When an investment adviser has custody of client assets, the situations that do not count, and the custodian, statement and surprise examination safeguards that follow

An investment adviser has custody when it holds client funds or securities, directly or indirectly, or has any authority to obtain possession of them. Custody does not require the adviser to physically hold a client’s money; the power to withdraw it, move it or take fees from it can be enough.

Custody is one of the most heavily regulated areas of investment adviser practice. An adviser with custody must use a qualified custodian to hold client assets, make sure clients receive account statements directly from that custodian at least quarterly and, in most cases, submit to a surprise examination by an independent accountant every year.

At federal level, these requirements are set out in SEC Rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940. This guide covers when an adviser has custody, the situations that do not count, the safeguards required, the state rules, worked examples, the exam traps and five practice questions.

Why Custody Is Regulated So Closely

When an adviser can reach client money, the risk of theft or misuse rises sharply. Many of the largest investment frauds in history involved an adviser who controlled client assets and sent clients statements that the adviser produced itself.

The custody rule is built to remove that opportunity. By placing assets with an independent custodian and having that custodian report directly to clients, the rule gives clients a second, independent record they can check against what the adviser tells them.

The SEC tightened the rule significantly in 2009, after the Madoff fraud showed how a manager who controlled both the assets and the statements could hide losses for decades. The surprise examination requirement was extended at that time to most advisers with custody.

Where This Topic Appears on the Exams

Custody is tested in the laws and regulations section of the Series 65, and it also appears on the Series 66. Questions typically describe a situation, such as an adviser receiving a check or holding a client’s password, and ask whether the adviser has custody and what it must do as a result.

FRC’s Series 65 Exam Preparation course covers the custody rule alongside the other adviser obligations, chapter by chapter, and the Series 65 needs no sponsoring firm. The SIE Examination Preparation course introduces customer protection and the role of custodians from the ground up.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. Custody questions follow a small number of patterns, so once the rules are clear they become reliable marks.

The Three Ways an Adviser Can Have Custody

The first is possession. An adviser that holds client funds or securities, such as client checks made out to the adviser for investment or share certificates kept in the adviser’s office, has custody.

The second is authority. Any arrangement that allows the adviser to withdraw client funds or securities, such as a general power of attorney over the account or the power to sign checks on the client’s behalf, gives the adviser custody even if it never uses that power.

The third is a legal role. An adviser, or a related person, that acts as general partner of a limited partnership, managing member of a limited liability company or trustee of a trust it advises has legal ownership or access to the assets. That role gives it custody of the vehicle’s funds and securities.

Fee Deduction Counts as Custody

Many advisers are paid by having their fees deducted directly from client accounts at the custodian. Because the adviser has authority to instruct the custodian to pay it, this arrangement gives the adviser custody.

The SEC custody rule relieves advisers whose only custody comes from fee deduction of the surprise examination requirement. They must still use a qualified custodian and have a reasonable basis to believe that clients receive the custodian’s account statements.

State rules modelled on NASAA’s approach typically add conditions. These include written authorisation from the client and sending the client an invoice or statement showing the fee and how it was calculated, at the same time the custodian is asked to pay it.

What Does Not Count as Custody

An adviser that inadvertently receives client funds or securities does not have custody if it returns them to the sender promptly, and in any case within three business days. A client who posts a share certificate to the adviser by mistake, for example, does not create custody if the adviser sends it back in time.

Under the state rules, a check made payable to a third party, such as the custodian, that the adviser forwards within three business days generally does not create custody either. The adviser should keep a record of when it received and forwarded the check.

A check made payable to the adviser for its own advisory fee is not custody of client funds. The money belongs to the adviser once paid, so it is simply fee income, although large fees paid in advance raise separate disclosure requirements.

Safeguard One: A Qualified Custodian

An adviser with custody must keep client funds and securities with a qualified custodian. Qualified custodians include banks and savings associations, registered broker-dealers, registered futures commission merchants for certain assets and some foreign financial institutions.

The assets must be held in a separate account for each client under that client’s name, or in accounts containing only clients’ assets under the adviser’s name as agent or trustee for the clients. The adviser must not mix client money with its own.

When an account is opened, the adviser must promptly notify the client in writing of the custodian’s name and address and how the assets are held. It must notify the client again if any of those details change.

