Quick Answer
Custody includes authority to obtain client assets, even by deducting fees. Under the Uniform Securities Act, an adviser must not take custody if the Administrator prohibits it; absent a prohibition, it must notify the Administrator. NASAA's custody model adds qualified-custodian, notice, statement, and examination safeguards, subject to its exceptions.
This section covers who is allowed to hold client assets, what counts as having custody, and the safeguards NASAA requires when an investment adviser does.
When Is an Adviser's Custody Unlawful?
Under the Uniform Securities Act's custody provision, it is unlawful for an investment adviser to take or have custody of client securities or funds if:
- The Administrator by rule prohibits custody, or
- In the absence of such a rule, the adviser fails to notify the Administrator that it has or may have custody
This gives the Administrator two regulatory options: ban IA custody outright, or require notification. If a state has not adopted a specific custody rule, the default is that the adviser must at minimum notify the Administrator. The Administrator may also adopt rules, such as NASAA's custody rule for investment advisers, that impose additional safeguards beyond this baseline.
What Counts as "Custody"?
An investment adviser has custody when it holds, directly or indirectly, client funds or securities, or has the authority to obtain possession of them. The adviser also has custody if a related person holds client funds or securities, or has authority to obtain them, in connection with the advisory services the adviser provides. Custody includes:
- Physical possession of client funds or securities (for example, holding stock certificates or checks)
- Authority to withdraw funds or securities from a client's account, such as deducting advisory fees directly
- Legal ownership or access to client funds through any arrangement that lets the adviser obtain them, including acting as trustee for a client trust or holding signatory authority over a client's bank account
Two narrow situations do not count as custody, even though the adviser briefly holds something belonging to a client, provided the adviser also keeps the required records of the transfer:
- Inadvertent receipt: the adviser receives client funds or securities by mistake and returns them to the sender within three business days
- Third-party checks: a client's check is made payable to a third party, and the adviser forwards it to that third party within three business days of receipt
Is Discretionary Authority the Same as Custody?
No. Discretionary authority by itself is not custody. The two powers answer different questions:
| Power | What it lets the adviser do |
|---|---|
| Discretion | Decide the security, the amount, or the action in a client's account without asking first |
| Custody | Hold client funds or securities, or obtain them |
An adviser that is authorized to choose the securities and amounts for trades in a client account held at a qualified custodian has discretion. If that adviser cannot withdraw cash or securities and has no other authority to obtain the account's assets, it has discretion without custody.
The two often appear together, and the Administrator may require a bond for either one. That shared consequence is what makes students merge them. They remain separate determinations, and a fact pattern can give an adviser one, both, or neither.
Exam Tip: Gotchas
"Custody" does not require the adviser to physically hold the assets. If the adviser has the authority to access or withdraw client funds, even only through automatic fee deductions, that is custody. It also does not require the adviser itself to hold anything: a related person with that authority gives the adviser custody too. The narrow three-business-day exceptions (inadvertent receipt, forwarding third-party checks) are the only carve-outs from "possession equals custody." Discretion is a separate question, not a carve-out. Authority to choose trades is not authority to obtain assets, so an adviser with discretion alone never triggers the custody rule.
What Does NASAA's Custody Rule Require?
NASAA's custody rule for investment advisers, the NASAA Custody Requirements for Investment Advisers Model Rule, gives state-registered advisers (and advisers required to be state-registered) with custody a detailed set of safeguards:
| Requirement | Details |
|---|---|
| Qualified custodian | Client assets must be maintained with a bank or savings association whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC); a broker-dealer registered in the state and with the Securities and Exchange Commission (SEC) that holds them in customer accounts; a registered futures commission merchant holding the rule's limited product types in customer accounts; or a qualifying foreign financial institution |
| Notice to Administrator | An adviser with custody must promptly notify the Administrator on Form ADV |
| Account-opening notice | The adviser promptly tells the client the custodian's name and address and how assets are maintained, and updates the notice after any change |
| Quarterly statements | The adviser has a reasonable basis for believing the qualified custodian sends clients statements at least quarterly |
| Surprise examination | An adviser with custody generally undergoes an annual surprise examination by an independent certified public accountant |
| Account structure | The qualified custodian may use separate client accounts or a client-only account properly titled under the adviser as agent or trustee, or under the managed pooled vehicle; the other custody safeguards still apply |
Who Qualifies as a Custodian?
Client assets must be held by a qualified custodian:
- Banks and savings associations with deposits insured by the Federal Deposit Insurance Corporation (FDIC)
- Broker-dealers registered in the state and with the Securities and Exchange Commission (SEC) that hold the assets in customer accounts
- Registered futures commission merchants holding customer funds, security futures, or securities incidental to commodity futures or options transactions, in customer accounts
- Foreign financial institutions that customarily hold customer financial assets and keep advisory client assets segregated from proprietary assets
An adviser (or a related person) that independently qualifies may act as its own clients' custodian, subject to extra safeguards beyond the standard surprise examination.
Account statements from the qualified custodian go directly to the client, not through the adviser, to prevent misappropriation. If the adviser also sends its own account statements to that client, the adviser must include a notice urging the client to compare the custodian's statements against the adviser's.
Are There Exceptions to the Custody Safeguards?
- Mutual fund shares: the adviser may use the fund's own transfer agent in place of a qualified custodian
What Does the Annual Surprise Examination Require?
If an adviser has custody of client assets, it generally must engage an independent certified public accountant to conduct an annual surprise examination to verify that client assets are present and properly accounted for.
When Is the Surprise Examination Not Required?
An adviser whose only form of custody is deducting advisory fees can be relieved of the independent-verification (surprise-examination) requirement if it meets NASAA's conditions for fee-deduction custody:
- The adviser has written authorization from the client to deduct fees from the account held with the qualified custodian
- Each time a fee is deducted, the adviser concurrently sends the custodian an invoice or statement of the fee amount
- At the same time, the adviser sends the client an itemized invoice or statement showing the fee formula, the assets under management the fee is based on, and the period covered
- The adviser notifies the Administrator in writing, on Form ADV, that it intends to use these safeguards
Exam Tip: Gotchas
- Only the client's invoice must be itemized; the custodian receives the fee amount. The exception removes independent verification only; every other custody safeguard (qualified custodian, quarterly statements, and so on) still applies.
What Should You Check on Exam Day?
- Under the Uniform Securities Act, IA custody is unlawful unless a rule permits it or the adviser notifies the Administrator.
- Custody is about authority to obtain funds or securities, not just physical possession; fee-deduction authority alone is custody, and a related person's authority counts too.
- Discretion alone is not custody. Choosing the security, amount, or action is not the same as being able to obtain the assets. An adviser can hold one power, both, or neither.
- The narrow exceptions are inadvertent receipt and forwarding a third-party check, each within three business days with the required records kept.
- Custody safeguards include a qualified custodian (FDIC-insured bank, state-and-SEC broker-dealer customer accounts, limited-scope futures commission merchant, or qualifying foreign institution), Form ADV and client notices, quarterly statements, and generally an annual surprise examination.