Custody of Customer Funds and Securities

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:

1. The Administrator by rule prohibits custody, or
2. 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

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."

What Does NASAA's Custody Rule Require?

NASAA's custody rule for investment advisers gives state-registered advisers (and advisers required to be state-registered) with custody a detailed set of safeguards:

Who Qualifies as a Custodian?

Client assets must be held by a qualified custodian:

• Banks and savings associations
• Registered broker-dealers
• Futures commission merchants
• Foreign financial institutions that meet specified conditions

An adviser (or a related person) that independently qualifies may act as its own clients' custodian, but that arrangement carries extra safeguards beyond the standard surprise examination.

• The independent CPA performing the verification must itself be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board
• The adviser must obtain a written internal control report on the custodial safekeeping controls at least once every calendar year

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
• Certain privately offered securities: securities acquired directly from the issuer outside a public offering, that are uncertificated and recorded only on the issuer's or transfer agent's books in the client's name, and that are transferable only with the issuer's or other holders' consent, do not need a qualified custodian
• Audited pooled vehicles: this exception does not remove the qualified-custodian requirement. Instead, a limited partnership, LLC, or similar pooled vehicle can satisfy the quarterly-statement and surprise-examination requirements by having its financial statements audited annually and distributed to investors within 120 days of fiscal year-end, in place of those two requirements

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.

• The examination must be conducted on an unannounced basis, at a time chosen by the accountant, and must be irregular from year to year
• The first examination must generally occur within six months of the adviser becoming subject to the requirement; if the adviser (or a related person) is itself the qualified custodian, the first exam is instead due within six months of obtaining the required internal control report
• The accountant must file a certificate on Form ADV-E with the Administrator within 120 days of the examination
• If the accountant finds material discrepancies, it must notify the Administrator within one business day
• If the accountant resigns, is dismissed, or is otherwise terminated, it must file Form ADV-E with an explanatory statement within four business days

When Is the Surprise Examination Not Required?

An adviser whose only form of custody is deducting advisory fees is exempt from independent verification only (not from the rest of the custody safeguards) if all of the following are true:

• The adviser's only custody is the ability to deduct advisory fees directly from client accounts
• The client gave written authorization for the deduction
• Each time a fee is deducted, the adviser concurrently sends the custodian (or an independent gatekeeper) the deduction amount and sends the client an itemized invoice showing the fee formula, assets under management, and period covered
• The adviser notifies the Administrator through Form ADV

Exam Tip: Gotchas

If fee deduction is the adviser's only form of custody, the surprise-examination exception requires written client authorization, concurrent itemized invoices to both the custodian and the client, and Form ADV reporting. 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 the Administrator's rule permits it, or (absent a rule) 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 gives the adviser custody too.
• The narrow exceptions are inadvertent receipt and forwarding a third-party check, each returned/forwarded within three business days with the required records kept.
• NASAA's custody rule requires a qualified custodian, Form ADV notice, client account-opening notice, quarterly statements, and an annual surprise examination.
• Qualified custodians are limited to banks/savings associations, registered broker-dealers, futures commission merchants, and qualifying foreign financial institutions. Mutual fund transfer agents and certain privately offered securities are exceptions to the qualified-custodian requirement itself; an audited pooled vehicle instead substitutes an annual audit for the quarterly-statement and surprise-exam requirements.
• The surprise examination is unannounced and irregular year to year, with the first exam generally within six months, a Form ADV-E filing to the Administrator within 120 days, same-next-business-day notice of material discrepancies, and a Form ADV-E filing within four business days if the accountant is terminated.
• The fee-deduction exception removes only the independent-verification requirement, and only with written authorization, concurrent itemized invoices, and Form ADV notice.
• Custody or discretionary authority over client funds can also trigger the Administrator's surety-bond requirement, covered in this course's investment adviser regulation unit; a bond and a custody or discretionary-authority determination are related but separate exam topics.