13.4 Custody Requirements
Key Takeaways
Custody includes possession, authority to obtain possession, or fee deduction authority.
Client assets must be held by a qualified custodian.
Annual surprise exams are required unless an exception applies.
Fee deduction custody requires direct custodian statements to clients.
State net capital minimums are $35,000 for custody and $10,000 for discretion only.
The custody rule (SEC Rule 206(4)-2) imposes significant requirements on investment advisers who hold or have access to client assets. These protections help prevent theft and misappropriation.
What Constitutes Custody
An adviser is deemed to have custody of client assets if:
| Situation | Example |
|---|---|
| Direct Possession | Physically holds client funds or securities |
| Authority to Obtain Possession | Can withdraw from client's account |
| Fee Deduction Authority | Can deduct fees directly from client accounts |
| Related Person as Custodian | Related party holds client assets |
| Trustee/General Partner | Acts in fiduciary capacity with asset control |
Fee Deduction = Custody
Having the authority to deduct advisory fees directly from client accounts is a form of custody because the adviser can access client funds. This is sometimes called "constructive custody."
On the Exam: Many questions test whether specific situations create custody. Remember that fee deduction authority alone creates custody.
Qualified Custodian Requirement
Client assets must be held by a qualified custodian:
| Qualified Custodian Types | Examples |
|---|---|
| Banks | Commercial banks, savings associations |
| Broker-Dealers | SEC-registered broker-dealers |
| Futures Commission Merchants | For certain commodities-related assets |
| Foreign Financial Institutions | Under certain conditions |
Qualified Custodian Obligations
| Requirement | Details |
|---|---|
| Separate Accounts | Maintain client assets separately from firm assets |
| Account Name | In client's name OR adviser's name as agent/trustee |
| Quarterly Statements | Send directly to clients (not through adviser) |
Surprise Examination Requirement
Advisers with custody (with limited exceptions) must undergo an annual surprise examination:
| Requirement | Details |
|---|---|
| Examiner | Independent public accountant (it must also be PCAOB-registered and inspected if the adviser or a related person is the qualified custodian) |
| Timing | At least once per calendar year |
| Notice | "Surprise"—no advance notice to adviser |
| Irregular Timing | Varies from year to year |
| Verification | Actual examination of client funds and securities |
| Report | Accountant files Form ADV-E with the SEC within 120 days of the examination date it chose |
Exceptions to Surprise Examination
| Exception | Conditions |
|---|---|
| Fee Deduction Only | Custody solely due to fee deduction authority |
| Pooled Investment Vehicles | Subject to annual audit with statements distributed to investors |
| Operationally Independent Custodian | Related custodian operates independently |
Fee Deduction Safeguards: SEC vs. State Rule
Under the SEC rule, an adviser whose custody arises solely from its authority to deduct advisory fees does not need the surprise examination; the qualified custodian still sends quarterly statements. The NASAA model custody rule for state-registered advisers adds conditions:
| Requirement (NASAA model rule) | Details |
|---|---|
| Written Authorization | Client authorizes fee deduction from the account at the qualified custodian in writing |
| Invoice to Custodian | Each time a fee is deducted, the adviser concurrently sends the custodian the amount to be deducted |
| Invoice to Client | At the same time, the adviser sends the client an itemized invoice (fee formula, assets the fee is based on, period covered) |
| Notice | The adviser tells the Administrator on Form ADV that it uses these safeguards |
Net Capital and Bonding Requirements
State-Registered Advisers
| Custody Status | Net Capital/Bonding Requirement |
|---|---|
| Has Custody | $35,000 minimum net worth (or surety bond) |
| Discretionary Authority Only | $10,000 minimum net worth (or surety bond) |
| Advisory Only | Positive net worth (varies by state) |
Surety Bond Alternative
| Situation | Requirement |
|---|---|
| Net Worth Shortfall | Post bond equal to shortfall, rounded up to nearest $5,000 |
| Bond Amount | Must cover the deficit amount |
| State Variations | Some states require higher amounts (e.g., Alabama requires $50,000) |
Client Notification Requirements
Advisers must inform clients about custody arrangements:
| Notification | Content |
|---|---|
| Custodian Identity | Where assets are held |
| Account Information | Account numbers and how to access |
| Statement Rights | Right to receive custodian statements |
| Verification | How to verify holdings independently |
Internal Controls for Custody
| Control | Purpose |
|---|---|
| Segregation of Duties | Separate authorization and custody functions |
| Dual Control | Multiple persons required for transactions |
| Reconciliation | Regular comparison of records to custodian |
| Written Procedures | Document all custody-related processes |
Key Takeaways
- Custody includes direct possession, authority to obtain possession, and fee deduction authority
- Client assets must be held by a qualified custodian (bank, broker-dealer, FCM)
- Annual surprise examination required unless exception applies
- Fee deduction exception requires direct custodian statements to clients
- State net capital: $35,000 for custody, $10,000 for discretion only
An investment adviser is deemed to have "custody" of client assets if the adviser:
Only provides investment recommendations
Has authority to deduct advisory fees directly from client accounts
Sends trade confirmations to clients
Uses a third-party custodian for client assets
The annual surprise examination of an adviser with custody must be conducted by:
The SEC or state administrator
An independent public accountant
The adviser's compliance officer
A FINRA examiner
A state-registered investment adviser with custody of client assets must maintain minimum net worth of:
$10,000
$25,000
$35,000
$50,000
Sections you finish are checked off in the contents.