What Happens to Stocks If a Brokerage Goes Bankrupt?

Investors have to consider all kinds of risks when deciding what assets to put their money into. From individual business concerns to macroeconomic shifts, shareholders must be ready for all eventualities.

One risk most investors may not have considered, though, is that of their brokerage going bankrupt.

What happens to stocks if a brokerage goes bankrupt, and how much protection exists for shareholders in this situation?

Why Would a Stock Brokerage Go Bankrupt?

Like any other business, a stock brokerage might reach a point where it is unable to meet its obligations and continue business operations.

In 2008, for instance, massive investment banks like Bear Stearns and Lehman Brothers found themselves without enough liquidity to cover their positions in subprime mortgage instruments.

It’s worth mentioning, though, that instances of brokerage bankruptcy are fairly rare. As with banks, stock brokerages are held to minimum capital requirements intended to safeguard them against excessive financial risk.

There are also guardrails around how much debt a brokerage can take on to balance the problem of insolvency on the other side. For most brokerages, the maximum ratio of debt that can be taken on is equal to 1,500% of their net capital.

What Protections Are in Place for Investors?

The good news for investors is that the rules regarding the separation of brokerage and customer assets are extremely strict.

The Securities and Exchange Commission (SEC) requires brokerages to fully separate customer cash and securities from their own holdings.

As long as a brokerage is meeting this basic legal requirement, customer assets will be protected from the financial difficulties of the firm.

Another layer of defense for investors comes in the form of the Securities Investor Protection Corporation (SIPC), which provides insurance on brokerage accounts. In some ways, the SIPC resembles the FDIC in the banking world and plays a role in ensuring that investors don’t lose their assets when brokerages fail.

The coverage provided by the SIPC gives investors insurance on up to $500,000 per brokerage account. Of this, up to $250,000 per account can be in the form of cash. SIPC covers stocks and bonds but doesn’t provide protection for derivatives like futures contracts or Forex trades.

Finally, in the rare cases where a brokerage breaches the strict rules requiring it to separate its own assets from those of its customers, investors may be able to sue the brokerage directly.

The taking of customer funds, known formally as conversion, can trigger massive fines and leave brokerages liable for damages.

Generally, these cases are arbitrated by the Financial Industry Regulatory Authority (FINRA) rather than going through the ordinary court system.

What Happens When a Brokerage Fails?

Although the SEC’s rules protect customers from losing cash or stocks held by a brokerage, insolvent brokers still have to go through a liquidation process.

In many cases, the brokerage will be able to self-liquidate. When this happens, customer assets are transferred directly to another registered broker, after which customers regain access to them.

Another common path for bankrupt brokerages is to simply find a buyer for their assets. As with self-liquidation, this ensures that customer accounts will be protected and that investors will regain access to their shares under the umbrella of the purchasing brokerage.

A buyout of this sort can be beneficial for both companies, as the brokerage getting acquired gains the financial resources needed to pay its creditors while the acquiring brokerage expands its customer base.

Here, it’s worth quickly noting that brokerage buyouts don’t occur exclusively in cases where a brokerage has started bankruptcy proceedings. Historically, large brokerages have built up their businesses by strategically acquiring smaller competitors.

A prime example of this can be found in the case of online brokerage Scottrade. The firm was purchased by TD Ameritrade in 2017, after which all Scottrade customers were given new TD Ameritrade brokerage accounts. TD Ameritrade itself was bought by Charles Schwab in 2020, continuing the snowball of acquisitions.

The final option is a SIPC liquidation, which typically occurs when a brokerage has violated rules separating its money from that of its customers. This is where the SIPC’s insurance coverage comes into play. Investors at a brokerage in SIPC liquidation must file a claim by a deadline set by the SIPC after being notified that their brokerage is being liquidated. Once the claim has been filed, the investors in question become eligible for compensation from the SIPC.

The downside to all of this is the fact that investors usually can’t access their holdings readily during the liquidation process. According to FINRA, it usually takes about 1-3 months for customers to receive their assets in an SIPC liquidation.

Self-liquidations or buyouts may be faster, but there could still be a period of time during which investors won’t be able to trade or withdraw funds.

Are Stocks Safe in Brokerage Accounts?

Although brokerages aren’t immune from bankruptcy, stocks held in American brokerage accounts are quite safe.

The layers of regulatory and capital requirements placed on brokerages by FINRA prevent them from taking on excessive debts or operating without enough cash to meet their obligations under most circumstances.

Brokerages that follow the rules set up for them can also easily transfer customer assets to another brokerage by self-liquidating in the event that they do run into business trouble.

Even in the case of a brokerage that doesn’t follow these rules, the SIPC provides a great deal of coverage for investors whose money has been mishandled.

As of the end of Q3 2023, the average brokerage account held about $112,000, just 22.4 percent of the amount that the SIPC will cover.

The brokerage with the highest average account balance was Fidelity at about $258,000. For all but the wealthiest Americans, it would be fairly unusual to have over $500,000 in a single brokerage account.

For those few investors who do have balances of over $500,000, it’s easy to open up multiple brokerage accounts to stay under the SIPC’s coverage.

Brokerage accounts are, however, considered safe enough that even many wealth management experts don’t see substantial risks in keeping more than $500,000 in a single account.

Generally, investors are most often advised to open multiple accounts if doing so offers them the ability to invest in assets they can’t buy through their primary accounts.

With all of this said, it’s still important to choose a good brokerage when investing in stocks. Examining a firm’s history and reliability can be a good place to start. Investors must also consider the fee structures of different brokers, as trading fees and commissions can eat into total returns over the long run. As with almost everything else in the investment world, due diligence is key to choosing the right brokerage.

Even if a reliable brokerage does find itself in bankruptcy, though, the safeguards put in place by the SEC, FINRA and the SIPC provide strong protections to keep investors from losing their hard-earned money.

It’s important though to keep careful records of their transactions and ensure that these records remain up-to-date. In the rare event of an SIPC liquidation, these records may be required to successfully file a claim and receive compensation.

What Happens to Stocks If a Brokerage Goes Bankrupt?

When a brokerage goes bankrupt, SIPC protections mean that the stocks owned by the client should be recoverable. High net worth clients may wish to spread money across numerous brokerages to limit risk and maximize SIPC protections.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.