oversight

Securities Investor Protection: Update on Matters Related to the Securities Investor Protection Corporation

Published by the Government Accountability Office on 2003-07-11.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to Congressional Requesters




July 2003
             SECURITIES
             INVESTOR
             PROTECTION
             Update on Matters
             Related to the
             Securities Investor
             Protection
             Corporation




GAO-03-811
             a
                                                July 2003


                                                SECURITIES INVESTOR PROTECTION

                                                Update on Matters Related to the
Highlights of GAO-03-811, a report to           Securities Investor Protection
congressional requesters
                                                Corporation



As result of ongoing concerns                   SEC has taken steps to implement each of the seven recommendations
about the adequacy of disclosures               directed to SEC in GAO’s May 2001 report. SEC has updated its Web site to
provided to investors about the                 provide investors with more information about SIPC’s policies and practices,
Securities Investor Protection                  particularly with regard to unauthorized trading and nonmember affiliate
Corporation (SIPC) and investors’               claims. SEC has taken other steps consistent with our recommendations to
responsibilities to protect their
investments, GAO issued a report                improve its oversight of SIPC and is working with self-regulatory
in 2001 entitled Securities Investor            organizations (SRO) to increase investor awareness of SIPC’s policies
Protection: Steps Needed to Better              through distribution of the SIPC brochure and disclosures on account
Disclose SIPC Policies to Investors             statements.
(GAO-01-653). GAO was asked to
determine the status of                         Likewise, SIPC has taken steps to implement the three recommendations
recommendations made to the                     directed to SIPC in our 2001 report, but additional work is needed on one.
Securities and Exchange                         SIPC has updated its brochure and Web site to clarify that investors should
Commission (SEC) and SIPC in                    complain in writing to their securities firms about suspected unauthorized
that report. GAO was also asked to              trades. SIPC also expanded a statement in its brochure that discusses
review a number of issues involving             market risk and SIPC coverage and amended its advertising bylaws to
excess SIPC insurance, private
insurance securities firms purchase             require firms that display an expanded statement about SIPC to include a
to cover accounts that are in                   reference or link to SIPC’s Web site. Moreover, SEC, the NASD, and many
excess of SIPC’s statutory limits.              securities firms provide the recommended disclosures about the scope of
                                                SIPC coverage to investors on their Web sites. SIPC also added links to Web
                                                sites in its brochure that offer information about investment fraud.
                                                However, investors could benefit from more specific links to investor
To ensure that investors have                   education information.
access to relevant information
about SIPC, GAO recommends that                 Until this year, certain well-capitalized, large, and regional securities firms
SIPC provide more specific
                                                were able to purchase and provide excess SIPC coverage from four major
references to investor education
                                                insurers. The insurance policies varied by firm and insurer in terms of the
information in its brochure.
                                                amount of coverage offered per customer and in aggregate per firm.
In addition, GAO recommends that                Attorneys familiar with the policies agreed that the disclosure of the
SEC, in conjunction with the SROs,              coverage and the terms of coverage could be improved. During the review,
ensure that firms are providing                 GAO found that three of the four major insurers that offered excess SIPC
investors with meaningful                       coverage in 2002 stopped underwriting these policies in 2003. Consequently,
disclosures about excess SIPC and               as the policies expire in 2003, most insurers are not renewing their existing
monitor firm disclosures about any              policies and have stopped underwriting new policies. At this time, holders
changes in the coverage.                        of the insurance policies have not decided what to do going forward.
                                                However, several options are being explored including self-insuring and
SEC and SIPC generally agree with               purchasing policies from the remaining major insurer.
the report’s findings and
recommendations.



www.gao.gov/cgi-bin/getrpt?GAO-03-811.

To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Richard J.
Hillman, (202) 512-8678, hillmanr@gao.gov.
Contents



Letter                                                                                                     1
                             Results in Brief                                                              2
                             Background                                                                    5
                             SEC Has Taken Steps to Address Our Recommendations                           11
                             SIPC Has Taken Steps to Improve Investor Education                           16
                             Terms of Existing Excess SIPC Policies Vary, and Most Insurers
                               Have Stopped Underwriting New Policies                                     20
                             Conclusions                                                                  28
                             Recommendations                                                              29
                             Agency Comments                                                              29
                             Objectives, Scope, and Methodology                                           30


Appendixes
              Appendix I:    Comments from the U.S. Securities and Exchange
                             Commission                                                                   32
             Appendix II:    Comments from the Securities Investor Protection
                             Corporation                                                                  34
             Appendix III:   GAO Contacts and Staff Acknowledgments                                       36
                             GAO Contacts                                                                 36
                             Acknowledgments                                                              36


Table                        Table 1: Examples of How SIPC Protects Investors                             11




                             Page i                                 GAO-03-811 Securities Investor Protection
Contents




Abbreviations

FDIC         Federal Deposit Insurance Corporation
IG           Inspector General
NERO         Northeast Regional Office
NYSE         New York Stock Exchange
OCIE         Office of Compliance Inspections and Examinations
OGC          Office of General Counsel
PSA          public service announcement
SEC          Securities and Exchange Commission
SIA          Securities Industry Association
SIPA         Securities Investor Protection Act of 1970
SIPC         Securities Investor Protection Corporation
SRO          self-regulatory organization


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 reproduce this material separately.




Page ii                                         GAO-03-811 Securities Investor Protection
A
United States General Accounting Office
Washington, D.C. 20548



                                    July 11, 2003                                                                             Leter




                                    The Honorable John D. Dingell
                                    Ranking Minority Member
                                    Committee on Energy and Commerce
                                    House of Representatives

                                    The Honorable Barney Frank
                                    Ranking Minority Member
                                    Committee on Financial Services
                                    House of Representatives

                                    The Honorable Paul E. Kanjorski
                                    Ranking Minority Member
                                    Subcommittee on Capital Markets,
                                     Insurance and Government Sponsored Enterprises
                                    Committee on Financial Services
                                    House of Representatives

                                    Disclosure has an important role in securities market regulation, and the
                                    Securities Investor Protection Corporation (SIPC) has a responsibility to
                                    inform investors of actions they can take to protect their investments and
                                    help ensure that investors are afforded the full protections allowable under
                                    the Securities Investor Protection Act of 1970 (SIPA). In our 2001 report,
                                    we concluded that many investors were unaware of the steps they should
                                    take to protect their investments.1 We found that SIPC and the Securities
                                    and Exchange Commission (SEC), which play vital roles in investor
                                    education, had missed opportunities to disclose information on SIPC’s
                                    policies, practices, and coverage to investors. Our report contained 10
                                    recommendations to SEC and SIPC about ways to improve the information
                                    available to the public about SIPC and SEC’s oversight of SIPC.

                                    This report responds to your August 16, 2001, and October 30, 2001,
                                    requests that we followup on our 2001 report recommendations. As
                                    requested, this report also includes information about “excess SIPC,”
                                    which refers to private insurance that securities firms can purchase to
                                    cover customer claims that are in excess of the $500,000 (which includes
                                    $100,000 cash) limits established by SIPA. Excess SIPC policies typically


                                    1
                                     U.S. General Accounting Office, Securities Investor Protection: Steps Needed to Better
                                    Disclose SIPC Policies to Investors, GAO-01-653 (Washington, D.C.: May 25, 2001).




                                    Page 1                                          GAO-03-811 Securities Investor Protection
                   cover cash and securities like SIPC, but the dollar amount of the coverage
                   can vary from net equity coverage to a specific dollar amount. Although the
                   policies are advertised as excess SIPC, not all policies may be consistent
                   with SIPA. In light of these concerns, you asked that we review
                   implications for investors and possible investor misunderstanding about
                   these policies.

                   To determine the status of our 2001 report recommendations to SEC and
                   SIPC, we interviewed relevant officials from SEC and SIPC to determine
                   what steps they had taken to implement our recommendations since May
                   2001. We verified changes to SEC and SIPC Web sites and SIPC’s brochure
                   to determine what SEC and SIPC disclosed to investors regarding SIPC’s
                   policies and practices regarding unauthorized trading2 and nonmember
                   affiliate issues.3 We also spoke with self-regulatory organization (SRO)
                   officials about related disclosure issues.4 To address issues surrounding
                   excess SIPC coverage, we interviewed SEC, SIPC, and SRO staff;
                   representatives from underwriters and insurance brokers; securities firms
                   (policy holders); SIPC trustees; and attorneys knowledgeable about excess
                   SIPC. We also reviewed a sample of excess SIPC policies, including one
                   policy from each of the four major underwriters that provided coverage in
                   2002. We conducted our work from October 2002 through July 2003 in
                   accordance with generally accepted government auditing standards.



