee associations recommends that states prohibit any insurer, agent,

or affiliate of an insurer from publishing, disseminating, or advertising

membership in a life/health state insurance guarantee association “for the

purpose of sales, solicitation, or inducement to purchase any form of

insurance covered by the guarantee association.” The purpose of

prohibiting advertising of membership is to help prevent people from

making insurance decisions out of a belief that they are protected from

financial loss.

State Insurance Guarantee

Association Disclosure
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Financial Industries Restructure

Page 67 GAO-01-653 Securities Investor Protection

However, the advertising prohibition does not mean that policyholders do

not know of the existence of their state’s life/health insurance guarantee

association. The model act also recommends that states require insurers to

provide a document that summarizes the general purposes and current

limitations of their state’s life/health guarantee association whenever the

insurer delivers a policy or contract to a policy or contract owner. The

model act recommends that this document state clearly and

conspicuously, among other things, (1) that the guarantee association may

not cover the policy or, if it does, that coverage will be subject to

substantial limitations and exclusions and (2) the types of policies for

which the association will provide coverage. An example of a substantial

limitation or exclusion is that most of the life/health associations do not

cover nonindemnity policies, such as health maintenance organizations.

Table 2 also shows the number of states whose laws conform to the model

act’s recommendation on life/health insurance guarantee association

disclosure and advertising. As the table indicates, 48 states, Washington,

D.C., and Puerto Rico prohibit insurers from using the existence of their

association to sell any insurance product; and 24 states and Washington,

D.C., require insurers, insurance agents, and affiliates of insurers to

provide a written explanation of their association’s coverage and coverage

limits to all new policyholders.

As banks, securities firms, and insurance companies consolidate and offer

similar products to the public, some people may increasingly confuse

SIPC, FDIC, and state life/health insurance guarantee organizations.

GLBA makes major changes to the laws that govern how the U.S. financial

services industry is structured and regulated. Before GLBA passage,

federal and state laws limited the extent to which banking, securities, and

insurance companies could affiliate. For example, banking and insurance

companies were not allowed to affiliate nor were securities companies

permitted to own banks. National banks could underwrite and deal in only

certain types of securities known as bank-eligible securities. These

included U.S. government securities and general obligation bonds of states

and municipalities. Also, banks could engage in any mutual fund activity,

except for underwriting the mutual fund. Securities firms that were

Investor Confusion

May Increase as

Financial Services

Industy Consolidates

GLBA Eliminates Barriers

to Affiliation Among

Banks, Securities Firms

and Insurance Companies
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 68 GAO-01-653 Securities Investor Protection

affiliates of banks that were members of the Federal Reserve System were

allowed to underwrite and deal in securities to a limited extent.

GLBA repeals or overrides sections of federal and state laws that

restricted the affiliation of banks, securities firms, and insurance

companies and agents. It permits traditional bank holding companies and

foreign banks to expand into new insurance and securities activities and

insurance and securities firms to enter commercial banking. Under GLBA,

banking institutions can participate in the securities and insurance

businesses by becoming Financial Holding Companies (FHC), a new kind

of bank holding company authorized by the act. An FHC may directly

engage in, or affiliate with companies that engage in, a wide array of

financially related activities. These activities include securities

underwriting and dealing, insurance underwriting and agency activities,

and any other activity that the Federal Reserve Board (usually in

conjunction with the Secretary of the Treasury) determines to be financial

in nature or incidental or complementary to financial activities.

GLBA also expands the range of financial activities that banks that are not

FHCs may engage in. The act does this by allowing national banks to form

or purchase subsidiaries that may engage in some, but not all, of the

activities that FHCs may engage in. For example, the national bank

subsidiaries are prohibited from engaging as principle in underwriting

insurance (other than credit-related insurance) or providing or issuing

certain types of annuities.

Regarding insurance, GLBA reaffirms the traditional authority of the states

to regulate the insurance industry. However, the act uses broad

preemptive language intended to override any state law restricting the

establishment of bank-insurance affiliations or placing burdens on sales

and cross-marketing of insurance by banking institutions and their

affiliates. The preemption provisions apply to any type of affiliation

permitted by GLBA, not just to the FHCs that the law creates. GLBA does

maintain some restrictions on banks’ insurance activities. Still, many state

laws that prohibit insurers from merging or affiliating with banks or

securities firms will be superseded.

