Securities Law - Where Do Investors Stand?

[emilylynn]

I'll preface this by saying that I know nothing at all about securities law, and precious little about bankruptcy. So forgive me if my question is a little open-ended.

With all of the news about the tenuous financial condition of banks and other financial institutions, I've been pondering the question of what recourse investors would have in the event of a systemic meltdown. It occurred to me that while I work with concepts of "ownership," "interests," "rights," and "liabilities" all day, I really don't have a clue what the legal relationships are when it comes to my investments or how things would unwind if the music stopped and there weren't enough funds to go around.

Let's say that I have an account with Vanguard, and through Vanguard's brokerage I buy 100 shares of the Prudent Global Income Fund, one of the funds offered by Prudent Bear Funds, Inc. My 100 shares are immediately transferred to my account with Vanguard, which is maintained by Pershing, LLC, the clearing agent for Vanguard and the "holder" of my funds. That's four separate entities that stand between me and my funds. There might be additional entities to worry about if one of them gets cute and lends my shares for short-selling or uses them as collateral.

What is the nature of my legal relationship to the shares? Do I "own" them in the same way that I would if I were holding the certificates?

Which of these entities, if any, might have a claim over the assets represented by my shares in the event that it became insolvent? Would my shares be deemed segregated and identified to me, such that they would never become part of the bankruptcy estate at all?

Let's assume, for the sake of argument, that there's no such thing as SPIC insurance.

Any thoughts? Martha?

 

[FinanceDude]

I'll preface this by saying that I know nothing at all about securities law, and precious little about bankruptcy. So forgive me if my question is a little open-ended.

With all of the news about the tenuous financial condition of banks and other financial institutions, I've been pondering the question of what recourse investors would have in the event of a systemic meltdown. It occurred to me that while I work with concepts of "ownership," "interests," "rights," and "liabilities" all day, I really don't have a clue what the legal relationships are when it comes to my investments or how things would unwind if the music stopped and there weren't enough funds to go around.

Let's say that I have an account with Vanguard, and through Vanguard's brokerage I buy 100 shares of the Prudent Global Income Fund, one of the funds offered by Prudent Bear Funds, Inc. My 100 shares are immediately transferred to my account with Vanguard, which is maintained by Pershing, LLC, the clearing agent for Vanguard and the "holder" of my funds. That's four separate entities that stand between me and my funds. There might be additional entities to worry about if one of them gets cute and lends my shares for short-selling or uses them as collateral.

What is the nature of my legal relationship to the shares? Do I "own" them in the same way that I would if I were holding the certificates?

Which of these entities, if any, might have a claim over the assets represented by my shares in the event that it became insolvent? Would my shares be deemed segregated and identified to me, such that they would never become part of the bankruptcy estate at all?

Let's assume, for the sake of argument, that there's no such thing as SPIC insurance.

Any thoughts? Martha?

You would have little or no recourse against anyone..which is why SIPC exists..........similar to why FDIC exists, folks in the Depression had bank CD's,and they were worthless pieces of paper.........

 

[audreyh1]

What is the nature of my legal relationship to the shares? Do I "own" them in the same way that I would if I were holding the certificates?

Which of these entities, if any, might have a claim over the assets represented by my shares in the event that it became insolvent? Would my shares be deemed segregated and identified to me, such that they would never become part of the bankruptcy estate at all?

Yes.

Audrey

 

[brewer12345]

No, you would be totally exposed and every creditor of every entity that came within a country mile of your assets would have a claim on them. Hold on tight to your tinfoil helmet and BE AFRAID! If I were you, I would sell everything, buy shotgun shells, gold bullion, and a hand crank flashlight and hide in the cellar.

 

[emilylynn]

Brewer, I don't appreciate the derisive sarcasm expressed here and on other threads.

 

[Nords]

You're going to have to pardon Brewer's response (as much as I agree with it); we've been getting a lot of these apocalyptical falling-sky questions and our reasoned responses are met with flocks of Chicken Little's "Yeah buts".

Yeah, but I'll give it one more try.

What is the nature of my legal relationship to the shares? Do I "own" them in the same way that I would if I were holding the certificates?