Results in Brief   SEC has completed or is in the process of implementing each of the seven
                   recommendations made in our May 2001 report. Three recommendations
                   were aimed at improving the information SEC provides to investors about
                   SIPC’s policies and practices, particularly with regard to unauthorized
                   trading and nonmember affiliate claims. In response to our
                   recommendations, SEC updated the investor education section of its Web
                   site to include more consistent information about documenting

                   2
                    Unauthorized trading occurs when a firm buys or sells securities for a customer’s accounts
                   without the customer’s approval.
                   3
                    Most registered firms automatically become members of SIPC. However, affiliates (firms
                   that are formally tied within the same financial holding company) of securities firms are not
                   required to become members of SIPC.
                   4
                    SROs have an extensive role in regulating the U.S. securities markets, including ensuring
                   that members comply with federal securities laws and SRO rules. SROs include all the
                   registered U.S. securities exchanges and clearing houses, the NASD (formerly known as
                   National Association of Securities Dealers) and the New York Stock Exchange (NYSE).




                   Page 2                                            GAO-03-811 Securities Investor Protection
unauthorized trading claims and updated a Web page dedicated to
providing information about SIPC policies and practices. SEC has also
implemented two recommendations intended to improve its oversight of
SIPC operations. As recommended, SEC adjusted the sample of
liquidations it examined in its recently completed review of SIPC to include
a larger number of liquidations involving unauthorized trading or
nonmember affiliate issues. In response to the SEC Inspector General (IG)
and our recommendation that SEC establish a formal procedure to share
information about SIPC among its various divisions and offices, SEC began
holding quarterly meetings. SEC has subsequently determined that more
frequent, informal meetings were more effective. If this format continues to
allow SEC to share information with all the relevant parties, it would be an
effective response to our recommendation. Finally, SEC is still in the
process of implementing our recommendations to require firms to
distribute the SIPC brochure to customers and to require clearing firms to
include information about documenting unauthorized trades in writing on
account statements. SEC officials have sent letters to the New York Stock
Exchange (NYSE) and NASD asking them to explore how these
recommendations could be implemented through SRO rulemaking or
notices to members, and the SROs are evaluating possible approaches to
implement these recommendations.

SIPC has taken steps to implement each of our three recommendations, but
needs to complete additional work on one. We made recommendations to
SIPC aimed at improving the information it provides to investors about its
policies and practices, particularly regarding unauthorized trading and
nonmember affiliate claims. First, we recommended that SIPC revise its
informational brochure and Web site to include a full explanation of the
steps necessary to document an unauthorized trading claim. In response to
our recommendation, SIPC has updated its brochure and Web site to clarify
that investors should complain in writing to their securities firms about
suspected unauthorized trades. Second, we recommended that SIPC
amend its advertising bylaws to include a statement that SIPC does not
protect against losses due to market fluctuations. According to SIPC
officials, such a statement would be misleading unless additional
explanations were added. However, SIPC has expanded a statement in its
brochure that discusses market risk and SIPC coverage and amended its
advertising bylaws to require firms that display an expanded statement to
include a reference or link to SIPC’s Web site. In addition, we found that
SEC, SROs, and many securities firms provide the recommended
disclosures to investors on their Web sites. In combination, such actions
collectively respond to our recommendation. Third, we recommended that



Page 3                                   GAO-03-811 Securities Investor Protection
SIPC revise its brochure to warn investors to exercise caution when calling
to complain about an unauthorized trade in order to avoid unintentionally
ratifying an unauthorized trade. In response, SIPC provided investors with
links to Web sites, such as SEC’s, that offer information about investment
fraud. However, SIPC provides links to only the main Web site and not to
specific Web pages that contain the relevant information, so investors may
have difficulty locating information about specific types of fraud. For
example, based on the Web address provided in the brochure, investors
searching SEC’s Web site for “fraud,” would be linked to over 5,000 possible
references. Providing more specific links to investor education information
would make it much easier for investors to locate relevant information.

Until this year, excess SIPC coverage was generally available to certain
well-capitalized, large, and regional securities firms. The policies varied by
firm and insurer in terms of the amount of coverage offered per customer
and in aggregate per firm. Attorneys familiar with the policies agreed that
the disclosure of the coverage and the terms of coverage are sometimes
unclear. In our review of some of the policies, it was unclear who was
covered and how the claims process would work in the case of a firm’s
bankruptcy. The policies were also unclear in terms of when a claim can be
filed and whether the trustee or the customer would file it. During our
review, three of the four major insurers that offered excess SIPC coverage
in 2002 stopped underwriting these policies in 2003. Some of these insurers
said they had stopped providing coverage primarily because of the
complexity of quantifying their potential risk exposure in relation to the
relatively low premiums.5 Consequently, as the policies expire in 2003, most
insurers are not renewing their existing policies and have stopped
underwriting new policies. At this time, some of the policyholders have not
decided what to do going forward. However, several options are being
explored, including self-insuring and purchasing policies from the
remaining major insurer.




5
 To evaluate and measure the impact of losses to a firm, maximum potential loss and
maximum probable loss must be determined. The maximum potential loss, which is the
absolute maximum dollar amount of loss, could be significant because it is simply the
aggregate of all customer account balances over SIPC’s $500,000 limit. Conversely, the
maximum probable loss is the likely dollar loss if a firm were to become part of a SIPC
liquidation proceeding. This type of calculation is usually based on historical loss data for
the particular event, but unlike most other insurance products, actuaries have no historical
loss data for excess SIPC products because no claims-related losses have been incurred.




Page 4                                            GAO-03-811 Securities Investor Protection
                 Given the important and ongoing role that SEC and SIPC play in investor
                 education and protection, we make new recommendations to SEC and
                 SIPC aimed at further improving investor education and protection. First,
                 we recommend SIPC modify its brochure to provide more specific links to
                 investor education information as SIPC continues its efforts to improve
                 investor awareness of SIPC’s policies and practices and to educate
                 investors in general. Finally, as existing excess SIPC policies expire and are
                 replaced with new policies or are not replaced at all, we recommend that
                 SEC take actions to monitor these ongoing developments.

                 We requested comments on a draft of this report from the Chairman, SEC,
                 and the Chairman, SIPC. We received comments from the Director,
                 Division of Market Regulation, SEC, and President, SIPC. Both generally
                 agreed with the report’s findings and recommendations. SEC’s and SIPC’s
                 comments are discussed in greater detail at the end of this letter, and the
                 written comments are reprinted as appendixes I and II, respectively.



Background       SIPA established SIPC to provide certain financial protections to the
                 customers of insolvent securities firms. As required under law, 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.6 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 2002, SIPC initiated a total of
                 304 liquidation proceedings and paid about $406 million to satisfy such
                 customer claims.



SIPC’s Mission   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


                 6
                  SIPA authorizes an alternative to liquidation under certain circumstances when all
                 customer claims aggregate to less than $250,000.




                 Page 5                                           GAO-03-811 Securities Investor Protection
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 could not account for their
customers’ property. 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 when 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.” SIPC 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.7 SIPA sets 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 31 staff located in Washington, D.C. 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,
2002, SIPC had 6,679 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



7
 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.




Page 6                                             GAO-03-811 Securities Investor Protection
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,8 (2) selling variable annuities,9 (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.10 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
cover situations where an individual has a debtor-creditor relationship,
such as a lending arrangement, with a SIPC member firm.

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. Although bankers and brokers are customers under SIPA, they are
not eligible for SIPC fund advances. SIPA states that most customers are
eligible for SIPC assistance, but SIPC funds may not be used to pay claims
of any failed brokerage firm customer who is




8
 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.
9
 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.
10
   Typically, bank certificates of deposit are not securities under the Securities Exchange Act
of 1934; however, they are defined as securities in SIPA.




Page 7                                             GAO-03-811 Securities Investor Protection
• a general partner, officer, or director of the firm;

• the beneficial owner of 5 percent or more of any class of equity security
  of the firm (other than certain nonconvertible preferred stocks);

• a limited partner with a participation of 5 percent or more in the net
  assets or net profits of the firm;

• someone with the power to exercise a controlling influence over the
  management or policies of the firm; and

• a broker or dealer or bank acting for itself rather than for its own
  customer or customers.

