Client Funds and Securities

This file covers fiduciary duty, custody rules, discretionary authority, the prudent investor standard, and anti-money laundering requirements.

Fiduciary Duty of Investment Advisers

An investment adviser (IA) is a fiduciary and has a duty to act primarily for the benefit of its clients.

Fiduciary duty has two core components:

• Duty of Care - provide advice that is in the client's best interest, based on thorough understanding of the client's objectives, risk tolerance, and financial situation
• Duty of Loyalty - place the client's interests ahead of the adviser's own; fully disclose all material conflicts of interest

Key points:

• The duty applies to investment advisers, investment adviser representatives, and federal covered advisers
• The extent and nature of fiduciary duty varies according to the nature of the relationship and the circumstances of each case
• Fiduciary duty cannot be waived by the client

Exam Tip: Gotchas

• Investment advisers owe a fiduciary duty to clients. Broker-dealers owe a suitability obligation (and now Reg BI's "best interest" standard). The exam tests whether you know which standard applies to which role. An investment adviser representative (IAR) always has the higher fiduciary standard.

Custody: What Creates It

Custody exists when an investment adviser (IA) directly or indirectly holds client funds or securities, or has authority to obtain possession of them.

Think of it this way: Custody is about access to client assets. If you can touch the money or securities (physically or through legal authority), you have custody and must follow strict safeguard rules.

Situations That Create Custody

An adviser has custody if it:

• Has physical possession of client assets
• Has the ability to deduct fees directly from client accounts
• Acts as trustee for a client
• Has access to client funds through passwords or authority (but NOT read-only data aggregation)
• Has signatory power over a client's bank account or brokerage account

Exam Tip: Gotchas

• A limited power of attorney (LPOA) covering only trading = discretion, NOT custody. Custody requires authority to withdraw or transfer assets.
• "Can I touch the money?" If yes = custody. Authority to withdraw = custody, even without physical possession.

Custody Requirements Once Custody Exists

1. Qualified Custodian

Client assets must be maintained with a qualified custodian (bank, broker-dealer, trust company, or futures commission merchant).

2. Client Account Statements

The qualified custodian must send account statements to clients at least quarterly.

3. Notice to the Securities and Exchange Commission (SEC)

Adviser must report custody status on Form ADV.

4. Annual Surprise Examination

An independent certified public accountant (CPA), registered with the Public Company Accounting Oversight Board (PCAOB), must conduct an annual surprise examination to verify client assets.

• Must be conducted at an irregular time chosen by the accountant without prior notice
• CPA has 120 days from the surprise date to file Form ADV-E with the SEC

Audit exception: A pooled investment vehicle is exempt from the surprise examination if it undergoes an annual Generally Accepted Accounting Principles (GAAP) audit with results distributed to investors within 120 days of fiscal year-end.

Minimum Financial Requirements

State-registered advisers with custody must maintain a minimum net worth:

Exam Tip: Gotchas

• Deducting advisory fees directly from a client's account = custody. Many advisers do not realize this. If you can pull money from the account (even just your fee), you have custody and must comply with all custody requirements.
• Using the client's own username and password to access their account is an unethical business practice.

Street Name and Segregation of Customer Securities

When a broker-dealer holds securities on behalf of a customer, those securities are typically registered in the firm's name (or its nominee) rather than the customer's name. This is called holding securities in street name.

• The customer remains the beneficial owner with all economic rights (dividends, voting, gains/losses)
• The broker-dealer is the registered owner (nominee) whose name appears on the issuer's books
• Street name is standard practice because it enables faster electronic settlement

Segregation Requirement

Broker-dealers that hold customer securities in street name must keep them in segregated accounts that are physically separate from the firm's own proprietary holdings.

• Commingling (mixing customer and firm assets in the same account) is prohibited
• Record-keeping alone is not sufficient; actual account separation is required
• This protects customers if the firm becomes insolvent, because customer assets are identifiable and not part of the firm's estate

Exam Tip: Gotchas

• Street name does NOT mean the customer loses ownership. The customer keeps all economic rights. The firm's name is on the registration only for operational convenience.
• Segregation is about account separation, not just record-keeping. A firm cannot hold customer securities in its proprietary account even if it maintains records showing which belong to clients.

