Treatment Of Customers And Financial Counterparties In Stockbroker Liquidations Under SIPA And The Bankruptcy Code

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. Both SIPA and subchapter III of chapter 7

require the liquidation of a failed stockbroker. 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:

the SIPC member is insolvent;

there is already a pending proceeding against the member

and a receiver, trustee or liquidator has been

appointed;

the member is in violation of certain financial

responsibility or hypothecation rules promulgated by the SEC

or a selfregulatory organization; or

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.

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.

After a SIPA liquidation is commenced, SIPC will designate a

trustee3 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. Many of the steps taken

in a bankruptcy case parallel those taken in a SIPA

liquidation. Specifically, a bankruptcy trustee is chosen to

secure and marshal the debtor's assets, return

"customer name" (as opposed to street name)

securities to their owners, invite all creditors to file

claims, and pay those creditors in accordance with statutory

priorities. As discussed in more detail below, the fact that

all securities are liquidated and customer claims are paid in

cash (except for securities registered in the customer's

name which are returned to the customer) is a key distinction

between a bankruptcy liquidation and one under SIPA, where SIPC

and the SIPA trustee will attempt to return securities to

customers in satisfaction of their customer claims.

Priority of Customer Claims

Both SIPA and the Bankruptcy Code seek to return the

customers to the economic position they were in...