The SIPC fund was valued at $1.26 billion as of December 31, 2002, which it
uses to make advances to trustees for customer claims and to cover the
administrative expenses of a liquidation proceeding.11 Administrative
expenses in a SIPA 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.
SIPC, after consultation with the SROs, sets the amount of member
assessments based on the amount necessary to maintain the fund and
repay any borrowings by SIPC.12 At different times during the 1970s, 1980s,
and 1990s members were assessed at a higher rate. Rates fluctuated
depending on the level of expenses. SIPC’s board of directors attempted to
match assessment rate increases with declines in the fund balance, so that
years of high SIPC expenses were followed by periods of higher
assessments. Since 1996, SIPC has charged each broker-dealer member an




11
  The SIPC board decided the fund balance should be raised to $1 billion to meet the long-
term financial demands of a very large liquidation. The SIPC balance reached $1 billion in
1996.
12
  15 U.S.C. 78ddd(c)(2). The assessments shall be a percentage of each member’s gross
revenues if (1) the fund is below a level that the Commission determines is in the public
interest; (2) SIPC is obligated on any outstanding borrowings; or (3) SIPC is required to
phase out the lines of credit it has established. Otherwise, SIPC shall impose an annual
assessment. 15 U.S.C. 78ddd(d)(1).




Page 8                                            GAO-03-811 Securities Investor Protection
                             annual assessment of $150.13 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 relend the funds to SIPC). In
                             addition, SIPC has a $1 billion line of credit with a consortium of banks.



SEC Oversight of SIPC        SIPA gives SEC oversight responsibility over SIPC. SEC’s primary mission
                             is to protect investors and the integrity of the securities markets. SEC
                             seeks to fulfill its mission by requiring public companies to disclose
                             financial and other information to the public. SEC is also responsible for
                             conducting investigations of potential securities law violations and
                             overseeing SROs such as securities exchanges, as well as broker-dealers
                             (securities firms), mutual funds, investment advisors, and public utility
                             holding companies. 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 SEC may require SIPC to adopt, amend, or repeal
                             any bylaw or rule.14 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.



SEC Rules Strengthen         The law that created SIPC also required SEC to strengthen customer
Customer Protection in the   protection and increase investor confidence in the securities markets by
                             increasing the financial responsibility of broker-dealers. Pursuant to this
Securities Market
                             mandate, SEC developed a framework for customer protection based on
                             two key rules: (1) the customer protection rule and (2) the net capital rule.
                             These rules respectively require broker-dealers that carry customer
                             accounts to (1) keep customer cash and securities separate from those of
                             the company itself and (2) maintain sufficient liquid assets to protect
                             customer interests if the firm ceases doing business. SEC and SROs, such



                             13
                              15 U.S.C. 78ddd(d)(1)(C). “The minimum assessment imposed upon each member of SIPC
                             shall be $25 per annum through the year ending December 31, 1979, and thereafter shall be
                             the amount from time to time set by SIPC bylaw, but in no event shall the minimum
                             assessment be greater than $150 per annum.” Id.
                             14
                              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 a type that SEC determines by rule does not require SEC approval.




                             Page 9                                           GAO-03-811 Securities Investor Protection
                           as NYSE, are responsible for enforcing the net capital and customer
                           protection rules.



Excess SIPC Coverage Was   Under a typical SIPC property distribution process, SIPC customers are to
Introduced in the 1970s    receive any securities that the firms holds that are registered in their name
                           or that are being registered in their name, subject to the payment of any
                           debt to the firm. If some of the customer assets are missing and cannot be
                           found by the trustee, the customer will receive a pro rata share of the firm’s
                           remaining customer property. In addition, SIPC is required to replace
                           missing securities and cash in an investor’s account up to the statutory
                           limits. For firms with excess SIPC policies, this coverage would be
                           available as well. For example, if a firm is liquidated by a SIPC trustee that
                           should have $10 billion in customer assets, but the trustee can account for
                           only $9.8 billion or 98 percent of the $10 billion in assets, each customer
                           would receive 98 percent of their net equity (pro rata share). A customer
                           with net equity of $10 million would receive 98 percent or $9.8 million of
                           their $10 million. In addition the trustee may use up to $500,000 advanced
                           from the SIPC fund to satisfy the customer’s claim, but only $100,000 may
                           be advanced for cash. With a $200,000 advance from SIPC, the customer in
                           this example would have received the entire $10 million in assets owed. To
                           protect customers who have claims in excess of the SIPC limit, Travelers
                           Bond15 first began offering excess SIPC coverage to brokerage firms in
                           1970, soon after SIPA was enacted. Other companies began to join the
                           market in the mid-1980s. However, such claims above the SIPA limit are
                           rare and regulatory and industry officials confirmed that most customers
                           would not be affected by such policies because their accounts are within
                           the SIPA limits.

                           As seen in table 1, the amount of customer funds recovered determines if
                           the investor will have a loss and whether excess SIPC would be triggered.
                           For example, if the trustee determined that 50 percent of the customer
                           assets were missing, a customer who is owed $1 million in assets would
                           receive a $500,000 pro rata share from the estate and an advance from SIPC
                           at its statutory limit of $500,000. However, a customer with $5 million in
                           assets with the same 50 percent pro rata share would have $2 million in
                           excess of the $500,000 SIPC advance and could be eligible for excess SIPC
                           coverage if offered by the securities firm. Conversely, a customer with


                           15
                                Travelers Bond is now Travelers Property Casualty Corp.




                           Page 10                                            GAO-03-811 Securities Investor Protection
                                                                $5 million in assets and a pro rata share of 90 percent or higher would be
                                                                made whole by SIPC and would not have losses in excess of SIPC limits.



Table 1: Examples of How SIPC Protects Investors

                                              Percent of customer Pro rata share of assets                                  Amount in excess of
Customer assets                                property recovered   returned to customer                SIPC advance                  SIPC limit
$1,000,000                                                           50               $500,000               $500,000                          $0
5,000,000                                                            50              2,500,000                 500,000                  2,000,000
5,000,000                                                            60              3,000,000                 500,000                  1,500,000
5,000,000                                                            70              3,500,000                 500,000                  1,000,000
5,000,000                                                            80              4,000,000                 500,000                   500,000
5,000,000                                                            90              4,500,000                 500,000                          0
10,000,000                                                           50              5,000,000                 500,000                  4,500,000
10,000,000                                                           60              6,000,000                 500,000                  3,500,000
10,000,000                                                           70              7,000,000                 500,000                  2,500,000
10,000,000                                                           80              8,000,000                 500,000                  1,500,000
10,000,000                                                           90              9,000,000                 500,000                   500,000
10,000,000                                                           98              9,800,000                 200,000                          0
Source: SIPC and GAO analysis of how SIPC protects investors.




SEC Has Taken Steps                                             In our 2001 report, we made seven recommendations to SEC to address
                                                                needed improvements to information it provided to investors about SIPC’s
to Address Our                                                  policies and practices, particularly regarding the evidentiary standard for
Recommendations                                                 unauthorized trading claims and to expand its review of SIPC operations
                                                                among others. SEC has taken action to address all of the recommendations
                                                                either directly or indirectly by delegating the implementation to the SROs.

                                                                First, we recommended that SEC review sections of its Web site and, where
                                                                appropriate, advise customers to complain promptly in writing when they
                                                                believe trades in their account were not authorized. This advice should
                                                                include an explanation of SIPC’s policies and practices regarding claims
                                                                and a general warning about how to avoid ratifying potentially
                                                                unauthorized trades during telephone conversations. In 2001, we found that
                                                                SIPC liquidations involving unauthorized trading accounted for nearly two-
                                                                thirds of all liquidations initiated from 1996 through 2000. SIPC’s policies
                                                                and practices in these liquidation proceedings generated controversy,




                                                                Page 11                                  GAO-03-811 Securities Investor Protection
primarily because of the large numbers of claims that were denied and the
methods used to satisfy certain approved claims.

In addition, we found that SIPC’s policies and practices were often not
transparent to investors and SEC had missed opportunities to provide
investors with consistent information about SIPC’s evidentiary standard for
unauthorized trading. For example, some sections of SEC’s Web site
encouraged investors to call to complain about unauthorized trades, while
other sections told the investor to complain immediately in writing.
Although the telephone-based approach SEC recommended was
reasonable if the firm acted in good faith to resolve problem trades,
fraudulently operated firms were known to have used high pressure and/or
fraudulent tactics to convince persons who called to complain about
potentially unauthorized trades to ratify these trades. In response to our
recommendation, SEC updated sections of its Web site to include
consistent information on making unauthorized trading complaints in
writing. In addition, they expanded the section entitled Cold Calling to
include warnings about high-pressure sales tactics that some brokers may
use.

