Introduction With the possibility of a major stock brokerage liquidation appearing more likely than it has been in recent periods, the effect of a liquidation on customers and financial counterparties has become of great interest to many of our clients and others.
This article summarizes some of the key issues that may arise in a stockbroker liquidation and, in particular, the impact upon customers with securities accounts and counterparties to securities contracts, swaps, repurchase agreements and other common financial instruments under either (i) the Securities Investor Protection Act of 1970 (“SIPA”) (1), or (ii) chapter 7 of the United States Bankruptcy Code (the “Bankruptcy Code”).
(2) Liquidation Under SIPA and the Bankruptcy Code in General Neither SIPA nor the Bankruptcy Code allow a broker-dealer to reorganize.
If failure has occurred or is likely and one of these tests is satisfied, the federal district court will issue a protective order at SIPC’s request that will serve to protect customer accounts and customer property and limit the failing SIPC member’s activities in certain ways described below.
Although the district court enters the protective order, the SIPA proceeding is then referred to the bankruptcy court for the district which actually oversees the liquidation.
Except to the extent SIPA mandates different treatment, a SIPA trustee operates as and has the powers of a bankruptcy trustee under chapter 7 of the Bankruptcy Code.
The protective order, much like the automatic stay in bankruptcy, freezes customer activity and unless there is a sale of the customer accounts to a more stable brokerage firm (which is common but might be more problematic where a large broker is in liquidation), the customer may find himself without access to his securities or cash in his securities account for months.
Both liquidation schemes, however, prioritize to a significant extent the repayment of “customer” claims over those of general unsecured creditors, which may include those who “lend” their excess cash to the broker, foreign exchange creditors and more routine creditors such as landlords and vendors.
SIPA Among the most important aspects of SIPA is the liquidation process that is overseen by the SIPA-created Securities Investor Protection Corporation (“SIPC”).
Also important is the SIPA fund (the “SIPA Fund”), which is essentially an insurance program funded by SIPC members to protect customers from loss if a SIPC member fails.
A SIPA liquidation proceeding may only be commenced by SIPC in federal district court, and then only if SIPC determines that a member has failed, or is in danger of failing, to meet its obligations to its customers and one of the following has occurred: (i) the SIPC member is insolvent; (ii) there is already a pending proceeding against the member and a receiver, trustee or liquidator has been appointed; (iii) the member is in violation of certain financial responsibility or hypothecation rules promulgated by the SEC or a selfregulatory organization; or (iv) the member cannot compute whether it is in compliance with the financial responsibility or hypothecation rules promulgated by the SEC or a self-regulatory organization.
After a SIPA liquidation is commenced, SIPC will designate a trustee (3) who will then set about the tasks of notifying customers of the impending liquidation, transferring customer accounts to a more financially stable brokerage firm if possible, having customers and other creditors file claims, and paying customers and other creditors in accordance with the statutorily mandated priorities.
The Bankruptcy Code Through subchapter III of chapter 7 of the Bankruptcy Code, Congress has provided an alternative method for stockbroker liquidation in the relatively rare instances when the stockbroker is not a SIPC member.
As with SIPA, under the Bankruptcy Code, stockbrokers are only entitled to liquidate assets for the benefit of customers and creditors and may not reorganize.