Barrons.com (May 1, 2015 8:25 pm) - Nearly every brokerage firm advertises that $500,000 of the holdings in client accounts, including up to $250,000 in cash, is insured by the Securities Investor Protection Corp. But many investors might be surprised to learn how limited SIPC protection can be when fraud is suspected of having caused a loss.

A case in Redlands, Calif., illustrates this. Securities regulators contend that, from November 2010 through April 2013, brokerage Thornes & Associates and its president, John Thornes, looted $4.4 million from two trust accounts. One was set up for the care of Belva Jeanne Shultz, an elderly Alzheimer’s patient, by her husband, now dead. The other, the Harbison Trust, was established in an individual’s will to provide college scholarships to academically distinguished high school graduates. It supported up to 15 students at a time.

In a routine examination in April 2013, inspectors for the Financial Industry Regulatory Authority, or Finra, found that Thornes had converted the Shultz trust to a margin account and then conducted leveraged transactions in it that produced for his firm $49,000 in margin-interest charges, plus $11,422 in brokerage commissions. Worse, the inspectors alleged, Thornes had written checks from the Shultz and Harbison trusts for unsecured loans to a local businessman, ultimately emptying both accounts.

IN JULY 2013, FOLLOWING a disciplinary hearing, Finra, which regulates brokers, permanently expelled Thornes and his firm from the industry. Without denying or admitting guilt, Thornes agreed to compensate the trusts, with interest. In August 2014, Thornes cut a similar deal with the Securities and Exchange Commission, which had begun a civil action against him, accusing him of theft and fraud. He agreed to pay more than $9 million in disgorgement, prejudgment interest, and penalties.

The SEC says Thornes’ mother, Doreen, 83, the Harbison trustee, had asked her son to help her manage the fund, delegating authority over it to him, and that he, without her knowledge, altered its profile to permit it to take greater risks, including using margin loans. “Thornes deceived his own mother,” the agency alleges. The SEC has named Thornes, his mother, and Chris Burnell, a businessman who received the unsecured loans, as “relief defendants,” for the purpose of recovering any illicit funds in their possession. Kyle Larick, another businessman who received money from Burnell that originated with the Thornes firm, was named a relief defendant, too.

Barron’s couldn’t reach Thornes or Burnell for comment. Larick, through his lawyer, contends that he thought the money was a legitimate payment for loans he had made to Burnell and that he has repaid the sums at issue to the trusts.

Then, in December 2014, an arbitrator appointed by Finra ruled that Thornes must pay Shultz $4.5 million in compensatory damages. However, Richard Nervig, a lawyer for the Shultz trust, tells Barron’s that Thornes probably doesn’t have the assets to pay what he agreed to.

If he doesn’t, the SIPC seems unlikely to provide money to the trusts. To understand why, consider the SIPC’s history. Congress established it in 1970 after about 130 brokerage firms went bust during a bear market that led, essentially, to a run on investment firms. Brokers begged Congress to establish an industry-financed, federally backstopped fund to halt the panic. To ensure that the backstop rarely would be used, Congress strictly limited coverage.

The SIPC, which has a very small staff, generally relies on the larger SEC to help it determine if an investor is eligible for an insurance payment. The circumstances surrounding a loss dictates what happens.

A GOVERNMENT OFFICIAL familiar with SIPC gives these examples: If you have securities or cash at a brokerage house, and it fails because of poor business decisions, you should receive a payment. If you haven’t given a broker discretionary authority over your account and he takes assets out of it without your permission, that, too, is covered. But if you’ve authorized a broker to make decisions in your account, and he used fraudulent representations to induce you to buy, say, the penny stock of a company that goes belly up, the SIPC doesn’t cover that. A case involving a trustee, or someone with a trustee’s authority, might fall into this last category.

Says this official: “Sometimes, assets are taken out of an account through legal authority, and, although there may have been a fraud involved, custodianship was not at issue. If you gave the registered representative trading authority—told him, in effect, ‘Here’s my account, and you can do whatever you want with it because I trust you with my money’—and then the rep does something inappropriate, under SIPC they say, ‘Look, you gave the person authority, so it’s not a custodial issue any more. It’s that he did not act in your interest, and that’s different.’ ”

Says Hugh Berkson, a Cleveland lawyer who is president-elect of the Public Investors Arbitration Bar Association: “SIPC doesn’t do what people think it does. They do everything they can to limit payouts to the most narrow of circumstances.” The SIPC, which hasn’t ruled on the trusts’ insurance claims, wouldn’t comment to Barron’s.

Thornes had served the Shultz family well for years, until November 2010, when he persuaded Shultz’s two daughters, both trustees of the fund, to let him convert it to a margin account. Then he made unsecured, one-year loans to Burnell, who allegedly promised him an interest rate of up to 20%. Burnell has been sued by eight people who claim to have lent him hundreds of thousands of dollars and say they’ve never been repaid. At least one has been awarded a judgment by a state superior court judge.

No criminal charges have been filed against anyone involved in the Shultz or Harbison cases. However, the Secret Service tells Barron’s that it is investigating to determine if money-laundering laws were breached when Thornes allegedly funneled some cash to Burnell through transactions at a tribal casino.

But even if criminal charges are filed, it will be small recompense to the trusts’ potential beneficiaries, especially if no payments from SIPC materialize.

E-mail: jim.mctague@barrons.com