Second, we recommended that SEC require firms that it determines to have
engaged in or are engaging in systematic or pervasive unauthorized trading
to prominently notify their customers about the importance of
documenting disputed transactions in writing. In 2001, we found that
although SEC may identify and impose sanctions on firms that have
engaged in pervasive unauthorized trading long before they ever become
SIPA liquidations, it does not routinely require such firms to notify their
clients about documenting unauthorized trading claims. For example,
between 1992 and 1997, one securities firm operated under intensive SEC
and court supervision in connection with, among other violations,
pervasive unauthorized trading and stock price manipulation. However,
there was no requirement that the firm notify their customers to document
their complaints in writing. Imposing this requirement could help investors
protect their interests and benefit unsophisticated investors who may not
review the SIPC brochure or other disclosures made on account
statements. At the time the report was issued, SEC had agreed to
implement this requirement on a case-by-case basis. Since 2001, SEC
officials said that they have not had a case that required this action.
Moreover, SEC officials noted that their first course of action would be to
shut down firms that engage in pervasive unauthorized trading.




Page 12                                 GAO-03-811 Securities Investor Protection
Third, we recommended 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’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 2001, we found that SEC had missed opportunities to
educate investors about the potential risks associated with certain
nonmember affiliates. SEC’s Web site provided limited information about
dealing with nonmember affiliates, and investors may not have been fully
aware of the risks that can be associated with certain nonmember
affiliates. In response to this recommendation, SEC updated an on-line
publication called Securities Investor Protection Corporation, which
discusses the problems that can occur when investors place their cash or
securities with non-SIPC members. Investors are also told to always make
sure that the securities firm and clearing firm16 are members of SIPC
because firms are required by law to tell you if they are not.

Next, we recommended that SEC take several actions to improve its
oversight of SIPC. Specifically, we recommended that SEC implement the
SEC IG’s recommendation that the Division of Market Regulation, the
Division of Enforcement, the Northeast Regional Office (NERO) and the
Office of Compliance, Inspections, and Examinations (OCIE) conduct
periodic briefings to share information related to SIPC. In 2000, SEC’s IG
found that communication among SEC’s internal units regarding SIPC
could be improved. 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. At the time our report was issued, SEC had
not yet implemented this recommendation, and we recommended that they
do so. SEC officials said that they began to hold quarterly meetings, but
determined that more frequent, informal meetings were more effective.
They said that they meet to discuss SIPC as issues arise, which is typically
more than once every quarter. As long as SEC continues to meet frequently
and share information among all the relevant units, this approach
effectively responds to the concern our recommendation was intended to
address.

Fifth, we recommended that SEC expand its ongoing examination of SIPC
to include a larger number of liquidations with claims involving


16
     Clearing firms clear customer transactions and hold customer cash and securities.




Page 13                                             GAO-03-811 Securities Investor Protection
unauthorized trading or nonmember affiliate issues. SEC periodically
conducts examinations of SIPC’s operations to ensure compliance with
SIPA. In May 2000, the Division of Market Regulation and OCIE initiated a
joint examination of SIPC. As of March 2001, SEC had included four SIPA
liquidations involving unauthorized trading in its sample, but had not
included any liquidations involving nonmember affiliate issues. Given the
controversies involving SIPA’s liquidations involving unauthorized trading
and nonmember affiliates, we believed that including a larger number of
liquidations with these types of claims was warranted. SEC agreed with
this recommendation and included a larger number of liquidations
involving unauthorized trading or nonmember affiliate issues in the sample
used for the review. Of the eight liquidations in SEC’s sample, five involved
unauthorized trading and two involved nonmember affiliate issues.

SEC completed its examination in January 2003 and issued its examination
report in April 2003, which assessed SIPC’s policies and procedures for
liquidating failed securities firms and identified several areas of
improvement that warrant SIPC’s consideration.

• SEC found that there was insufficient guidance for SIPC personnel and
  trustees to follow when determining whether claimants have
  established valid unauthorized trading claims. Although the evidentiary
  standards used were found to be reasonable, the standards differed
  between trustees. Therefore, SEC recommended that SIPC develop
  written guidance to help establish consistency between trustees and
  liquidations. SIPC agreed to adopt such written guidance for reviewing
  unauthorized trading claims.

• Concerning SIPC’s investor education programs, SEC found that SIPC
  should continue to review the information that it provides to investors
  about its policies and practices. For example, SEC found that some
  statements in SIPC’s brochure and Web site might overstate the extent
  of SIPC coverage and mislead investors. SIPC plans to continue to
  reexamine the adequacy of the information provided in its brochure and
  Web site to eliminate any potential confusion.

• SEC also found that SIPC should improve its controls over the fees
  awarded to trustees and their counsel for the services rendered and
  their expenses. SEC found that some descriptions of the work that the
  trustees performed were vague, making it difficult to assess whether the
  work was necessary or appropriate. SEC believed that SIPC could do a
  better job of reviewing and assessing fees that were requested. SIPC



Page 14                                  GAO-03-811 Securities Investor Protection
   agreed to ask trustees and counsel in SIPC cases to submit invoices at
   least quarterly and arrange billing records into project categories. SIPC
   also agreed to instruct its personnel to document discussions with
   trustees and counsel regarding fee applications and to note any
   differences in amounts initially requested by trustees and counsel and
   those amounts recommended for payment by SIPC.

• In addition, SEC found that SIPC lacks a record retention policy for
  records generated in liquidations where SIPC appoints an outside
  trustee. It was found that trustees had different procedures for retention
  of records, and SEC was not able to review records from one liquidation
  because the trustee had destroyed the records. SIPC has agreed to
  develop a uniform record retention policy for all SIPA liquidations,
  following a cost analysis.

• SEC also found that the SIPC fund was at risk in the case of failure of
  one or more of the large securities firms. SEC found that even if SIPC
  were to triple the fund in size, a very large liquidation could deplete the
  fund. Therefore, SEC suggested that SIPC examine alternative strategies
  for dealing with the costs of such a large liquidation. SIPC management
  agreed to bring this issue to the attention of the Board of Directors, who
  evaluates the adequacy of the fund on a regular basis.

Also as part of SEC’s ongoing oversight effort, in September of 2000, SEC’s
Office of General Counsel (OGC) initiated a 1-year pilot program to
monitor SIPA liquidations. According to SEC, the primary objective of the
pilot program was to provide oversight of claims determinations in SIPA
liquidation proceedings in order to make certain that the determinations
were consistent with SIPA. According to SEC officials, this program has
since been made permanent. SEC’s OGC now enters notices of appearance
in all SIPA liquidation proceedings. The cases are followed mostly by
NERO and the Midwest Regional Office, given the significant numbers of
SIPA liquidations in these locations. The staff can recommend that
Commission staff intervene in SIPA liquidations, if appropriate.

Sixth, we recommended that SEC, in conjunction with the SROs, establish
a uniform disclosure rule requiring clearing firms to put a standard
statement about documenting unauthorized trading claims on their trade
confirmations and/or other account statements. In 2001, we found that
SEC, NASD, and the NYSE, did not have requirements that clearing firms
notify customers that they should immediately complain in writing about
allegedly unauthorized trades. A review of a judgmental sample of trade



Page 15                                  GAO-03-811 Securities Investor Protection
                       confirmations and account statements found that many firms voluntarily
                       notify their customers to immediately complain if they experience any
                       problems with their trades, but instructions about the next course of action
                       varied and did not necessarily specify that the investor should complain in
                       writing. Initially, SEC expressed concern about promulgating a rule itself.
                       However, in 2003, SEC began to take steps to implement this
                       recommendation. Specifically, SEC has asked NYSE and NASD to explore
                       how this recommendation can be more fully implemented through SRO
                       rulemaking and Notices to Members. As of June 9, the SROs were still
                       evaluating how best to implement this recommendation. According to an
                       SRO official, concern about potentially penalizing investors who may not
                       complain in writing but may file claims in other forums, such as arbitration
                       proceedings, will need to be resolved. However, SEC believes that they will
                       be able to craft acceptable language that ensures that these investors are
                       not harmed.

                       Lastly, we recommended that 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 existing customers more
                       widely. This recommendation was an additional step aimed at educating
                       and better informing customers about how to protect their investments.
                       The SIPC informational brochure called How SIPC Protects You provides
                       useful information about SIPC and its coverage. However, SIPC bylaws and
                       SEC rules do not require SIPC members to distribute the brochure to their
                       customers. The authority lies with SEC or the SROs to require the firms to
                       provide the brochure to their customers. To date, it is unclear what action
                       will be taken. SEC officials expressed concern about imposing another rule
                       on securities firms. Instead, SEC included this recommendation in its letter
                       to NYSE and NASD to explore how this could be implemented through SRO
                       rulemaking and Notices to Members. According to SEC and SRO officials,
                       both NASD and NYSE are in the process of exploring how best to
                       implement this recommendation. SEC officials said that they did not
                       expect the SROs to have problems implementing this recommendation.



