The SIPC safety valve: What financial advisors should know about brokerage failures

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• What's at stake: Many financial advisors may be unprepared for what could happen to their firms and clients if a brokerage they use fails, making it an underexplored area of risk management, according to an industry expert.  
• Supporting data: Since its founding nearly 50 years ago, the Securities Investor Protection Corporation has helped investors recover nearly $150 billion in assets. RIA clients may be eligible for SIPC coverage of up to $500,000 per customer, per "separate capacity."
• Expert quote: "SIPC protects the custody function of cash and securities against loss — it does not protect against a decline in the value of securities or losses due to a broker's or advisor's investment advice." — Michael Post, president and CEO of SIPC

It's a process financial advisors and their clients hope they never experience firsthand. Yet experts say registered investment advisory firm owners and their customers should understand it anyway.

Rising stock and bond volatility, the growth in alternative investments among retail investors and the fierce competition for custody of RIA assets offer just three timely reasons why the Securities Investor Protection Corporation remains an important institution for industry professionals. When a brokerage firm fails, SIPC works to reclaim the value of missing customer cash and securities. Since its inception in 1970 — in the wake of "go-go stocks" and a "Paperwork Crisis" that shuttered hundreds of broker-dealers — SIPC has helped hundreds of thousands of investors recover $143.8 billion in assets. While FDIC protection loomed large in the regional banking crisis three years ago, it was SIPC that stepped in to protect investors after earlier high-profile cases, including the demise of Lehman Brothers and Bernie Madoff's firm.   

The limits of SIPC coverage

Since RIAs and advisors generally hold client assets with outside custodians, their clients may be eligible for SIPC coverage of up to $500,000 "per customer, for each account held in a separate capacity (with a sublimit of $250,000 for cash)," according to SIPC President and CEO Michael Post. Individual, joint or corporate accounts, individual retirement accounts or accounts held by trust are examples of separate capacities. So the level of protection can double in value when compared to that of the FDIC, but the safety valve applies to liquid assets the investor uses to buy securities. If that cash is part of common industry accounts known as "sweep" holdings that effectively move those assets from a brokerage firm to a bank, those assets will likely be covered by a bank's FDIC insurance, rather than a brokerage's SIPC coverage.

"SIPC protects the custody function of cash and securities against loss — it does not protect against a decline in the value of securities or losses due to a broker's or advisor's investment advice," Post said in an email. "SIPC-covered securities include stocks, bonds, Treasury securities, CDs and mutual funds. Investments that SIPC does not cover include foreign exchange trades, unregistered investment contracts, fixed annuities, stablecoins and non-security crypto or digital assets. Advisors can help their clients best protect their interests against the financial failure of a brokerage firm by encouraging them to carefully review confirmations or account statements and raise any possible errors or discrepancies with the brokerage firm promptly in writing."

Through the fees paid by member brokerage firms and interest earnings, the SIPC Fund has topped $4.8 billion, and the institution can also call upon its credit line of $2.5 billion from the U.S. Treasury. Since advisors act "as an advocate for your client," they should prepare ahead of any possible crises by thinking through how the rules for SIPC coverage may affect the customers' holdings in any worst-case scenarios, noted Michael Quinn, a managing director for financial accounting advisory services with Ernst & Young.

"You should understand how SIPC works, what it protects against and what are the limitations," Quinn said. "I think, as an advisor, I would want to be fully up to speed on what it covers." 

A respected RIA leader's concern

But this may be an oversight for many advisors, who don't give it the same attention as due diligence around other key vulnerabilities such as cybersecurity, investment risk or staff management and supervision, according to Mark Tibergien, the former CEO of Pershing Advisor Solutions with BNY Pershing. He's now an industry consultant, as well as an independent board member with RIA firm Pathstone and an advisor-in-residence with Ernst & Young's Wealth and Asset Management business.

Tibergien said several RIA owners he spoke with recently worried that they haven't evaluated this aspect of risk management as well as other areas. While no custodian serving the RIA and wealth management market has, in Tibergien's memory, failed and triggered SIPC protection, that means the process would be a new one to most advisors and their firms, he said. 

Given those conversations with RIAs, and the trend toward using multiple custodians, Tibergien said there are concerns about a possible reputational, financial or legal "radiation effect" should a provider of any size go under. Because RIAs' disclosures typically state that they refer clients to particular custodians and maintain relationships with those external firms that often involve financial incentives, the fallout from any collapse for advisors could be significant.

"I think we take SIPC protection and FDIC protection for granted, but anytime you have to call on insurance, that's a disaster," Tibergien said. "As we see RIA firms become larger and more complex in an environment that is volatile, it is time for them to examine all of their risk management strategies, including their vendor and custodian relationships."