Discretionary vs. Non-Discretionary Accounts

Discretionary Authority Defined

The adviser determines which security to buy/sell, in what quantity, and when, WITHOUT obtaining prior client approval for each transaction.

Memory Aid: AAA

An order is discretionary if any of these is missing:

• Asset (which security)
• Action (buy or sell)
• Amount (number of shares)

Time and Price Is NOT Discretion

If the client chooses the security and quantity and only delegates timing/price, this is NOT discretionary, and no power of attorney is required.

Authorization Requirements

• Written discretionary authority must be obtained within 10 business days of the first transaction placed under oral discretionary authority
• Determining only price or time of execution (not what or how much to trade) does not constitute discretion

Third-Party Trading Authorization

• Placing orders on instruction of a third party requires written third-party trading authorization from the client
• Example: a family member calling to place trades in the client's account needs prior written authorization

Exam Tip: Gotchas

• If a client says "buy some tech stocks when you think the time is right," the adviser is exercising discretion (choosing security, amount, and timing). The adviser must obtain written discretionary authority within 10 business days of the first trade. Verbal authority covers the gap but only for 10 business days.

Recommendation/Advice Standard of Care

IAs must have reasonable grounds to believe a recommendation is suitable based on:

• Client's investment objectives
• Financial situation and needs
• Information furnished by the client after reasonable inquiry
• Any other information known to the adviser

Suitability obligation applies to each recommendation, not just account opening.

Uniform Prudent Investor Act (UPIA) - Five Core Principles

Exam Tip: Gotchas

• Under UPIA, a speculative stock is not automatically imprudent. It depends on how it fits within the total portfolio. The old "prudent man" rule judged each investment individually; the UPIA judges the portfolio as a whole. The exam frequently tests this distinction.

Agency Cross Transactions (NASAA Model Rule 102(f)-1)

An agency cross transaction is one in which an investment adviser (IA) acts as agent for both sides of a trade: the advisory client AND another person on the opposite side (often another advisory client). The adviser has a divided loyalty, so the NASAA Model Rule imposes a strict set of conditions before such transactions may proceed.

The Six Conditions

An adviser may effect agency cross transactions only if all six conditions are met:

1. Prospective written consent: client provides written consent in advance authorizing agency cross transactions
2. Written disclosure: adviser discloses in writing that it will act as broker, receive commissions, and have a potentially conflicting division of loyalty between the client and the other party
3. Per-transaction confirmation: written confirmation sent no later than completion of each transaction, including the source and amount of any commission
4. Annual statement: adviser sends an annual written statement showing the total number of agency cross transactions and the total commissions received
5. Right to revoke: every written disclosure and confirmation must prominently state that consent may be revoked at any time
6. No dual recommendations: adviser may not recommend the transaction to both parties; at least one side must come unsolicited

Exam Tip: Gotchas

• Prospective (blanket) consent is permitted for agency cross because the conditions provide ongoing protections (per-transaction confirmation, annual statement, right to revoke).
• The no-dual-recommendation rule means the adviser cannot have advised both the buyer and the seller. If the adviser recommended to one side only and the other side initiated independently, the transaction is permissible.
• The right to revoke must appear in every disclosure and confirmation, not just at the original consent.
• Even when all six conditions are satisfied, the adviser still owes a continuing fiduciary duty to act in each client's best interests and to obtain best price and execution.

Anti-Money Laundering (AML)

The Bank Secrecy Act (BSA) requires financial institutions to assist in detecting and preventing money laundering. As of January 1, 2026, investment advisers (Securities and Exchange Commission (SEC)-registered registered investment advisers (RIAs) and exempt reporting advisers (ERAs)) are defined as "financial institutions" under BSA (FinCEN final rule, August 2024).

Key AML Requirements

Exam Tip: Gotchas

• Structuring (breaking up deposits to stay under $10,000 each) is itself a federal crime, even if the underlying funds are legitimate. A client who deposits $9,500 on Monday and $9,500 on Tuesday to avoid the CTR is committing structuring.