SIPC Has Taken Steps   In our 2001 report, we made three recommendations to SIPC to improve
                       the information available to investors about its coverage, particularly with
to Improve Investor    regard to unauthorized trading. In addition to taking steps to implement
Education              our recommendations, SIPC has continued a nationwide investor
                       education program that addresses many of the specific issues raised in our
                       2001 report. SIPC has a responsibility to inform investors of actions they
                       can take to protect their investments and help ensure that they are afforded



                       Page 16                                  GAO-03-811 Securities Investor Protection
the full protections allowable under SIPA. Our 2001 report found that
investors might confuse the coverage offered by SIPC, Federal Deposit
Insurance Corporation (FDIC), and state insurance guarantee associations
and not fully understand the protection offered under SIPA. This was
significant because the type of financial protection that SIPC provides is
similar to that provided by these programs, but important differences exist.
To address these and other investor education issues, SIPC began a major
public education campaign in 2000. As part of the campaign, SIPC worked
with a public relations firm to make its Web site and brochure more reader
friendly and less focused on legal terminology. The changes were designed
to ensure that the Web site is easy to use and written in plain English. In
addition to revising its brochure and Web site, SIPC produced a series of
audio and video public service announcements (PSA).17 From June 15,
2002, to November 15, 2002, the PSAs were aired over 76,000 times.
According to SIPC’s 2002 annual report, the TV PSAs have appeared on 129
stations, in 106 cities, in 46 states; and the radio spots have aired on 415
stations, in 249 cities, in 49 states. They have also been aired nationally on
CNBC and the Fox News Channel.

SIPC and its public relations firm are continuing to work together to
improve investor awareness of SIPC and its policies. They are developing a
new television and radio campaign scheduled to begin in July 2003. They
are also working to better explain the claims process through a new
brochure and video. The claims process brochure will provide information
to individuals that do not have access to the Internet. This investor
education campaign has increased the amount and clarity of information
available about SIPC and has provided investors who review it with
important information.

As mentioned, in addition to identifying investor education concerns in our
2001 report, we recommended that SIPC take three specific actions to
improve its disclosure. First, we recommended that SIPC revise its
brochure and Web site to include a full explanation of the steps necessary
to document unauthorized trading claims. SIPC has determined, and courts
have agreed, that an objective evidentiary standard, such as written
complaints, is necessary to protect the SIPC fund from fraudulent claims.
However, in our 2001 report, we found that SIPC had also missed
opportunities to provide investors with complete information about dealing
with unauthorized trading. For example, we found that claimants in 87


17
     These PSAs may also be viewed at www.sipc.org/streaming.html.




Page 17                                           GAO-03-811 Securities Investor Protection
percent of the claims we reviewed telephoned complaints to their brokers.
Given that many investment transactions are largely made by telephone,
we were concerned that investors were not aware of the importance of
documenting their complaints in writing if they were ever required to file a
claim with SIPC. Furthermore, we found the SIPC brochure did not advise
investors that SIPA covers unauthorized trading and that investors should
promptly complain in writing about allegedly unauthorized trades. As
previously mentioned, the brochure was revised as part of the investor
education campaign and now includes the statement, “If you ever discover
an error in a confirmation or statement, you should immediately bring the
error to the attention of the [firm], in writing.” In addition, SIPC has created
a Web page, entitled Documenting an Unauthorized Trade, which includes
the same information on complaining in writing to the firm about any
errors.

We also recommended that SIPC amend its advertising bylaws to include a
statement that SIPC does not protect against loss due to market
fluctuations. SIPC officials did not agree with the recommended statement
and felt that it would be misleading unless additional explanations were
added. Instead, SIPC has expanded a statement in its brochure that
discusses SIPC coverage of market fluctuation to read,

“Most market losses are a normal part of the ups and downs of the risk-oriented world of
investing. That is why SIPC does not bail out investors when the value of their stocks,
bonds, and other investments fall for any reason. Instead, SIPC replaces missing stocks and
other securities where it is possible to do so…even when investments have increased in
value.”

In addition, SIPC amended its advertising bylaws in 2002 to require firms
that choose to make an explanatory statement about SIPC to include a link
to the SIPC Web site.18 This will further enable the customer to access
information about what SIPC does and does not cover. NASD and SEC have
also begun to make disclosures about SIPC and market risk to investors.
For example, the NASD Web site says, “SIPC does not protect against
market risk, which is the risk inherent in a fluctuating market. It protects
the value of the securities held by the [firm] as of the time the SIPC trustee
is appointed.” SEC informs investors that “SIPC does not protect you
against losses caused by a decline in the market value of your securities.”
Furthermore, many securities firms also include similar statements about


18
 Firms are required to mention their SIPC membership in advertisements, but are not
required to use one of the explanatory statements provided by SIPC.




Page 18                                          GAO-03-811 Securities Investor Protection
SIPC protection on their Web sites. SIPC’s statement about market risk and
amended bylaws as well as the availability of other disclosures by the
regulators and firms effectively responds to the concern our
recommendation was intended to address.

Finally, we recommended that SIPC revise its brochure to warn investors to
exercise caution in ratifying potential unauthorized trades in telephone
discussions with firm officials. SIPC believes that the statement discussed
above encouraging investors to complain in writing about unauthorized
trades in its brochure and Web site will make oral ratification unlikely.
SIPC officials also maintain that this type of information is best handled in
those publications and Web pages that warn investors about securities
fraud. Therefore, in its brochure, SIPC provides links to several Web sites,
such as SEC’s, that have investor education information about investment
fraud. However SIPC provides links to only the main Web site and not to
the specific Web pages that contain the relevant information, so investors
may have difficulty locating information about specific types of fraud, such
as unauthorized trading. For example, based on the Web address provided
in the brochure, investors searching SEC’s Web site for “fraud,” would be
linked to over 5,000 possible sites. SIPC also recommends the Securities
Industry Association19 (SIA) Web site for information about investment
fraud. However, based on the information SIPC provided, a search for
“unauthorized trading” on this Web site yields only three results, none of
which send the investor to useful educational information contained on the
Web site. Investors are also directed to NASD’s Web site, which has a page
entitled Investors Best Practices, which includes detailed information on
cold calling and unauthorized trading. However, an investor may not be
able to find this useful information without specific links to the relevant
Web pages for this and other Web sites listed in the brochure. For example,
a search for “unauthorized trading” on NASD’s Web site only yields one
result, which provides a link to a definition for unauthorized trading but no
reference to the useful educational information.




19
 SIA is a trade group that represents broker-dealers of taxable securities. SIA lobbies for its
members’ interests in Congress and before SEC and educates its members and the public
about the securities industry.




Page 19                                            GAO-03-811 Securities Investor Protection
Terms of Existing             Excess SIPC coverage is generally offered by well-capitalized, large, and
                              regional securities firms and is generally marketed by the firms as
Excess SIPC Policies          additional protection for their large account holders. Our review of the
Vary, and Most Insurers       excess SIPC policies offered by the four major insurers found the policies
                              varied by firm and insurer in terms of the amount of coverage offered per
Have Stopped                  customer and in aggregate per firm. In our review of some of the policies,
Underwriting New              we found that excess SIPC coverage was not uniform and was not
Policies                      necessarily consistent with SIPC protection. Attorneys familiar with the
                              policies also agreed that the disclosure of the coverage and the terms of
                              coverage could be improved. During our review, three of the four major
                              insurers that offered excess SIPC coverage in 2002 stopped underwriting
                              these policies in 2003 for a variety of reasons. Consequently, as the policies
                              expire, most insurers are not renewing their existing policies beyond 2003
                              and have stopped underwriting new policies in general. At this time, it is
                              unclear what some of the securities firms that had excess SIPC coverage
                              plan to do going forward.



Excess SIPC Coverage Is       Excess SIPC is generally limited to certain well-capitalized, large, and
Generally Limited to Larger   regional firms that have a relatively low probability of being part of a SIPC
                              liquidation. Moreover, the policies—usually structured as surety bonds—
Firms
                              are generally purchased by clearing firms.20 The insurance underwriters of
                              excess SIPC policies told us that they use strict underwriting guidelines
                              and have minimum requirements for a firm requesting coverage. Most
                              insurers evaluate a securities firm for excess SIPC coverage by reviewing
                              its operational and financial risks. Insurers also consider the firm’s internal
                              control and risk management systems, the type of business that the firm
                              conducts, its size, its reputation, and the number of years in business. Some
                              insurers also required the firms to annually submit information on the
                              number and value of customer accounts above the $500,000 SIPC limit, to
                              help gauge their maximum potential exposure in the unlikely event that the
                              firm became part of a SIPC liquidation. Firms below a certain dollar net
                              capital threshold were generally not considered for coverage.




