How to Protect Yourself From the Next MF Global

After reading (In)Securities: Why Your Stocks and Bonds Are No Longer Your Property, a recent free special report from Casey Research, I felt it was absolutely necessary to share with you today's article.

Here's a short summary of it:

Your stocks and bonds are not safe anymore… and haven't been for the last decade. If your broker goes broke, there's a chance you'll be left holding the bag. Discover the ugly truth—and how to protect yourself.

If you have a 401(k), IRA, or brokerage account of any kind, you must read (In)Securities: Why Your Stocks and Bonds Are No Longer Your Property to protect yourself.

Here's what you'll discover in this shocking report:

  • How your stocks and bonds can legally be taken from you if your broker suffers an insolvency (learn what you can do to give yourself maximum protection from losing your assets).
  • Documented cases where investors have lost control of their personal assets (and learn why even having a fully segregated brokerage account may not protect you if your broker goes bankrupt).
  • How the US government guarantees that big investment banks can make unlimited risky bets with clients' collateral (yet more proof that the government does not have your best interests at heart).
  • Why Jon Corzine didn't face criminal prosecution after $1.6 billion in client assets went missing while he was CEO of MF Global (learn the legal loophole that kept him free—and virtually ensures that no executive will ever be imprisoned for improperly using clients' accounts as collateral for risky loans).

The possibility that your broker could end up being the next MF Global is a terrifying thought. But that doesn't mean it should be disregarded. Quite the contrary. With the combination of the practice of rehypothecation and many brokerage firms being leveraged to the hilt, another MF Global-type scenario is not as unlikely as many would believe.

Thankfully, there are some practical strategies you can take to mitigate this risk, including using multiple brokers and diversifying with foreign brokers.

Until next time,

Nick Giambruno, Senior Editor

The DRS: Going Direct

The MF Global bankruptcy was an unwelcome event that roused investors from a complacent slumber. What had been regarded as a quaint formality—reading and understanding your broker's customer and margin agreements—was hastily penciled in at the top of every investor's "must read" list.

The details of the bankruptcy eventually exposed that the company engaged in excessive leverage as well as various fraudulent maneuvers. Nonetheless, the practice known as rehypothecation (customer shares used multiple times as collateral) was at the heart of the broker's demise… and it was and still is legal.

A groundswell of concern surfaced and left investors to question not just the soundness of their personal broker, but the regulations that underpin the entire industry.

The industry responded quickly that investors were protected through the Securities Investor Protection Corporation (SIPC). Similar to the FDIC, which backstops bank deposits, the SIPC insures up to $500,000 of securities and money held at a broker, with a $250,000 limit for cash.

But no one buys flood insurance and eagerly awaits the chance to use it. The emotional energy spent and personal time lost while making oneself whole cannot be recouped. It likely will take months before an SIPC claim is paid. Meanwhile, the investor must forgo the use of his money, and any holdings that exceed the insurable limits will very possibly be lost.

The Workaround

Heightened liquidity and leverage risks are the new normal for today's investor. These risks also apply to brokerage firms. The good news is that a way around these uncertainties is available to every investor: the Direct Registration System (DRS).

Individual investors have three options regarding how to hold securities:

  • Physical Certificate. When the investor holds a hard-copy paper certificate, his name is registered on the books of the issuing company—just like direct registration. The investor must safeguard the certificate from loss or theft. To replace a certificate is difficult and might include a charge based on a percentage of the certificate's value. The certificate must be surrendered to sell the securities it represents. Selling a portion of the shares requires certificate surrender and a new certificate issued for the remaining shares.
  • Street Name Registration. Securities are recorded as an electronic entry on the books of a broker, registered in the name of a brokerage firm, with the individual shareowner being the beneficial owner. A printed stock certificate is not issued, and there is no direct relationship with either the company whose securities you own or its transfer agent. Any company dividend or disbursement is credited to your brokerage account or mailed to the investor by the broker.
  • Direct Registration. The security is registered in your name on the issuer's books, and either the company or its transfer agent holds the security for you in book-entry form. Securities held in direct registration are easily transferred.

When an investor elects to hold securities via direct registration, the shares do not appear on the books of a broker. Should the broker go out of business or enter receivership, shares are not caught in any legal process. Shares held in the DRS cannot be borrowed, lent, or used as collateral by a broker.

Inside the DRS

The Direct Registration System has operated in US markets for over a decade. It is supported by: the Securities and Exchange Commission (SEC); the Securities Industry and Financial Markets Association (SIFMA), which represents securities firms, banks, and asset managers; the Depository Trust Company (DTC); and the three national US stock exchanges (NYSE, AMEX, and NASDAQ).

The commitment and confidence in the system was cemented when, effective January 2007, the NYSE, AMEX, and NASDAQ made DRS availability a requirement for all subsequent issues listed on US exchanges. Then in January 2008, direct registration was required for all companies listed on these three US exchanges.