Yes, you own the shares. The custodian/brokerage possesses them only by virtue of being responsible for keeping track of them. That's among the services you're paying an expense ratio for. I'm not sure that paper is actually created to track the existence of these shares; they may only reside as electrons in someone's computer ledger. However most of the stock market's transactions assume that it takes three trading days to deliver the paper, and that's why there are so many intermediaries between you and your liquidity.

UncleMick, for example, has owned shares directly. The company would issue them to him in the form of dividends, convert them to paper certificates, and get them to him via insured mail or a courier service. He'd lock them up in a cabinet somewhere and have to worry about fire, floods, & theft. When he was ready to sell them, he'd have to make sure that the buyer got them within three trading days or the sale would be off. In the meantime your four intermediaries would execute the same transaction within a couple of mouseclicks and an overnight server update.

Let's assume, for the sake of argument, that there's no such thing as SPIC insurance.

Let's not do that. SIPC is what keeps these people credible and (mostly) from running away to the Caymans. And most financial institutions purchase insurance above & beyond the SIPC minimum.

Is there anyone among the crowd of people concerned about a "systemic meltdown" who've actually read Dimson & Marsh's "Triumph of the Optimists", let alone studied the Weimar Republic or the Depression's bank holidays or the 1980s S&L "crisis" or even the Japanese 1990s bank frauds? Users of the phrase should be able to do the research to reassure themselves, or at a minimum find someplace trustworthy to hold their gold bullion & shotgun shells...

Does anyone even remember who was the first head of the SEC?!?

 

[emilylynn]

The reason I wanted to leave SIPC out of the mix is that I didn't want the discussion to turn into another "tin hat" debate over the plausibility of an economic meltdown. I don't regard my question as silly or unworthy of discussion. Rather, it seems unreasonable to me that the vast majority of people who invest in securities, such as myself, have no understanding at all of the legal relationships that are created by the transaction. I, for one, would like to have some understanding of the subject. My interest has more to do with my legal training, and the fact that I am paid to think about the worst that can happen, rather than with bunkers and ammunition.

 

[Martha]

Hey, how did I miss this thread?

Emilylynn, the Bankruptcy Code has special provisions for stockbroker bankruptcies with its own set of rules. First of all, they can't reorganize under chapter 11, but must do a liquidation under special provisions of chapter 7. Here is a link to the code section if you are in the mood to read: Donate to the Legal Information Institute

Basically, the intention is to get stock that is held for the account of a customer to that customer.

However, my understanding is that it is unlikely that a broker would go through the chapter 7 process but most likely will go through the SIPC process instead. Part of the purpose of SIPC is to return to customers their stock and cash, besides providing insurance of up to $500,000 for cash or securities that have "disappeared," whether through bad record keeping, some kind of fraud, or other reason.

 

[emilylynn]

Yes, you own the shares. The custodian/brokerage possesses them only by virtue of being responsible for keeping track of them. That's among the services you're paying an expense ratio for. I'm not sure that paper is actually created to track the existence of these shares; they may only reside as electrons in someone's computer ledger. However most of the stock market's transactions assume that it takes three trading days to deliver the paper, and that's why there are so many intermediaries between you and your liquidity.

If the brokerage's relationship to a shareholder is merely that of a custodian, how is it that a brokerage can pledge investors' shares as collateral, or lend them out for short-selling?

So you're saying that in the event of a bankruptcy anywhere along the line a shareholder would have the right to replevin of the asset itself, and would not be a creditor of the bankrupt entity?

 

[FinanceDude]

The reason I wanted to leave SIPC out of the mix is that I didn't want the discussion to turn into another "tin hat" debate over the plausibility of an economic meltdown. I don't regard my question as silly or unworthy of discussion. Rather, it seems unreasonable to me that the vast majority of people who invest in securities, such as myself, have no understanding at all of the legal relationships that are created by the transaction. I, for one, would like to have some understanding of the subject. My interest has more to do with my legal training, and the fact that I am paid to think about the worst that can happen, rather than with bunkers and ammunition.

Well you can't leave SIPC out of the equation, unless you're willing to waive FDIC.....then we could have an INTERESTING discussion.........

Bottom line, you do have rights, but it's a question of HOW MANY PEOPLE are in line in FRONT of you............