                              20
                               In general terms, a surety bond represents a contract in which one party to the contract,
                              the “surety,” is obligated to pay third parties if the other party to the contract fails to
                              perform a duty owed to the third parties. See REST 3d ~ 1.




                              Page 20                                           GAO-03-811 Securities Investor Protection
Excess SIPC Coverage Is       Although an excess SIPC claim has never been filed in the more than 30
Not Uniform and Is Not        years that the coverage has been offered, we identified several potential
                              investor protection issues.21 Our review of excess SIPC policies, which
Necessarily Consistent with   included one from each of the four major insurers, revealed that excess
SIPC Coverage                 SIPC coverage is not uniform and that some policies are not always
                              consistent with SIPC coverage. Although the policies were advertised as
                              covering losses (or losses up to an amount specified in the policy) that
                              would otherwise be covered by SIPC except for the $500,000 limit, we
                              found that claims under the policies could be subject to various terms and
                              limitations that do not apply to SIPC coverage. Attorneys familiar with
                              SIPA and excess SIPC have also raised questions about who is covered in
                              the policies and how the claims process would work in the case of a firm’s
                              bankruptcy. These potential inconsistencies or concerns include

                              • Some policies included customers that would generally be
                                ineligible under SIPA. The wording in some of the policies could be
                                interpreted as protecting individuals who are not customers eligible for
                                SIPC advances. Others contained specific riders that expanded the
                                excess SIPC policy to include classes of customers beyond those
                                covered by SIPC. For example, some policies have riders that extend
                                coverage to officers and directors of the failed firm, as long as they are
                                not involved with any fraud that contributed to the firm’s demise. As
                                mentioned previously, SIPC coverage excludes certain customers, such
                                as officers and directors of the failed firm and broker-dealers and banks
                                acting on their own behalf.

                              • Some policies limited the duration of coverage. Each policy we
                                reviewed provided coverage only if SIPC were to institute judicial
                                proceedings to liquidate the firm while the policy was in effect. Three of
                                the four policies provided for specific periods of time during which they
                                were in effect, as well as for cancellation by the insurer under specified
                                conditions. Although each of the three policies required the securities
                                firm to notify its customers of a cancellation, none of the policies
                                expected notification to the customers regarding expiration.22


                              21
                               According to one insurer, while no claims have been filed, certain attorney fees and a very
                              small number of settlements have been paid to a few investors.
                              22
                               Two of the policies specified that it was the broker-dealer’s “responsibility” to notify its
                              customers of discontinuance of the coverage, but neither the insurer nor the firm was
                              obligated to make this disclosure.




                              Page 21                                             GAO-03-811 Securities Investor Protection
     According to NYSE and NASD, there are not any specific SRO rules that
     require these firms to notify their customers. However, NYSE said that
     they generally expect firms to notify investors of any changes in their
     excess SIPC protection under rules involving disclosure requirements
     for fees changes. NASD generally expects firms to notify their
     customers under NASD’s Just and Equitable Rule.

• Some excess SIPC policies varied from SIPA in scope of
  coverage. Certain policies also differed from SIPA in terms of the scope
  of excess coverage. Specifically, customer cash, which would generally
  be covered under SIPA, was not covered by two of the policies we
  reviewed. One of the policies specifically restricted coverage to lost
  securities; the other described coverage as pertaining only to a
  customer’s claim for “loss of securities.”23 Also, in addition to a cap on
  the amount of coverage per customer, one policy contained a cap on the
  insurer’s overall exposure—the policy established an aggregate cap of
  $250 million—regardless of the total amount of customer claims. SIPC
  has no such aggregate cap.

• The mechanics of the claims process were unclear. In addition to
  limitations on coverage, at least one policy had other characteristics
  that could either restrict a customer’s ability to recover losses that
  exceed the amount covered under SIPA or delay a customer’s recovery
  until long after the net equity covered by the insurance has been
  determined. The policy conditioned the customer’s recovery upon the
  customer providing the insurer with a claim notice subject to specific
  time, form, and content specifications. Among other things, the
  customer was required to submit a written claim accompanied by
  evidence satisfactory to the insurer and an assignment to the insurer of
  the customer’s rights against the firm. The other policies did not address
  when a customer must file a claim.

• The role of the trustee in the claims process was unclear. Another
  difference we found is the role of the trustee regarding customer claims
  under SIPA and excess SIPC coverage policies. Under SIPA, the trustee
  acts on behalf of customers who properly file claims to see that they
  recover losses as provided in SIPA. It is unclear whether the trustee
  could represent customers on claims for excess insurance because, in


23
 A similar policy contained a rider specifying coverage for lost cash in excess of the
$100,000 SIPA cap.




Page 22                                           GAO-03-811 Securities Investor Protection
     some cases, the policies indicate that only individual customers could
     bring claims and, in any case, the trustee may not have authority under
     the bankruptcy laws to do so.24 SIPC trustees and other attorneys
     experienced with SIPA liquidations also agreed that it was not clear who
     was responsible for filing the claim, the customer or the trustee.

• The policies did not clearly state when a claim would be paid. The
  policies also differed from SIPC coverage regarding when customers
  could recover their losses. For purposes of SIPC coverage, the trustee
  discharges obligations of the debtor from available customer property
  and, if necessary, SIPC advances, without waiting for the court to rule
  on customer property and net equity share calculations. Under the
  excess coverage policies, it is unclear when customers would be eligible
  to recover assets in excess of those replaced by SIPC. Some of the
  policies provide for “prompt” replacement or payment of the portion of
  a customer’s covered net equity. In contrast to SIPC coverage, however,
  they specify that the insurer shall not be liable for a claim until the
  customer’s net equity has been “finally determined by a competent
  tribunal or by written agreement between the Trustee and the
  Company,” which could take years. Under another policy, the insurer
  could wait until after liquidation of the broker-dealer’s general estate
  before replacing a customers’ missing assets. The general creditor
  claims process could also take several years. An attorney
  knowledgeable about SIPC and excess SIPC said that some policies
  indicate that the insurance company has no liability until the customer
  claim is paid by SIPC. However, in many cases SIPC does not directly
  pay investors, but does so through a trustee. Therefore, the policy, if
  taken literally, would preclude an investor from ever being paid through
  excess SIPC insurance.

• Excess SIPC coverage appears to be limited to clearing firm
  failures. Most of the excess SIPC polices we reviewed provide that only
  the policy holder, usually a clearing firm, is covered under the policy.
  Introducing firms of clearing firms may advertise the coverage provided
  by their clearing firm. For example, we reviewed the Web sites of 53
  introducing firms and found that about 25 percent advertised the excess


24
 See Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 434, 32 L. Ed. 2d 195, 92 S. Ct.
1678 (1972) (Bankruptcy trustee did not have standing to assert debenture holders’ claims of
misconduct against respondent indenture trustee where the cause of action belonged solely
to the debenture holders and not to the bankruptcy estate.)




Page 23                                           GAO-03-811 Securities Investor Protection
                                 SIPC protection provided by the clearing firm. This creates the potential
                                 for investor confusion because the coverage would apply only in the
                                 case of the clearing firm’s failure. Because introducing firms do not clear
                                 securities transactions or hold customer cash or securities, the
                                 customer’s assets should be unaffected in the event of an introducing
                                 firm’s failure. However, there have been cases where customer funds
                                 were “lost” before they were sent to the clearing firm, typically due to
                                 fraudulent activity. If the introducing firm fails while the assets are still
                                 with the introducing firm but the clearing firm continues to operate,
                                 investors may not be aware that the excess SIPC protection would only
                                 apply in the event of the clearing firm’s failure. Conversely, SIPC will
                                 initiate liquidation proceedings against introducing firms and protect
                                 their investors in certain situations.



Three of the Four Major       During our review, three of the four major insurers that offered excess
Insurers Identified Stopped   SIPC coverage in 2002 stopped underwriting these policies beyond 2003.
                              The insurers provided various reasons for not continuing to underwrite
Underwriting Excess SIPC
                              excess SIPC policies, such as their concern about the complexity of
Policies in 2003              quantifying their maximum probable loss. In addition, officials from
                              securities firms and attorneys knowledgeable about excess SIPC had
                              opinions about why the insurers are no longer underwriting excess SIPC
                              policies.