Ultimately, GLBA may lead to creation of financial conglomerates that

contain under one corporate umbrella underwriters and distributors of

banking, securities, insurance, and other financial and complementary

products and services. Such consolidation already has occurred in some

institutions. Whether or not financial one-stop shops become the norm in

this country, as the U.S. financial services industry consolidates to take

Greater Disclosure May

Help Address Investor

Confusion
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 69 GAO-01-653 Securities Investor Protection

advantage of GLBA’s opportunities, it will be more common in the future

for individuals to purchase financial products from the same institution

that are covered by the three different financial guarantee organizations

that we have been discussing. An individual who buys securities from a

securities firm affiliate of an FHC may be protected by SIPC should the

firm fail. That same person may be covered by a state insurance guarantee

fund if he or she buys certain types of insurance from the same or another

affiliate. And, funds deposited with a banking affiliate of one of these

entities may be insured by FDIC.

In chapters 2 and 3, we highlighted the need to improve disclosure of

SIPC’s policies and practices. SIPC has engaged a private firm to survey

investors to discover how well they understand SIPC coverage. The firm is

also charged with devising ways in which SIPC coverage could be better

advertised.

SIPC and FDIC perform similar functions: they return customer property

when a member firm fails if the firm cannot do so. Moreover, SIPC and

FDIC share similar logos and coverage amounts. As financial companies

continue to consolidate, investor confusion concerning SIPC protections

could grow more widespread. In a consolidated entity, it’s possible for a

single customer to have various accounts with various affiliates that are

afforded different types of protection.

Although SIPC’s mission is to return the securities or cash that should

have been in a customer’s account when liquidation proceedings start, we

found some evidence that investors are unaware that SIPC does not

protect against decreases in the price of their securities. This type of

misperception has led some investors to file claims for market losses in

SIPA liquidation proceedings that were denied. The official explanatory

statement that SIPC members can opt to use does not state that SIPC does

not protect against losses from changes in the market value of securities.

We recommend that the Chairman, SIPC, amend SIPC advertising bylaws

to require that the official explanatory statement about a firm’s

membership in SIPC include a statement that SIPC coverage does not

protect investors against losses caused by changes in the market value of

their securities.

SIPC agreed with our conclusion that there is ample anecdotal evidence

that some investors believe that SIPC protection is akin to FDIC

protection and that some investors believe that SIPC will protect them

from market losses. Furthermore, they agreed that the industry has an

Conclusions

Recommendation

Agency Comments

and Our Evaluation
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 70 GAO-01-653 Securities Investor Protection

obligation to correct these misperceptions. However, they disagreed with

our recommendation that SIPC require any statement about SIPC

membership to include information about the fact that SIPC does not

protect investors from market losses. According to SIPC officials, the

statute does not give SIPC the power to adopt such a bylaw and such a

statement, without elaboration, would be misleading.

Regarding SIPC’s concern about its statutory authority, SIPC stated that in

the early 1970s it proposed a bylaw that would have required members to

give public notice of their SIPC membership. According to SIPC, SEC

rejected the proposal “on the ground that SIPC did not have authority to

require its members to identify themselves as such.” Consequently, in

1978, Congress amended 15 U.S.C. § 78kkk(e) and added the following

sentence: “SIPC may also by bylaw prescribe such minimum requirements

as it considers necessary and appropriate to require a member of SIPC to

provide public notice of its membership.” Even though the sentence

appears to grant SIPC discretion to determine what such “minimum

requirements” should be, SIPC maintains that, on the basis of the

legislative history, Congress strictly limited that discretion to allow only

for a requirement that a SIPC member must identify its status as a

member. Although we recognize SIPC’s discretion to interpret its enabling

legislation, we do not believe that the provision in question precludes SIPC

from adding our recommended statement to an official explanatory

statement already authorized in its bylaws. Further, SEC staff does not

share SIPC’s statutory concern. The legislative history cited by SIPC in its

comments clearly shows that Congress intended SIPC to have discretion

to impose “minimal notice” of SIPC membership. As shown below, SIPC’s

bylaw permitting use of an official explanatory statement allows a

member’s statement about its membership to include a statement about

SIPC coverage. We believe that SIPC has discretion to require members to

disclose in prescribed language the fundamental consequence of SIPC

membership when a firm chooses to use SIPC’s official explanatory

statement.

