The Investor’s Bankruptcy Shield and the Series 7 Exam

By Steven M. Rice

For the Series 7 exam, you need to know some basics about the bankruptcy shield. The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance, which guarantees a certain level of safety to people who have money on deposit at a bank. FDIC protects accounts from bank failure (bankruptcy). At the present time, each depositor is protected up to $250,000.

The Securities Investor Protection Corporation (SIPC) protects the customer against broker-dealer bankruptcy. Although it’s not a government agency, this private, nonprofit organization was created by the government in 1970. The SIPC protects each separate customer’s assets (securities and cash) up to $500,000 total, of which no more than $250,000 can be cash.

Although brokerage firms are required to follow net capital rules — specifically SEC Rule 15c3-1 — that are designed to minimize the chances of broker-dealer failure and protect customer assets, broker-dealers occasionally (too often) declare bankruptcy.

The following question concerns SIPC coverage.

  1. John Fredericks has a cash account with $150,000 in securities and $300,000 cash and a margin account with $50,000 in equity. Additionally, John has a joint cash account with his wife Mary with 250,000 in securities and $300,000 cash. If John’s broker-dealer goes bankrupt, what is his coverage under SIPC?

    (A) $450,000

    (B) $500,000

    (C) $850,000

    (D) $950,000

The right choice is (D). If one of your customers has a cash and margin account titled under one name, as John does, it’s treated as though it belongs to one customer. Therefore, John’s cash and margin account is covered up to $500,000, of which no more than $250,000 can be cash. He’s covered for the $200,000 in securities ($150,000 in securities plus the $50,000 equity) and $250,000 of the $300,000 cash for a total of $450,000. Next, the joint account with his wife is treated as though from a separate customer. Therefore, that account is covered for the $250,000 in securities and $250,000 in cash. Add the two together, and you see that John is covered for a total of $950,000 ($450,000 plus $500,000).

If an investor is not fully covered under SIPC, the investor is still owed money by the bankrupt broker-dealer; therefore, the investor becomes a general creditor of the firm for the balance owed.