I. INTRODUCTION
In 2002, the FDIC alerted financial institutions of credit risks involved when maintaining custodial relationships with broker-dealers for the safekeeping of securities. The FDIC advised that management should review existing custodial relationships, evaluate the creditworthiness and reputation of custodians and insure that the financial institution maintains properly diversified custodial relationships. The alert was prompted by losses resulting from the failure of a large regional broker-dealer and its subsequent liquidation by the Securities Investor Protection Corporation (SIPC).
II. SECURITIES INVESTOR PROTECTION ACT OF 1970
The Securities Investor Protection Act of 1970 (SIPA) created the SIPC to provide certain protections to customers against losses from the failure of securities broker-dealers. Under the SIPA, only customers of a SIPC (i.e., member firms that qualify for SIPC protection) and only “customer property” (as defined in the SIPA and determined to be in a member firm’s custody) are covered. Although SIPC coverage allows a financial institution, for its own account, to share in “customer property,” an institution cannot receive advances from SIPC. In the event that a financial institution demonstrates that it is acting as an agent for an investor, that investor is entitled to separate status as a “customer” and is eligible to receive advances from SIPC.
In general, when a broker-dealer fails, during the subsequent liquidation proceeding, the trustee for the failed broker-dealer will: (1) return, to customers, property that is registered in a specific customer’s name; (2) pay those customers their pro rata share of “customer property”; and (3) provide customers (other than financial institutions and broker-dealers for their own accounts) SIPC advances up to $500,000 to cover losses caused by missing securities or cash (but not loss of principle or interest). Customers not subject to SIPC protection, e.g. financial institutions, receive a pro rata distribution of “customer property.”
III. FINANCIAL INSTITUTION DUE DILIGENCE REQUIRED
Financial institutions should be aware of the SIPC’s coverage and claims procedures and be able to differentiate between institution-owned and institution customer-owned accounts and securities held at failed broker-dealers. The FDIC advises financial institutions to use due diligence when selecting a broker-dealer for custodial services. Institutions should establish and periodically review broker-dealer selection criteria, including an inquiry into the broker-dealer’s creditworthiness and its reputation, by checking with state and federal securities regulators and industry self-regulatory organizations such as the National Association of Securities Dealers (NASD).
IV. CONCLUSION
Suggesting that even the use of sound due diligence practices may not adequately minimize a financial institution’s potential exposure, the FDIC encourages institutions to maintain “properly diversified custodial relationships” by maintaining relationships with different custodians to minimize its exposure in this area.