Under the Uniform Commercial Code, the interest of a secured creditor of your broker takes priority over your claim if the secured creditor “takes control” of the securities. So if your broker pledges “your” securities to a bank in return for a loan, and if your broker goes bust, guess who gets the securities? (Hint: not you).
Professor James Rogers, the draftsman of the statute, put the objection to this provision of the law like this, with his tongue firmly if inappropriately in cheek:
This is outrageous! If this statute is enacted then customers will never be safe. You mean to say that if my broker goes insolvent, then the banks that lent it money will be able to come in and take away my securities! You people are either crazy, tools of the plutocrats, or both. It would be terrible if Article 8 were adopted to change the law like this. We should stick with the simple tried and true property concepts. If we need to modernize the law, that’s fine, but we’ve got to preserve the simple basic point that if I decide to leave my securities with my broker, they’re still mine. And, doggone it, nobody else should be able to get their mitts on them–especially not some bank that lent money to the broker.
43 U.C.L.A. L. Rev. 1431, 1511 (1996).
Now, there are various pollyana-ish responses to this concern, one of which is that investors are protected by the SIPC (up to $500,000 in securities and $100,000 in cash). But the SIPC’s funds are not unlimited, and it’s interesting and a bit scary to note that in 2003, insurers stopped writing excess insurance policies to protect investors over the SIPC limits. The Customer Asset Protection Company was created to offer such insurance, but it is funded by its member firms, i.e., the brokers themselves. Sure, it has reinsurance, but in light of the AIG fiasco, that’s not very reassuring.
I have no way to prove it, but I suspect that the possibility of brokerage failures, which could lead to banks seizing investors’ securities, was one of the circumstances making a bail-out necessary.
As part of the bailout, I hope Congress will look at modifying the relevant provision of the U.C.C. (it’s section 8-511, if you’re interested) to provide greater protections to investors. If this means brokerage firms will no longer be able to pledge investments they are holding for customers, then so be it.
(By the way, although the UCC is state law, I take it that Congress, under the Commerce Clause, clearly has the power to set a uniform rule in this area).
TedF