                              According to the insurers that have stopped offering excess SIPC, they
                              made a business decision to stop offering the coverage after reviewing their
                              existing product offerings. They said that this practice of periodically
                              reviewing product lines and profitability is not uncommon. Most of the
                              underwriters were property and casualty insurance companies, and the
                              excess SIPC product was viewed as a relatively small part of their standard
                              product line and provided low return in the form of premiums relative to
                              the significant potential risk exposure. Some of the underwriters said that
                              documenting and explaining the potential risk associated with excess SIPC
                              policies is difficult. For example, the maximum potential loss for excess
                              SIPC could be significant because it is simply the aggregate of all customer
                              account balances over SIPC’s $500,000 limit. Quantifying the probability of
                              loss, which would be significantly less, is much more difficult because
                              insurers have never had a claims-related loss associated with the excess
                              SIPC policies; therefore, no historical loss data exists.

                              Another insurer said credit rating agencies began to ask questions about
                              potential risk exposures from excess SIPC; and rather than risk a change to



                              Page 24                                    GAO-03-811 Securities Investor Protection
its credit rating, it opted to stop providing the coverage given the limited
number of policies it underwrote.25 Others in the industry said that in light
of the Enron Corporation failure and the losses experienced by the
insurance underwriters that had exposure from Enron-related surety
bonds, credit rating agencies have begun to more closely scrutinize
potential losses and risk exposures of insurance companies overall. While
surety bonds are still considered relatively low-risk products, insurers are
more sensitive to their potential risk exposures. As mentioned, given the
absence of actuarial data it is difficult for insurers to quantify the maximum
probable losses from excess SIPC.

Securities firms and others also had opinions about why insurers stopped
underwriting the policies. Some believed that a general lack of knowledge
about the securities industry and SIPC, in particular, might have
contributed to the products being withdrawn from the market. Many firms
said that the risk of an excess SIPC claim ever being filed is low for two
primary reasons. First, securities firms that carry customer accounts are
required to adhere to certain customer protection rules. Specifically, firms
must keep customer cash and securities separate from those of the firm
itself and maintain sufficient liquid assets to protect customer interests if
the firm ceases doing business. Moreover, SEC and the SROs have
established inspection schedules and procedures to routinely monitor
broker-dealer compliance with customer protection (segregation of assets)
and net capital rules. Firms not in compliance can be closed.

Second, SIPA liquidations are rare in general and claims in excess of the
SIPA limit are even more rare. For example, since 1998, more than 4,000
firms have gone out of business, but less than 1 percent or 37 firms became
part of a SIPA liquidation proceeding. This is consistent with historical data
dating back to the 1970s. Moreover, since 1971 of the almost 623,000 claims
satisfied in completed or substantially completed cases as of December 31,
2002, a total of 310 were for values in excess of SIPC limits (less than one-
tenth of 1 percent). Of these 310 claims, 210 were filed before 1978 when
the limit was raised to $500,000. Only two firms involved in a SIPA


25
 Credit ratings produced by credit rating agencies are widely circulated; many investors
rely on these ratings to make investment decisions. These ratings include opinions about the
creditworthiness of certain public companies and their financial obligations, including
bonds, preferred stock, and commercial paper. The credit ratings that result from analyses
of this information can affect securities markets in a number of important ways, including
an issuer’s access to and cost of capital, the structure of financial transactions, and the
ability of certain entities to invest in certain rated obligations.




Page 25                                          GAO-03-811 Securities Investor Protection
                         liquidation have offered excess SIPC, but no claims have been filed to date.
                         According to officials knowledgeable about a 2001 proceeding, which
                         included a firm with an excess SIPC policy, claims for excess SIPC are
                         likely to be filed. However, the amount of claims to be filed are unclear at
                         this time.



Securities Firms Are     Most of the six holders of the excess SIPC policies we contacted are
Exploring a Variety of   currently exploring a number of options; but at this time, it is unclear what
                         most will do. Although most said that the coverage is largely a marketing
Options                  tool, some felt that the policies increased investor confidence in the firm
                         because an independent third party (the insurance company) had
                         examined the financial and operational risks of the firm prior to providing
                         them coverage. Several of the firms and those in the securities industry we
                         contacted said that they were surprised to learn that the insurers planned
                         to stop providing excess SIPC coverage. Therefore, most firms are still
                         exploring a number of options on how best to proceed, including

                         • Self-insuring or creating a “captive” insurance company that would offer
                           the coverage. 26 However, firm officials involved in exploring the captive
                           expressed concerns about whether they could establish the insurance
                           company by the end of 2003. Others questioned whether this option was
                           feasible given the competitive nature of the securities industry.

                         • Purchasing policies from the remaining major insurer. While some have
                           already chosen this option, officials from some of the larger firms said
                           that this might not be an acceptable option because the remaining
                           insurer generally limits the amount of the coverage per firm. Firms that
                           currently offer net equity coverage were concerned that their high net
                           worth customers may not be satisfied with a policy that has a cap on its
                           coverage. Additionally, the policy of the remaining underwriter raised
                           the most questions about its consistency with SIPC coverage.

                         • Letting the policies expire and not replacing them. Some of the firms we
                           spoke with said that the larger firms really do not need the excess SIPC
                           because they are well capitalized and the existing customer protection
                           rules offer sufficient protection. However, some officials said that if one


                         26
                           A captive insurance company is a type of self-insurance whereby a insurance company
                         insures all or part of the risks of its parent. This company is created when a business or
                         group of businesses form a corporation to insure or reinsure their own risk.




                         Page 26                                           GAO-03-811 Securities Investor Protection
   larger firm continued to offer the coverage, they all would have to
   continue to offer the coverage in order to effectively compete for high,
   net worth client business. Other firm officials suggested that SIPA might
   need to be reexamined in light of the numerous changes that have
   occurred in securities markets since 1970. Some officials said that at a
   minimum, the SIPA securities limit of $500,000 should be raised to $1.5
   million. Another said that it is still possible that another insurance
   company may decide to fill the void left by the companies exiting the
   business. Other industry officials said that they were still in negotiations
   with the remaining insurer to increase the coverage limits, which was a
   concern for the larger firms.

Many of the securities firms we spoke with had policies that will expire by
the end of 2003. All planned to notify affected customers, but many had not
developed specific time frames. Most firms said that they planned to have
some type of comparable coverage, which could mitigate the importance of
notifying customers. In the interim, several securities firms have asked SIA
to produce information for the firms to use when talking to their customers
about SIPA and the protections they have under the act. The information
being developed for the securities firms is to also include information
about SIPC, excess SIPC, and how securities markets work. As mentioned
previously, NYSE officials said that there is no specific rule that requires
securities firms to notify investors if the SIPC coverage expires without
being replaced. However, they generally expect firms to notify customers
under rules concerning fee disclosure requirements. Likewise, NASD
officials said that it had no specific rule requirements but would generally
expect firms to notify affected investors under general rules concerning
just and equitable principles.

In March 2003, in response to concerns raised about excess SIPC coverage
and the potential investor protection issues, SEC began its own limited
review of these issues. Initially, SEC planned to collect information on the
securities firms that offer the coverage, the major providers, and the nature
of the coverage offered. Because most of the firms that have excess SIPC
coverage are NYSE members, SEC asked NYSE to gather information
about excess SIPC coverage and information about the policies. In
response, NYSE compiled information on its members with excess SIPC
insurance policies and their insurers. NYSE also analyzed other data and
descriptive statistics such as assets protected under excess SIPC. NYSE
also reviewed the coverage offered by the major insurers. Out of more than
250 NYSE members, they determined that 123 had excess SIPC insurance
coverage and that most of the members were insured by one of the four



Page 27                                   GAO-03-811 Securities Investor Protection
              major insurance providers. However, when several underwriters decided to
              stop providing the coverage, SEC suspended most of its review activity and
              has not actively monitored the changes in the availability of the coverage or
              the firms’ plans going forward. Given the changes occurring in this market
              and the potential concerns about the policies, SEC officials agreed that
              they should continue to monitor these ongoing developments to ensure
              that investors are obtaining adequate and accurate information about
              whether excess SIPC coverage exists and what protection it provides.



Conclusions   SEC and SIPC have taken steps to implement all of the recommendations
              made in our May 2001 report. However, SEC has some additional work to
              do with the SROs to implement two of our recommendations. Although
              SEC has asked the SROs to explore actions to encourage broader
              dissemination of the SIPC brochure to customers and to include
              information on periodic statements or trade confirmations to inform
              investors that they should document any unauthorized trading complaints,
              no final actions have been taken to implement these recommendations.

