Custody of Customer Funds and Securities
The handling of client assets is one of the most heavily regulated areas of the securities industry. Understanding what constitutes "custody" and the safeguards required when an adviser has it is essential for the Series 63.
Uniform Securities Act Section 102(e) - Custody Restrictions on Investment Advisers
Under Uniform Securities Act (USA) Section 102(e), it is unlawful for any investment adviser to take or have custody of client securities or funds if:
- The Administrator by rule prohibits custody, or
- In the absence of a rule, the investment adviser fails to notify the Administrator that it has or may have custody
Think of it this way: The Administrator has two options: ban investment adviser (IA) custody entirely or require notification. If the state has no specific custody rule, the IA must at minimum notify the Administrator.
The Administrator may adopt additional rules (such as North American Securities Administrators Association (NASAA) Model Rule 102(e)(1)-1) that impose safeguards beyond the basic USA requirement.
What Constitutes "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.
Custody includes:
- Physical possession of client funds or securities (e.g., holding stock certificates or checks)
- Authority to withdraw funds or securities from a client's account (e.g., deducting advisory fees directly)
- Legal ownership or access to client funds through any arrangement that permits the adviser to obtain them
Common situations that create custody:
- An IA that deducts advisory fees directly from a client's custodial account (even though a qualified custodian holds the assets)
- An IA that serves as trustee for a client trust
- An IA with signatory authority over a client's bank account
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 through automatic fee deductions), that constitutes custody. Custody is about authority, not physical possession.
NASAA Model Rule 102(e)(1)-1 - Custody Requirements
This model rule, adopted by NASAA in 2013, provides detailed custody safeguards for state-registered IAs. When an IA has custody, the following requirements apply:
| Requirement | Details |
|---|---|
| Qualified custodian | Client funds and securities must be maintained with a qualified custodian (bank, savings association, broker-dealer, or futures commission merchant) |
| Notice to Administrator | The IA must promptly notify the state Administrator on Form ADV |
| Client notification | The qualified custodian must send account statements directly to the client at least quarterly, showing all transactions, holdings, and debits/credits |
| Surprise examination | The IA must undergo an annual surprise examination by an independent public accountant to verify client assets |
| Segregation | Client assets must be held in separate accounts in the client's name (or the IA's name as agent/trustee for the client); they must not be commingled with the IA's own assets |
Qualified Custodian Requirement
Client assets must be held by a qualified custodian; the IA generally may not hold client assets itself.
Qualified custodians include:
- Banks and savings associations
- Registered broker-dealers
- Futures commission merchants
- Foreign financial institutions that meet certain conditions
Key points:
- The qualified custodian must be independent of the investment adviser (with limited exceptions)
- Account statements go directly to the client (not through the IA) to prevent misappropriation
Annual Surprise Examination
If an IA has custody of client assets, the IA must engage an independent public accountant to conduct an annual surprise examination.
- The purpose is to verify that client assets are present and properly accounted for
- The examination must be conducted on an unannounced basis at a time chosen by the accountant
- The accountant must file a report with the Administrator within 120 days of the examination
- If the accountant finds material discrepancies, the accountant must notify the Administrator within one business day
Exception to the Surprise Examination Requirement
An IA is generally exempt from the surprise examination if all three conditions are met:
- The IA's only form of custody is the ability to deduct advisory fees directly from client accounts
- The qualified custodian sends statements directly to the client
- The IA sends its own itemized invoice to the client at the same time fees are deducted
Think of it this way: Fee deduction is a limited, well-documented form of custody that poses lower risk than holding actual client assets. If there's full transparency (statements from the custodian plus an itemized invoice from the IA), the surprise exam isn't needed.
Exam Tip: Gotchas
- The exam may present a scenario where an IA deducts fees and ask whether a surprise examination is required. If fee deduction is the IA's only form of custody and the client receives statements from the custodian and the IA sends an itemized invoice, no surprise exam is needed. If the IA has any other form of custody, the surprise exam is required.