Custody Definition and Obligations

This section reinforces the custody rules covered in Client Funds and Securities. The exam outline lists this as a separate topic to emphasize how frequently custody concepts are tested.

What Must an Adviser With Custody Do?

An adviser with custody must:

• Maintain client assets with a qualified custodian (bank, broker-dealer (BD), trust company, futures commission merchant (FCM))
• Ensure the custodian sends quarterly statements directly to clients
• When opening an account with a qualified custodian on the client's behalf, tell the client in writing the custodian's name and address and how the assets are held, and urge the client to compare the custodian's statements against the adviser's own
• Report custody status on Form ADV
• Submit to an annual surprise examination by an independent certified public accountant (CPA); the CPA must be registered with the Public Company Accounting Oversight Board (PCAOB) only when the adviser itself acts as the qualified custodian or for the audit of a pooled investment vehicle, not for the ordinary surprise examination

What Are the Surprise Examination Details?

• Must be conducted at an irregular time chosen by the accountant without prior notice to the adviser
• CPA has 120 days from the surprise date to file Form ADV-E with the Administrator (the state securities regulator)

Think of it this way: The entire point is independence. The accountant picks the date, the accountant contacts clients directly, and the accountant reports to the regulator. The adviser is kept out of the loop so it cannot prepare or conceal problems.

Audit exception: A pooled investment vehicle is exempt from the surprise examination only if every condition holds: it is audited at least annually under Generally Accepted Accounting Principles (GAAP); the audited financial statements are distributed to all beneficial owners within 120 days of fiscal year-end; the auditor is an independent CPA registered with and inspected by the PCAOB; on liquidation, the final audited statements are distributed promptly; and the engagement requires the auditor to notify the Administrator on resignation, dismissal, or removal.

Exam Tip: Gotchas

• Form ADV-E is not Form ADV. ADV-E is the cover page for the surprise examination report. Form ADV is the adviser's registration document.
• 120 days appears twice. The accountant has 120 days to file the surprise exam report. Pooled vehicles also have 120 days to distribute audited financials to investors.

What Are the Minimum Financial Requirements?

These are minimum net worth requirements for the adviser's own firm, not the client's net worth. States use this as a financial-stability safeguard before letting a firm handle client money.

What Should You Check on Exam Day?

• Custody requires a qualified custodian (bank, BD, trust company, or FCM), with quarterly statements sent directly to clients
• When opening a custodial account for a client, the adviser must give written notice of the custodian's name/address and how assets are held, and urge the client to compare statements
• Custody status is reported to the Administrator on Form ADV
• The annual surprise examination is conducted by an independent CPA at an irregular, unannounced time, except when fee-deduction-only custody qualifies for the narrow exemption
• PCAOB registration for the CPA is required only when the adviser itself is the qualified custodian or for a pooled-vehicle audit, not for an ordinary surprise exam
• The CPA has 120 days from the surprise date to file Form ADV-E; a pooled vehicle's audit exception requires ALL of: annual GAAP audit, results to investors within 120 days of fiscal year-end, a PCAOB-registered/inspected auditor, prompt final statements on liquidation, and auditor notice to the Administrator on resignation, dismissal, or removal
• Form ADV-E (the surprise exam report) is a different filing from Form ADV (the registration document)
• Minimum net worth: $35,000 for custody, $10,000 for discretion without custody, and positive net worth for prepaid fees of $500+ collected more than 6 months in advance
• These net worth figures apply to the adviser's firm, never to the client

Exam Tip: Gotchas

• Deducting advisory fees directly from a client's account = custody. But there's a carve-out: an adviser whose ONLY custody is fee deduction is exempt from the annual surprise examination if it has written client authorization, sends an invoice to the custodian and the client each time it deducts, and notifies the Administrator it relies on this safeguard. The other custody duties still apply.
• This is the adviser's net worth, not the client's. A client's own net worth is never a factor in these requirements.