              We also found that SIPC has substantially revamped its brochure and Web
              site and continues to be committed to improving its investor education
              program to ensure that investors have access to information about
              investing and the role and function of SIPC. By doing so, SIPC has shown a
              commitment to making its operations more transparent. We did note,
              however, that SIPC’s response to our recommendation about warning
              customers about unintentionally ratifying unauthorized trades, has not
              completely addressed our concern that investors have specific information
              about the risks of unintentionally ratifying trades when talking to brokers.
              In 2001, we recommended that SIPC revise its brochure to warn investors
              to exercise caution in discussions with firm officials. Rather than including
              this information in its brochure, SIPC revised its brochure to provide
              references or links to Web sites, such as SEC and NASD, but not to the
              specific investor education oriented Web pages discussing ratifying
              potentially unauthorized trades or fraud. We found that these broad
              references make it difficult or virtually impossible for investors to find the
              relevant information. More specific links to investor education Web pages
              within each Web site would mitigate this problem.

              Concerning excess coverage, three of the four major insurance companies
              stopped underwriting excess SIPC policies in 2003 after reevaluating their
              potential risk exposures and product offerings. Although an excess SIPC
              claim has never been filed to date, insurance companies have become more



              Page 28                                   GAO-03-811 Securities Investor Protection
                  sensitive to potential risk exposures in light of their recent experience with
                  Enron and other high profile failures. Most made business decisions to stop
                  offering this apparently low-risk product. Many of the firms appear to have
                  been surprised by this decision and are exploring several options, including
                  letting the coverage expire, purchasing coverage from the remaining
                  underwriter, or creating a captive insurance company to provide the
                  coverage. Given the limitations and concerns we and others have raised
                  about the protection afforded investors under excess SIPC, including
                  limitations on scope and terms of coverage and an overall lack of
                  information on the claims process and when claims would be paid, SEC
                  and the SROs have vital roles to play in ensuring that existing and future
                  disclosures concerning excess SIPC accurately reflect the level of
                  protection afforded customers.



Recommendations   As SIPC continues to revamp and refine its investor education program, we
                  recommend that the Chairman, SIPC, revise SIPC’s brochure to provide
                  links to specific pages on the relevant Web sites to help investors access
                  information about avoiding ratifying potentially unauthorized trades in
                  discussions with firm officials and other potentially useful information
                  about investing.

                  Given the concerns that we and others have raised about excess SIPC
                  coverage, we also recommend that the Chairman SEC, in conjunction with
                  the SROs, ensure that firms are providing investors with meaningful
                  disclosures about the protections provided by any new or existing excess
                  SIPC policies. Furthermore, we recommend that SEC and the SROs
                  monitor how firms inform customers of any changes in or loss of excess
                  SIPC protection to ensure that investors are informed of any changes in
                  their coverage.



Agency Comments   SEC and SIPC generally agreed with our report findings and
                  recommendations. However, SIPC said that providing more specific
                  linkages in its brochure would prove problematic because of the frequency
                  in which Web sites are changed. Rather, they agreed to provide a reference
                  in the brochure to the SIPC Web site, which will provide more specific links
                  to the relevant portions of the sited web pages. We agree that this
                  alternative approach would implement the intent of our recommendation
                  to provide investors with more specific guidance about fraud and
                  unauthorized trading.



                  Page 29                                   GAO-03-811 Securities Investor Protection
                         SEC agreed that securities firms have an obligation to ensure that investors
                         are provided accurate information about the extent of the protection
                         afforded by excess SIPC policies and that the policies should be drafted to
                         ensure consistency with SIPC protection as advertised. SEC officials
                         reaffirmed their commitment to work with the SROs to ensure that excess
                         SIPC as advertised, is consistent with the policies. Moreover, SEC agreed
                         that investors should be properly notified of any changes in the coverage.
                         Finally, SEC reiterates the recommendations it made to SIPC in its 2003
                         examination report, which as SEC describes are “important to enhance the
                         SIPA liquidation process for the benefit of public investors.”



Objectives, Scope, and   Our objectives were to (1) discuss the status of the recommendations that
                         we made to SEC in our 2001 report, (2) discuss the status of the
Methodology              recommendations that we made to SIPC in our 2001 report, and (3) discuss
                         the issues surrounding excess SIPC coverage. Finally, SEC reiterates the
                         recommendations made to SIPC in its 2003 examination report, which the
                         letter describes as “important to enhance the SIPA liquidation process for
                         the benefit of public investors.”

                         To meet the first two objectives, we interviewed staff from SEC’s Market
                         Regulation, OGC, OCIE, and the Division of Enforcement as well as SIPC
                         officials to determine the status of the recommendations that we made in
                         our 2001 report. We also reviewed a variety of SEC and SIPC informational
                         sources, such as SIPC’s brochure and SEC’s and SIPC’s Web sites, to
                         determine what SEC and SIPC disclosed to investors regarding SIPC’s
                         policies and practices. We also reviewed the Web sites of the sources
                         provided by SIPC, such as SIA, NASD, the National Fraud Information
                         Center, Investor Protection Trust, Alliance for Investor Education, and the
                         North American Securities Administrators Association.

                         To address the third objective—to discuss the issues surrounding excess
                         SIPC coverage—we interviewed agency officials, regulators, SROs, and
                         trade associations to determine what role, if any, they play in monitoring
                         excess SIPC. We also interviewed representatives or brokers of the four
                         major underwriters of excess SIPC policies to obtain information about the
                         coverage, their claim history, and their rationale for discontinuing the
                         excess SIPC product. In addition, we interviewed six securities firms that
                         had excess SIPC policies to (1) obtain their views on the scope of coverage,
                         (2) determine what they were told about the excess SIPC product being
                         withdrawn, and (3) to identify what they planned to do about replacing the
                         coverage going forward. We also interviewed two SIPC trustees who had



                         Page 30                                  GAO-03-811 Securities Investor Protection
liquidated firms that had excess SIPC policies to obtain their views and
opinions about the coverage. We also met with attorneys knowledgeable
about SIPC and excess SIPC policies and coverage to obtain their views
and perspectives on excess SIPC issues. Moreover, we also reviewed
sample policies from the four major excess SIPC providers to determine
the differences and similarities among the policies as well as their
consistency with SIPC’s coverage. We also reviewed a random sample of
clearing and introducing firms’ Web sites to determine if they advertised
excess SIPC protection on their Web sites and the nature of the protection.

We conducted our work in New York, NY, and Washington, D.C., from
October 2002 through July 2003 in accordance with generally accepted
government auditing standards.


As 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. At that time, we will send copies of this report to the Chairman,
House Committee on Energy and Commerce; the Chairman, House
Committee on Financial Services; and the Chairman, Subcommittee on
Capital Markets, Insurance and Government Sponsored Enterprises, House
Committee on Financial Services. We will also send copies to the Chairman
of SEC and the Chairman of SIPC and will make copies available to others
upon request. In addition, the report will be available at no charge on the
GAO Web site at http://www.gao.gov.

If you or your staff have any questons about this report, please contact
Orice Williams or me at (202) 512-8678. Other GAO contacts and staff
acknowledgments are listed in appendix III.




Richard Hillman, Director
Financial Markets and Community Investment




Page 31                                  GAO-03-811 Securities Investor Protection
Appendix I

Comments from the U.S. Securities and                                 Appendx
                                                                            ies




Exchange Commission                                                    Append
                                                                            x
                                                                            Ii




              Page 32         GAO-03-811 Securities Investor Protection
Appendix I
Comments from the U.S. Securities and
Exchange Commission




Page 33                                 GAO-03-811 Securities Investor Protection
Appendix II

Comments from the Securities Investor
Protection Corporation                                                Appendx
                                                                            Ii




              Page 34         GAO-03-811 Securities Investor Protection
Appendix II
Comments from the Securities Investor
Protection Corporation




Page 35                                 GAO-03-811 Securities Investor Protection
Appendix III

GAO Contacts and Staff Acknowledgments                                                          Appendx
                                                                                                      iI




GAO Contacts      Richard J. Hillman (202) 512-8678
                  Orice M. Williams (202) 512-8678



Acknowledgments   In addition to those individuals named above, Amy Bevan, Emily Chalmers,
                  Carl Ramirez, La Sonya Roberts, and Paul Thompson made key
                  contributions to this report.




(250105)          Page 36                               GAO-03-811 Securities Investor Protection
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