We have reworded our recommendation to make it clear that it

contemplates SIPC amending SIPC’s bylaw allowing members to disclose

more information than can be gleaned from the SIPC logo by using a SIPC

“official explanatory statement.” The statement has two variants (1)

“Member of SIPC, which protects customers of its members up to $500,000

(including up to $100,000 for claims for cash). Explanatory brochure

available upon request;” or (2) “Member of SIPC. Securities in your

account protected up to $500,000.” As SIPC states, “SIPC can, by bylaw,

give its members the option of making a statement about SIPC coverage.”
Chapter 5: Investors May Confuse SIPC With

Other Financial Guarantee Programs as U.S.

Financial Industries Restructure

Page 71 GAO-01-653 Securities Investor Protection

Our recommendation involves amending SIPC’s official explanatory

statements to include information about losses from changes in market

values not being protected.

SIPC also raised an additional concern that the recommended language

that SIPC does not protect against market losses would be misleading. We

do not share SIPC’s concern that amending SIPC’s official statement,

without elaboration, would be misleading. In its comments, SIPC sets forth

three reasons why it believes the statement would be incomplete and

misleading. These reasons relate to steps SIPC might take in liquidating a

member should certain circumstances exist, that is; (1) providing the

actual securities, (2) purchasing replacement securities, and (3) providing

the cash value of the securities as of the filing date. Regardless of what

steps SIPC might take in a particular proceeding, SIPC’s actions would not

change the fundamental fact that a firm’s SIPC membership does not

protect investors against market losses.

Rather than being misleading, we believe that our recommended language

about market losses not being covered is consistent with current

disclosures about SIPC coverage that SIPC and securities regulators

already make to investors. For example, the first page of SIPC's

informational brochure contains the following statement:

"Of course, SIPC does not protect against changes in the market value of your investment.

It does, however, provide important protections against certain losses if a SIPC member

fails financially and is unable to meet obligations to its securities customers.”

Moreover, our recommended language, which was based on SIPC’s

information brochure, is similar to language used by SEC and NASDR on

their Web sites to discuss SIPC coverage. For example, the SEC Web site

states that “ SIPC does not protect you against losses caused by a decline

in the market value of your securities.”
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 72 GAO-01-653 Securities Investor Protection

Appendix I: Comments From the Securities

Investor Protection Corporation
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 73 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 74 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 75 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 76 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 77 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 78 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 79 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 80 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 81 GAO-01-653 Securities Investor Protection
Appendix I: Comments From the Securities

Investor Protection Corporation

Page 82 GAO-01-653 Securities Investor Protection
Appendix II: Comments From the Securities

and Exchange Commission

Page 83 GAO-01-653 Securities Investor Protection

Appendix II: Comments From the Securities

and Exchange Commission
Appendix II: Comments From the Securities

and Exchange Commission

Page 84 GAO-01-653 Securities Investor Protection
Appendix II: Comments From the Securities

and Exchange Commission

Page 85 GAO-01-653 Securities Investor Protection
Appendix II: Comments From the Securities

and Exchange Commission

Page 86 GAO-01-653 Securities Investor Protection
Appendix II: Comments From the Securities

and Exchange Commission

Page 87 GAO-01-653 Securities Investor Protection
Appendix II: Comments From the Securities

and Exchange Commission

Page 88 GAO-01-653 Securities Investor Protection
Appendix III: GAO Contacts and Acknowledgments

Page 89 GAO-01-653 Securities Investor Protection

Richard J. Hillman (202) 512-8678

Orice M. Williams (202) 512-8678

In addition to the persons named above, David Genser, Rosemary Healy,

Wesley M. Phillips, and Paul G. Thompson made key contributions to this

report.

Appendix III: GAO Contacts and

Acknowledgments

GAO Contacts

Acknowledgments

(233640)

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