Key Takeaways
- Custody means holding or having authority to obtain possession of client funds or securities.
- Client assets must be held with a qualified custodian (bank, BD, FCM, trust company).
- Qualified custodian must send account statements directly to clients at least quarterly.
- Annual surprise examination by independent CPA is required for advisers with custody.
- Advisers who only deduct fees from accounts are exempt from surprise examination.
- When adviser or affiliate is the custodian, internal control report is required.
- Inadvertent custody through custodial agreements can trigger custody requirements.
- State net worth requirements: typically $35,000 for custody, $10,000 for discretion.
Custody and Safeguarding Client Assets
The SEC's custody rule provides critical protections for investors when investment advisers hold their assets.
What Constitutes Custody?
An adviser has "custody" if they hold, directly or indirectly, client funds or securities, or have authority to obtain possession of them.
Examples of Custody
| Situation | Has Custody? |
|---|---|
| Possession of client funds or securities | Yes |
| Power of attorney to sign checks | Yes |
| Authority to withdraw funds or securities | Yes |
| Authority to deduct advisory fees | Yes |
| Trustee for client accounts | Yes |
| Access to client login credentials | Yes |
| General partner of fund | Yes |
Inadvertent Custody
Advisers may have custody without realizing it:
- Custodial agreement grants broader access than advisory contract
- Standing letter of authorization (SLOA) in certain situations
- Bill-paying or similar services
Qualified Custodian Requirement
Client assets must be maintained with a qualified custodian:
| Qualified Custodians |
|---|
| Banks (federal or state) |
| Savings associations |
| Registered broker-dealers |
| Registered futures commission merchants |
| Foreign financial institutions (if certain conditions met) |
Account Naming Requirements
Assets must be held in:
- Separate accounts for each client under the client's name, OR
- Commingled accounts under the adviser's name as agent/trustee
Required Notifications and Statements
Client Notification
When opening a custody account:
- Promptly notify client of custodian's identity and location
- Provide account opening documents
- Explain how assets will be held
Account Statements
| Requirement | Details |
|---|---|
| Who sends | Qualified custodian (NOT the adviser) |
| Frequency | At least quarterly |
| Content | All transactions and holdings |
| Direct delivery | Sent directly to client |
Adviser's Own Statements
If adviser also sends statements:
- Must include legend to compare with custodian statements
- Clients urged to verify custodian statements
- Discrepancies should be investigated
Surprise Examination Requirement
Advisers with custody must have an annual surprise examination by an independent public accountant.
Examination Requirements
| Requirement | Details |
|---|---|
| Timing | Unannounced ("surprise") |
| Frequency | At least annually |
| Performed by | Independent CPA registered with PCAOB |
| Purpose | Verify existence and location of client assets |
| Report | File Form ADV-E within 120 days |
Accountant Requirements
The accountant must:
- Be registered with PCAOB
- Be subject to regular PCAOB inspection
- Be independent of the adviser
Exceptions to Surprise Examination
| Exception | Condition |
|---|---|
| Fee deduction only | Custody solely from authority to deduct fees |
| Pooled investment vehicles | Subject to annual audit with GAAP financials |
| Qualified custodian sends statements | And meets other conditions |
Fee Deduction Exception Requirements
To qualify for the fee deduction exception:
- Client must authorize fee deduction in writing
- Custodian must send statement showing fee deduction
- Adviser must send invoice to custodian
- Custodian agrees to send statements directly to client
When Adviser or Related Person is Custodian
Additional requirements apply when the adviser or affiliate serves as custodian:
| Requirement | Description |
|---|---|
| Internal control report | Annual report from independent CPA |
| Opinion on controls | CPA opinion on safeguarding procedures |
| Type II SAS 70/SOC 1 | Or equivalent examination |
| Still need surprise exam | In addition to internal control report |
Segregation and Safeguarding
| Requirement | Description |
|---|---|
| Separate accounts | Client assets separate from firm assets |
| Client identification | Assets clearly identified as client-owned |
| No commingling | Cannot mix with adviser's own assets |
| Recordkeeping | Accurate records of all client assets |
State Net Worth Requirements
States typically require minimum net worth or bonding for advisers:
| Authority Type | Minimum Net Worth |
|---|---|
| Custody of assets | $35,000 |
| Discretionary authority | $10,000 |
| No custody/discretion | May have no requirement |
Bonding Alternative
If net worth is insufficient:
- May post surety bond
- Bond amount varies by state
- Must maintain minimum net worth thereafter
Reporting and Recordkeeping
| Requirement | Details |
|---|---|
| Form ADV Part 1A | Disclose custody arrangements |
| Form ADV-E | File after surprise examination |
| Records | Keep for 5 years, first 2 at principal office |
Exam Tip: Custody triggers multiple requirements: qualified custodian, quarterly statements (from CUSTODIAN to client), and annual SURPRISE exam. Fee deduction only = no surprise exam needed. State net worth for custody is typically $35,000.
An investment adviser has authority to deduct advisory fees directly from client accounts. Under the custody rule:
Under the SEC custody rule, account statements must be sent to clients by:
When an investment adviser's affiliated company serves as the qualified custodian, the adviser must:
A state-registered investment adviser with custody of client assets typically must maintain a minimum net worth of: