Wednesday, 18 August 2010

Protection for the Online Investor Against Insolvencies and Defaults

Times are tough, business failures have risen and even some governments sit on the brink of financial failure. It's hard enough earning the money to save and invest without it disappearing in flash. Can you get your money back? Let's look at the mechanisms that help protect the online investor in cases of default, insolvency and bankruptcy. The possibilities vary, depending on the situation. A chart below summarizes the protection offered for each type of investment, how the protection is backed up and by whom.

Broker goes bust
The failure of your broker should not mean the loss of any of your securities or cash (both Canadian and US dollars) due to the presence of the Canadian Investor Protection Fund, which will provide compensation of up to $1 million per account for holdings not handed back to you. To back up its promise, the CIPF collects fees from broker members and has a fund amounting to $359 million as of December 2009. It seems to have worked so far as the 17 broker insolvencies requiring $36 million in payouts since 1969 have easily been covered.

ETF and Mutual Fund provider hits the wall
Suppose Black Rock Asset Management, the managers of the popular iShares Canada ETFs were to fade to black, would you as an owner of iShares S&P/TSX 60 Index Fund (symbol: XIU) be stuck with worthless shares? The answer is no. Every XIU shareholder legally owns his or her proportional amount of the total holdings in the fund. The XIU holdings are kept in trust. In case of Black Rock failure, the assets could be distributed pro-rata among the XIU shareholders if XIU were to be dissolved but more likely another fund company would be brought in to take over management of the fund. All ETFs and mutual funds in Canada have the same basic trust structure as XIU.

Bond issuer failure
When the issuer of a bond goes into default by the failure to pay promised interest or principal, or by violating other terms of the bond indenture that sets out all its terms and conditions (see Wikipedia's Bond article), the bond investor is usually able to recover some value. Bondholders come before shareholders (but after banks and their loans, employees for their pay and governments for taxes) in claims for the remains of a corporation. Secured bonds include a claim against specific assets that may be sold while debentures hold a general claim. Another frequently seen form of recovery is that debt is converted into equity in a re-incarnated company, an example being when General Motors went into bankruptcy in 2009 according to this Wall Street Journal news item. The Financial Times' Downturn hits rates of debt recovery showed how bondholders in the past were able to recover as little as under 20% in severe economic downturns vs the 40% historical average. These are averages for all defaults and the experience for individual companies could of course vary from 0% to close to 100%.

With government bonds (or shorter term debt like Treasury bills), things are different. There are no secured bonds (forget the idea of buying Greek bonds in the hope of ending up with a piece of a Greek island in the sun!) only a promise to re-pay. Even when governments cannot pay according to the original bond terms and go into default, they have an incentive not to simply stiff the bondholders because they will want to borrow again. The result is a mix of pure loss debt write-off and re-structured easier-to-handle terms.

Guaranteed Investment Certificate issuer inability to pay
The risk of losing your money in GICs is almost non-existent since the Canada Deposit Insurance Corporation stands ready to reimburse principal and interest of up to $100,000 per issuer for any investor should the issuer not pay. It backs this up with funds of $1.88 billion and borrowing capacity of $15 billion.

Caveat: Some GICs provide a return based not on straightforward interest but on a stock exchange index, which means, as's (a website sponsored by the Ontario Securities Commission) How risky is a GIC? explains, you could end up with only your principal.

Segregated Funds sponsoring insurance company goes under
Segregated funds are technically insurance products (see Segregated Funds Come With a Guarantee on the Financial Advisor Association of Canada Advocis website) and they thus qualify for backup against loss due to provider difficulties under the Assuris not-for-profit organization. The coverage rules are a bit tricky so it is worth reading the Assuris website page for details, but the basic guarantee is that it will cover up to $60,000 or 85%, whichever is greater, of what you were promised. Assuris has a $100 million fund ready at hand to pay claims in addition to the power to levy its membership of all Canadian life insurance companies, who are required to be members. There have been only three life insurance company insolvencies since 1990 according to Assuris. As with those failures, rather than a payout to the investor, the more likely result is that the investor's product will simply be transferred to another insurance company.

Annuity and Guaranteed Minimum Withdrawal Benefit provider failure
These products are also provided by insurance companies and receive protection by Assuris of up to $2000 per month or 85% of the promised income.

Stocks - Company insolvency
There is no real protection for shareholders against company insolvency or bankruptcy. Shareholders are last in line with the right to claim against remaining assets and usually end up with little or nothing. Perhaps the best result is a restructured company with consolidated shares that leave existing shareholders with a much smaller proportional ownership after bondholders and new equity providers take over the lion's share. That exposed status is the reason equities should receive substantially higher returns than other forms of investment securities.

You the Self-Directed Investor go bankrupt
The self-directed online investor by definition does not have a relationship with an investment advisor. You are your own advisor. The sacrifice of the possible benefit of advice means not having to worry about fraud or inappropriate advice so we have not covered the various means of recourse involving advisors.

If you do yourself in, there is some protection against yourself! If you go bankrupt registered plans like RRSPs are protected against claims by outside creditors (except for contributions made within the last 12 months before bankruptcy) according to How does bankruptcy affect an RRSP? in

Time and Ease of Getting the Compensation Will Vary
As can be inferred from the different mechanisms, some types of protection will operate much quicker and more easily than others. Simple transfers from one provider to another can be relatively painless while court recourse can take years.

The possible angst and distraction of waiting for the compensation can be a significant negative. That's all the more reason for caution before investing to avoid the need for protection in the first place. However, avoidance can never be perfect and it is useful to know beforehand what protection exists.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Patrick said...

CIPF protection is actually at least $1M (to the limit if your account value of course). You can actually receive much more than $1M. See this CIPF web site.

CanadianInvestor said...

Patrick, that's a good clarification to make. The LOSS coverage is up to $1 million but that means, as the web page you link to says, your account value can be much larger than that.