This includes foreign-listed companies and ADRs (more on that in a minute). Direct registration of shares is available on exchanges outside the US.

A global leader in transfer agency and share registration, Computershare is at the forefront of efforts to enable book-entry ownership in England, Australia, New Zealand, and Canada. The degree of direct registration available for securities varies for each country, and none of them approaches the level offered by US markets. Computershare also operates in the Channel Islands, Germany, Hong Kong, Ireland, and South Africa.

How It's Done

Once the decision to convert from street name to direct registration is made, the procedure to accomplish this is straightforward. The investor should inquire with the broker that holds the security to determine if the issuer of the security offers direct registration. If direct registration is available, instruct your broker to move your security position to the issuer for direct registration.

When purchasing a security, instruct your broker that you want to hold your securities in direct registration. If you currently hold a security in certificate form, you can mail or take your certificate either to the issuer's transfer agent or to your broker with instructions to change to direct registration.

Once the process is initiated, it involves a few steps that require information-sharing between the investor and the security's transfer agent. Following the change in registration, you'll receive a statement of ownership from the issuer acknowledging your DRS book-entry position. Issuing corporations and transfer agents do not charge fees for recording your securities in DRS. Some brokers may charge a fee if you request a DRS transaction.

Selling shares held in the DRS is essentially the above steps in reverse. The investor instructs the issuer/transfer agent or broker to electronically move the shares to the broker account. Shares are then sold through the broker in the traditional way.

DRS and InteractiveBrokers

Your broker can advise if shares bought on a foreign exchange are also eligible for direct registration. I contacted InteractiveBrokers, and asked about its participation in the DRS. I received the following unedited response:

Customers who wish to use Direct Registration as a means for holding their shares can certainly do so but would need to establish their own arrangement with the issuer or an independent transfer agent as IB does not offer this service. IB holds all securities in street name meaning that they are registered electronically in the name of IB on the books of the issuer. IB, in turn, holds securities for customers in what is known in the industry as "book entry" form that simply means that we maintain a record on our books of each customer who is a beneficial owner of the securities. A few other points to keep in mind:

  • Not all securities are eligible for Direct Registration and the determination as to whether any one security is eligible is not determined by IB but rather by the issuer.
  • Securities held via Direct Registration remain under the control of the customer and not the broker. As a result, they are not maintained in the customer's IB account or reported on their account statement.
  • IB does not offer margin credit or loan value to securities held outside our control.
  • If a customer wishes to sell securities held via Direct Registration through their IB account they would first need to arrange to have them transferred from their Direct Registration account. Customers can request that IB initiate the transfer on their behalf, but should note that such transfers, while electronic, require operational tasks on the part of both IB and the transfer agent that may delay the transfer and sale of securities. We therefore do not recommend this form of holding where time is of the essence.
  • While there are no restrictions placed upon the sale or use of equity originating from Direct Registration securities transfers, such transfers are subject to a 10 business day hold during which the securities may not be re-transferred or the sales proceeds withdrawn. This hold period is intended to protect IB from exposure to losses from transfers which we have initiated and which the transfer agent reclaims.
  • The Direct Registration transfer agent may charge a fee to move securities to the customer's IB account and customers requesting that IB effect a transfer on their behalf must agree to indemnify IB for all fees charged to IB for this service.

Final Thought

In a dose of twisted irony, in the midst of my research for this article we learned of the downfall of another broker due to fraud: Peregrine Financial Group (PFGBest). Over $200 million of customer funds is missing, and the company will be liquidated under Chapter 7 of the bankruptcy code.

Granted, both MF Global and PFGBest were futures brokers. Nonetheless, the failure of these two firms has put the behavior and solvency of brokerages on the radar of investors.

We are not suggesting, nor do we have any reason to believe, that InteractiveBrokers is engaged in any activity that puts the company at risk. Indeed, following the MF Global bankruptcy, InteractiveBrokers responded to a Reuters article that mentioned them in regard to the issue of brokerages using hypothecation and rehypothecation of customer shares.

Risk mitigation via diversification must be part of an investor's strategy. That should include not only the use of multiple brokers, but also shares held by direct registration.

Editor's Note: Part of your strategy for diversifying your brokerage accounts should include the use of foreign brokerage companies. Not only will this help diversify the risk associated with using only one broker, but it will open up a whole new world of investment opportunities in countries that may not be available through a domestic broker. You can find Casey Research's top picks for foreign brokers—including ones that will open accounts for American clients remotely with no or very small account minimums (usually, a couple of thousand dollars)—by clicking here.

This article originally appeared in World Money Analyst, a Mauldin Economics publication. 

Tags: offshore banking, foreign brokerage account,