 

[emilylynn]

Hi, Martha-- thanks for the link. I will read it. Do you agree with Nord's analysis?

 

[jazz4cash]

Joe Kennedy?

 

[emilylynn]

Bottom line, you do have rights, but it's a question of HOW MANY PEOPLE are in line in FRONT of you............

Well, that's the question, FinanceDude--if you have to stand in line behind others, you're probably got only the status of a creditor.

 

[Martha]

The stock may be held in street name so the broker can do any number of things with the stock. However, I know we got to instruct our broker that our stock not be used for short sales, etc.

If you lose out and the stock is gone because of this sort of action by a broker, (which I know very little about) you can't replevin the stock. Instead, this is where you would have a claim with SIPC. And keep in mind, the broker can't file a chapter 11 and attempt to pay you over time. Also, under the bankruptcy code, the SIPC can interrupt the bankruptcy and file an "application for a protective decree under the Securities Investor Protection Act of 1970. The filing of such application stays all proceedings in the case under this title unless and until such application is dismissed. If SIPC completes the liquidation of the debtor, then the court shall dismiss the case."

So, basically the SIPC runs things.

 

[Martha]

I was hired by the feds once regarding a stock broker liquidation. The broker had stolen money from customers and only pretended to buy stock for them. My job was to find whatever I could that he owned and sell it. While the broker sat in jail I had the pleasure of searching his home and records to try to track things down. I will forever be amused by his book collection, including such things as Fodor's guide to the Cayman Islands and books about how to set up off shore bank accounts and trusts. It made it relatively easy to figure out what he was trying to do before he got caught.

 

[Gumby]

As I understand it, stock held in custodial account (but not margin accounts) is not property of the estate should the broker file Chapter 7, so you should be unaffected. If, however, the broker commingled your funds with its own funds, or you had a margin account, you share pro rata with the other investors in the commingled assets. Investors have priority over general unsecured creditors of the broker in this situation

In an SIPC liquidation, if the securities are identifiable to your account, you get the identified securities. If the securities are not uniquely identifiable to your account, you get a pro rata share of the all assets (only investors share in the pot, not general unsecured creditors). Then, you get cash from the SIPC up to $100,000 to make up the difference. Most brokers also have excess SIPC insurance should the shortfall exceed the SIPC guarantee amount.

 

[Martha]

Good explanation Gumby.

 

[emilylynn]

Could I ask, Gumby (and Martha), what you mean when you say "if the securities are identifiable to your account?" In the context of, say, a purchase of a refrigerator from a bankrupt dealer, I would assume that means that your name is on the box or the serial number is noted on your purchase order. What would "identify" shares to a particular shareholder?

 

[Nords]

The reason I wanted to leave SIPC out of the mix is that I didn't want the discussion to turn into another "tin hat" debate over the plausibility of an economic meltdown.
My interest has more to do with my legal training, and the fact that I am paid to think about the worst that can happen, rather than with bunkers and ammunition.

Hey, saying so up front would've helped avoid possible interpretations of yet another Chicken Little post. Including these two sentences in your original post would've helped a lot. You can see how your feelings change, too, after you wade through the next 50 or 60 falling-sky questions.

If the brokerage's relationship to a shareholder is merely that of a custodian, how is it that a brokerage can pledge investors' shares as collateral, or lend them out for short-selling?

Because people agree to do so by default in most brokerage agreements and most customers are oblivious as to who's doing what with their shares. As has been said already, shareholders can tell stockbrokers not to make certain shares available for margin. However some brokerages & mutual-fund companies, possibly Vanguard among them, share the profits they make from lending out shares and thereby reduce customer expenses. It's one of the big reasons that we can enjoy $8 trades.

So you're saying that in the event of a bankruptcy anywhere along the line a shareholder would have the right to replevin of the asset itself, and would not be a creditor of the bankrupt entity?

OK, I had to look that one up. IMO the answers are "irrelevant" and "correct".

