Extrapolating from letters we receive, it’s fair to say the Securities Investor Protection Corp. (SIPC) is one of the most misunderstood organizations in the investment world. 

SIPC was created by a 1970 federal law to protect investors against the loss of cash and securities when a member brokerage fails or runs into financial trouble. All registered broker-dealers, with a few exceptions, are SIPC members. But SIPC is not a government agency and has no regulatory or investigatory powers. It will not reimburse you if the value of your investment drops or if you are victimized by a fraud. 

This small nonprofit organization’s mission is to return investors’ holdings when a brokerage fails — and only in a limited set of circumstances. Since its 1970 creation, SIPC has overseen the liquidations of 330 failed brokerage houses and returned more than $140 billion to more than 773,000 investors. Fortunately, SIPC hasn’t had to handle a new brokerage failure case since 2017. To get some clarity on how SIPC works, we sat down with CEO Josephine Wang at SIPC’s Washington, D.C., headquarters.

KIPLINGER: How does SIPC protection work?

WANG: We protect the custodial function of brokerage houses. Whatever cash or securities the broker is holding for you, we make sure that you get that back, within certain limits. We don’t protect against fraud or market losses. We do protect against theft. So if you’re a victim of a pump-and-dump scheme where the broker-dealer convinces you to buy 100 shares of XYZ and the value drops, all we can do is return those securities to you, whatever the value may be.

But if there’s theft — like what Bernie Madoff did, conducting a Ponzi scheme by taking money from some customer accounts to pay out fictitious gains to other customers — that’s where SIPC protection applies, because we do protect customers against the loss of cash and securities entrusted to the broker. Or, if the broker-dealer, without your permission, takes your money and buys 100 shares of ABC for you, we will unwind that transaction and return your money. But you have to prove that the transaction was not authorized, preferably using things like written notes or records of your instructions to your broker. This is why it’s important to read your account statements and to complain promptly of any irregularity in your account.

How are you different from the Federal Deposit Insurance Corp.?

What we do is somewhat similar to what the FDIC does, but there are some important differences. The FDIC is a federal agency that regulates banks. We are a nonprofit membership organization of broker-dealers. We have no regulatory or enforcement authority, so we don’t have any insight into the financial status of brokerages. That is monitored by the Securities and Exchange Commission (SEC) or FINRA (the Financial Industry Regulatory Authority), the self-regulatory body for brokers.

When does SIPC protection come into play?

If the regulators tell us a firm is in financial trouble and customers need our protection, we review the information. If we agree that the situation is covered by SIPC, we ask a federal court to place the firm in liquidation. The liquidation proceeds in bankruptcy court like a regular bankruptcy case — except that we can provide funding to return cash or securities to account holders.

How do you return investors’ holdings?

Ideally, we try to transfer customer accounts to another brokerage shortly after the firm is placed in liquidation. That allows the customers to get back into their accounts as quickly as possible. That is what happened when Lehman Bros. failed in 2008. The accounts were transferred to different brokerages. All Lehman customers with valid claims were made whole. If we can’t transfer accounts to another brokerage, customers have to go through a claims process, which is what happened in the Madoff case. That case is still ongoing. By suing those who enabled the fraud and clawing back the fraudulent profits taken by some investors, the Madoff trustee, with SIPC’s support, has recaptured more than $14.4 billion for Madoff customers. Anyone who had a claim of up to $1.7 million in deposits has gotten their deposits back. Anyone who deposited more than that has gotten about 71 cents on the dollar so far.

In the Madoff case, you are only returning people’s initial deposits, not bogus gains? And you have sued some of Madoff’s customers to force them to give back money they thought they legitimately earned?

It is a difficult case. In fairness to everyone, the true victims are the people whose money was stolen and used to pay fictitious profits to others. Some people were receiving other customers’ money and were able to buy, say, a vacation home, whereas the person who left the money in the account had nothing. But for Madoff clients, the Madoff trustee set up a hardship program. So if returning the money truly creates a hardship for you, you can ask for relief from the clawbacks.

How much of my money in a brokerage account does the SIPC protect?

A total of $500,000 for cash and securities, of which up to $250,000 can be cash. What that means is that if your firm fails and you have $500,000 in securities that are owed to you, which are for whatever reason missing, we will go into the market and buy those securities and return them to you.

A lot of investors have more than $500,000 in their investment accounts. How can people protect larger accounts?

That cap is set by Congress. Our protection is geared toward smaller investors. But it is possible to hold accounts in different capacities. So, for example, if you have an account in your name, and you have another joint account with your spouse, and you have another trust account, each of those would be eligible for separate protection.

Do you protect cryptocurrency investments or holdings?

Not currently. That’s something that we and all the regulators are grappling with. Unless cryptocurrency is defined as a security under our statute, it’s not going to be protected. We need the courts to rule on this or Congress to act to determine what exactly cryptocurrencies are and how they should be regulated.

How are you funded?

We are funded by a fee that all SIPC member broker-dealers pay. We have built up a reserve fund of about $4.4 billion. And we can borrow up to $2.5 billion from the U.S. Treasury — which we have never had to do. We are aiming to get our reserve fund to $5 billion.

If I have a problem with my brokerage, do I call you?

No. You should call your firm. Then escalate it to a regulator. The SEC and FINRA have online complaint forms that are easy to access.

Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.