The last two weeks have seen vast changes to the financial industry in this country. These are so much in the news that there is little point in reiterating the lengthening list of investment banks, thrifts, and insurers that have failed, been bought, seized, or bailed out by the Treasury or the Fed. Because so many enormous, and venerable, institutions have been affected, investors may naturally worry, not just about the state of the markets and the economy, but about the safety of their financial assets. Indeed, we have received a few telephone calls from clients concerned about this issue. We therefore thought it would be appropriate to clarify the asset protection offered to our clients by their custodians (SCLC is not itself a custodian, and thus has no client assets to protect).

Fidelity, Schwab, and TD Ameritrade are the three custodians our clients most commonly employ. Like all registered broker/dealers, these firms may not commingle customer assets with their own. Rather, customer assets are held in trusts separate from those of the firm. In the event of a custodian’s bankruptcy, its own assets may thus easily be distinguished from those of its customers. To ensure the segregation of assets and the accuracy of recordkeeping, the SEC periodically audits the financial records of all broker/dealers. The relationship between custodians and customers is detailed in the SEC Customer Protection Rule (Rule 15C3-3).

When a broker/dealer closes its doors, the assets in customer accounts do not disappear, nor are they appropriated to settle the failed firm’s debts. Rather, in virtually all cases, the broker/dealer operation itself remains open for business, able to transact for clients, and to handle their service requests, until customer accounts can be transferred in orderly fashion to a competitor. In most cases, the transfer is to a competitor that has purchased the failed firm, or its brokerage subsidiary. In many cases, the circumstances of the purchase are such that customer accounts remain just where they had been. For example, it may well make more sense for Bank of America to merge its broker/dealer operation into the much larger broker/dealer operation of its newly purchased subsidiary, Merrill Lynch. Likewise, when Barclays purchased the brokerage operation of Lehman Brothers, they were motivated in part by the opportunity to capture a substantial footprint in the US, where their brokerage business has so far been insignificant. The Lehman broker/dealer may remain in full operation, with “Barclays” banners hung over the old “Lehman” signs.

That said, the failure of a broker/dealer can be a messy business, and it is not uncommon for failed firms to impose a blackout period on customers, generally lasting for a few days only, during which they are unable either to trade or to gain access to their assets, until the operational issues are sorted out. The process can be messy for customers, too, when their accounts are transferred to a successor broker/dealer: they must cope with new commission schedules, new statements, new service arrangements, new brokers, new office locations and back office procedures. We flatter ourselves that one of the first questions our own clients would ask in such a situation is, “Will the new broker/dealer continue to work with my registered investment advisor?”

We at SCLC have been blessed over the years to discover that our philosophy of investing has resulted in unforeseen benefits to our clients – and, therefore, to us. Our relentless focus on cost control has inclined us from the beginning to suggest to clients that their interests would be best served by their doing business with so-called “discount” broker-dealers, who are focused on excellent service to investors, with low trading fees, no sales commissions, and that are not also engaged in other businesses that are not focused on investors – such as large investment banking or insurance operations. We were interested primarily in reducing client trading expenses and conflicts of interest at the broker (engendered, e.g., by business imperatives arising from the investment banking operation). Lo and behold, the recent market turmoil has taken down exactly the sort of broker/dealers we have abjured. The recent problems with financial institutions have not been attributable to problems in their brokerage and custodial operations, but rather, to excessive leverage and poor risk management of the parent corporations, due to their involvement in businesses that are not focused directly on service to investors.

Our clients have elected to custody the vast majority of their assets at the “big three” discount brokers: Schwab, Fidelity, and TD Ameritrade. Schwab has only limited investment banking exposure; privately-owned Fidelity has none; and TD Ameritrade, owned by a large and stable Canadian commercial bank, has very little. None of the three are deeply involved in the insurance business, and such involvement as they have is ancillary to their investor service operations. There is of course no guarantee that any of these firms might not also experience problems. But, at least for the time being, the good news is that the firms we and our clients prefer are not of the sort that are failing; further, the firms most adapted to doing business with clients of independent registered investment advisors such as Schultz Collins seem to be of the type that are least likely to fail. We like to think that this happy fact constitutes yet another argument for the “unbundling” of investment advice and brokerage services – i.e., for the business model that we have adopted as best and most efficient for our clients, and least afflicted with conflicts of interest for us (and, therefore, for our clients).

Nevertheless, it cannot be too strongly emphasized that anything could happen, and it is of course always possible for any firm to fail. SEC regulations give significant protection to consumers in their broker/dealer relationships. But what if the worst happens? What if a brokerage firm fails, and the securities it has held for customers somehow disappear due to fraud, malfeasance, or loss of records?

All registered broker/dealers provide protection from this peril through the Securities Investor Protection Corporation (SIPC), which they must all join as a condition of doing business as a broker/dealer. SIPC protects brokerage accounts of each customer against broker/dealer failure, in amounts of up to $500,000 for accounts held in each separate legal capacity (e.g., joint tenant or sole owner), including a limit of $100,000 on claims for cash. Money market funds held in a brokerage account are considered securities. For details, please see www.sipc.org

FINRA – the Financial Industry Regulatory Authority (formerly known as the National Association of Securities Dealers, or NASD) – is the body charged with regulation of broker/dealers. A superb and lucid summary of the protections offered to investors by the regulatory regime in this country, and of what investors should do in the event their broker/dealer fails, may be found in an article at their website: If a Brokerage Firm Closes its Doors. You may also contact FINRA at (301) 590-6500

It is important to understand that SIPC does not compensate investors for declines in the market value of their securities, but only for the loss of the actual securities themselves. Nor does SIPC provide coverage of any kind at all for commodity futures, fixed annuities, currencies, hedge funds, or investments that are not registered with the SEC as securities (e.g., shares in a limited partnership formed among investors who are personally acquainted with each other, and of which, because they are never traded through registered brokers, SEC is agnostic).

In addition to SIPC coverage, Fidelity, Schwab, and TD Ameritrade all maintain additional coverage:

• Fidelity provides asset protection for total net equity (cash and securities) in each account. It is not subject to a dollar limit for any one account or for the firm. For more information about Fidelity’s excess SIPC coverage, visit www.capcoexcess.com

• Schwab provides additional insurance through Lloyd’s of London. Combined with SIPC, it provides protection of securities and cash up to an aggregate of $600 million, limited to a combined return to any customer from a Trustee, SIPC and Lloyd’s of $150 million, including cash of up to $1 million.
  

• TD Ameritrade also provides additional insurance through Lloyd’s of London. Combined with SIPC, it provides protection limited to a combined return to any customer from a Trustee, SIPC and Lloyd’s of $150 million, including cash of up to $900,000.
  

We hope this message has been informative. We will continue to monitor the situation, and provide noteworthy updates. If you have any questions or concerns on the topic, please feel free to contact us.