In layman's terms, most customers agreed to let their broker lend their shares out to someone who probably shorted them. The borrower can do so subject to a shorting provision called "buy-in", which means that if the owner wants their shares back then the borrower has to return them within three trading days. "Replevin" or other legal maneuvers don't apply-- the shares never belong to the brokerage in the first place. It's a case of the owner lending them out and being able to reclaim them whenever they want them, and it's one of the features of shorting that makes it so exciting. The broker can make money off the loan, or declare bankruptcy, or go to the Caymans-- but the ownership hasn't changed just because the broker's fortunes have changed. If the owner doesn't get their shares back then the person who sold (shorted) them is liable. That's not a bankruptcy issue. The arrest warrant would be sworn out in the name of the person who borrowed the shares, not the custodian who arranged the transaction.

Joe Kennedy?

Thank you, a student of investor history! One of the biggest crooks on Wall Street was given the privilege of [-]siring a political dynasty[/-] writing the rulebook.

 

[Martha]

Could I ask, Gumby (and Martha), what you mean when you say "if the securities are identifiable to your account?" In the context of, say, a purchase of a refrigerator from a bankrupt dealer, I would assume that means that your name is on the box or the serial number is noted on your purchase order. What would "identify" shares to a particular shareholder?

It might help if you read this info from the SPIC: Securities Investor Protection Corporation

• Terms of SIPC help. Customers of a failed brokerage firm get back all securities (such as stocks and bonds) that already are registered in their name or are in the process of being registered. After this first step, the firm’s remaining customer assets are then divided on a pro rata basis with funds shared in proportion to the size of claims. If sufficient funds are not available in the firm’s customer accounts to satisfy claims within these limits, the reserve funds of SIPC are used to supplement the distribution, up to a ceiling of $500,000 per customer, including a maximum of $100,000 for cash claims. Additional funds may be available to satisfy the remainder of customer claims after the cost of liquidating the brokerage firm is taken into account.
• How account transfers work. In a failed brokerage firm with accurate records, the court-appointed trustee and SIPC may arrange to have some or all customer accounts transferred to another brokerage firm. Customers whose accounts are transferred are notified promptly and then have the option of staying at the new firm or moving to another brokerage of their choosing.
• How claims are valued. Typically, when SIPC asks a court to put a troubled brokerage firm in liquidation, the financial worth of a customer’s account is calculated as of the “filing date.” Wherever possible, the actual stocks and other securities owned by a customer are returned to him or her. To accomplish this, SIPC’s reserve funds will be used, if necessary, to purchase replacement securities (such as stocks) in the open market. It is always possible that market changes or fraud at the failed brokerage firm (or elsewhere) will result in the returned securities having lost some – or even all – of their value. In other cases, the securities may have increased in value.

 

[Martha]

As a little clarification on legalese for the non-lawyer types, replevin is a state court procedure to get possession of some asset that you are entitled to possess. For example, if someone steals your car from you, you are entitle to replevin the car. Or if you pledge the car as collateral for a loan and don't pay the loan, the creditor is entitle to replevin the car. Or, if your neighbor borrows your car and doesn't return it when they are supposed to return it, you are entitled to replevin your car.

Or as another example, say someone has possession of a stock certificate that belongs to you. If they do not have the right of possession, you could sue to replevin the stock certificate.

Replevin technically doesn't apply in the broker liquidation case because federal law and procedures will trump state law and state procedures.

 

[audreyh1]

If the brokerage's relationship to a shareholder is merely that of a custodian, how is it that a brokerage can pledge investors' shares as collateral, or lend them out for short-selling?

You can instruct your broker NOT to make your shares available for short selling.

I once told Fidelity not to make my shares available, and they told me that they already weren't. They said that only if I open a margin account might my shares become available for short selling.

I guess each broker has different policies, but I suspect as you have control over your shares you just have to make your wishes known.

Audrey

 

[FinanceDude]

No brokerage firm I know of in America can make a client's stock positions available for short selling without a margin agreement........most compliance departments have strict rules on this........

 

[emilylynn]

These have been great responses. Thanks, everyone.

I think it's time for me to go get a Gilbert's on Securities Law. Martha et al.--Remember Gilbert's?

One of the funniest memories of my career was the first day of a really big trial, when a team of about eight high-rollling attorneys on the other side of the case filed ominously into the courtroom. One of the younger attorneys set his impressively large briefcase down on counsel's table, where it promptly fell to the floor and popped open. It was completely empty except for a Gilbert's on Commercial Law. Needless to say, we had the edge after that little fiasco.