Client Funds and Securities

Now that you understand how advisers are compensated, the next question is: who holds the client's money and securities, and what rules govern that custody?

Custody (SEC Rule 206(4)-2)

An adviser has custody when it holds, directly or indirectly, client funds or securities, or has the authority to obtain possession of them.

What triggers custody:

• Physical possession of client funds or securities
• Authority to deduct advisory fees directly from client accounts
• Acting as trustee for a client trust
• Access to client login credentials

Custody Requirements

When an adviser has custody, SEC Rule 206(4)-2 imposes strict safeguards:

Surprise examination details:

• The accountant selects the exam date without prior notice
• Must vary the date each year
• Accountant has 120 days from the exam date to complete and file Form ADV-E with the SEC

Audit exception: Advisers to pooled investment vehicles can bypass the surprise examination if the fund undergoes an annual audit conducted under Generally Accepted Accounting Principles (GAAP) by a PCAOB-inspected accountant, with audited statements distributed to investors within 120 days of fiscal year-end.

State-Level Custody Rules

• North American Securities Administrators Association (NASAA) Model Rule 102(e)(1)-1: State-level custody requirements that generally mirror SEC rules
• NASAA Model Rule 202(d)-1: Minimum financial requirements (higher net worth or bonding) for advisers with custody or discretion
• States may impose higher minimum net worth requirements on advisers that maintain custody

Exam Tip: Gotchas

• Custody isn't just holding a client's check. Deducting fees from a client account = custody. Being able to log into a client's brokerage account = custody. Each of these triggers the full set of custody requirements including the surprise examination.

Trading Discretion and Authorization

Discretionary authority is the power to make investment decisions (what to buy/sell, which security, how much) without getting the client's approval before 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-only direction is NOT discretion.

Key requirements:

• Requires written authorization from the client (typically in the advisory contract or a separate limited power of attorney)
• First exercise of discretion may trigger stricter custody or bonding requirements
• Even with discretion, the adviser retains full fiduciary duties of suitability and best execution

Non-discretionary accounts:

• Adviser recommends; client approves each transaction before execution
• The adviser cannot act without prior client consent

Exam Tip: Gotchas

• Discretion means the adviser decides what, when, and how much to trade. But discretion over trading does NOT remove the adviser's obligation to act in the client's best interest. Suitability and best execution still apply.

Prudent Investor Standards (Uniform Prudent Investor Act)

The Uniform Prudent Investor Act (UPIA) modernized the fiduciary standard for managing trust assets. Adopted by 44 states and D.C., it replaced the older "Prudent Man Rule."

Core principles:

• Trustees must invest and manage trust assets as a prudent investor would
• Must consider the purposes, distribution requirements, and other circumstances of the trust
• Diversification is mandatory unless circumstances specifically indicate otherwise
• Individual investments are judged in the context of the total portfolio - not in isolation
• Fiduciaries may delegate investment decisions to qualified agents when appropriate

Key shift from old standard: Under the old Prudent Man Rule, each individual investment was evaluated on its own. Under UPIA, the entire portfolio's risk/return profile is what matters.

Exam Tip: Gotchas

• Under UPIA, a single risky investment is not automatically imprudent. It is judged in the context of the total portfolio, not on its own.
• Diversification is required under UPIA, not just recommended. The only exception is when specific trust circumstances indicate otherwise.

Suitability

Recommendations must be appropriate for the specific client. There are two layers of suitability analysis:

Client profile factors:

• Financial situation (income, net worth, liquidity needs)
• Investment objectives (growth, income, preservation)
• Risk tolerance
• Time horizon
• Other relevant factors (tax status, existing holdings)

Exam Tip: Gotchas

• Reasonable-basis suitability (good for at least some investors) is different from customer-specific suitability (good for this particular client). Both must be satisfied before making a recommendation.

Anti-Money Laundering (Bank Secrecy Act / PATRIOT Act)

Financial institutions must establish Anti-Money Laundering (AML) compliance programs to detect and prevent money laundering.

Key requirements:

• SARs must be filed within 30 calendar days of initial detection

Exam Tip: Gotchas

• The two dollar thresholds are often mixed up: SARs = $5,000 (suspicious activity), CTRs = $10,000 (cash transactions).
• Tipping off a client about a SAR filing is prohibited. The client can never be informed that a report was filed.