Safeguard Two: Statements Straight From the Custodian

The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends account statements directly to each client at least quarterly. The statements show the amount of funds and of each security in the account and all transactions during the period.

The key word is directly. Statements produced by the adviser itself do not satisfy the rule, because the purpose is to give the client an independent record.

Advisers often send their own reports as well, showing performance and analysis. If they do, they must urge clients to compare those reports with the custodian’s statements.

Safeguard Three: The Surprise Examination

Most advisers with custody must hire an independent public accountant to carry out a surprise examination at least once a year. The accountant verifies that the client funds and securities exist, at a time chosen by the accountant without notice to the adviser.

Because the adviser does not know when the examination will happen, it cannot prepare by temporarily replacing missing assets. The accountant files a certificate with the SEC on Form ADV-E, and must report any material discrepancies to the SEC within one business day.

There are exceptions. Advisers whose only custody arises from fee deduction are exempt, and so are advisers to pooled investment vehicles that are audited each year and distribute audited financial statements to investors within 120 days of the fiscal year-end.

Pooled Investment Vehicles

Advisers to private funds often have custody because they or a related person act as general partner. For these funds, the SEC rule allows an annual audit to replace both the surprise examination and the requirement for quarterly custodian statements.

The audit must be performed by an independent public accountant registered with and inspected by the Public Company Accounting Oversight Board. The audited financial statements must be prepared under generally accepted accounting principles and delivered to all investors within 120 days of the fund’s fiscal year-end, or 180 days for funds of funds.

When the fund is liquidated, a final audit must be carried out and the statements distributed promptly. The exam tests the 120-day figure more than any other detail of this exception.

Standing Letters of Authorisation

Some clients set up a standing letter of authorisation that lets the adviser move money from their account to a named third party, such as a family member or a mortgage lender, on instruction. Because the adviser can direct where the client’s money goes, the SEC treats this as custody.

SEC staff guidance allows an adviser with this kind of arrangement to avoid the surprise examination if a set of conditions is met. These include the client signing the instruction, the custodian verifying it and sending the client a transfer notice, and the adviser having no ability to change the recipient.

Movements between a client’s own accounts at different custodians are treated differently. Where the client’s name is on both accounts and the custodian has the account details, these first-party transfers do not create custody.

Custody Under State Rules

State-registered advisers follow their state’s custody rules, most of which are based on NASAA’s model rule. Under that model, an adviser must notify the Administrator on Form ADV that it has custody and must follow safeguards similar to the SEC’s.

States also set minimum financial requirements for advisers with custody. Under the NASAA model, an adviser with custody of client funds or securities must maintain a minimum net worth of $35,000, compared with $10,000 for an adviser that has discretionary authority but no custody, and some states accept a bond as an alternative.

An adviser whose net worth falls below the minimum must notify the Administrator promptly and file a financial report. FRC’s guide to what powers the state Administrator has explains what the Administrator can do when an adviser fails to meet its obligations.

Custody and Form ADV

An adviser reports whether it has custody, and the amount of client assets it holds custody of, in Part 1A of Form ADV. These figures are updated at least annually and are visible to regulators.

Part 2A, the brochure, must also describe the custody arrangements to clients. It explains that clients will receive statements from the custodian and urges them to review those statements carefully.

FRC’s guide to the brochure rule explains when and how the brochure must be delivered. Clients reading it can see at a glance whether their adviser has custody and who holds their money.

Custody vs Discretion

Custody and discretion are separate powers, and the exam often places them side by side. Discretion is the authority to decide what to buy or sell in a client’s account without asking the client first, while custody is access to the client’s money and securities themselves.

An adviser can have discretion without custody. A manager who chooses investments in a discretionary account but cannot withdraw funds or deduct fees does not have custody.

The reverse is also possible. An adviser that deducts fees from a non-discretionary account has custody but no discretion, which is why the two must be assessed separately in any scenario.

Custody and the Fiduciary Duty

The custody rule sits alongside the adviser’s broader fiduciary duty. An adviser must act in the client’s best interest at all times, and protecting client assets from loss, theft or misuse is a basic part of that duty.

Misappropriating client funds is among the most serious violations an adviser can commit. It typically leads to the loss of registration, a bar from the industry, and civil and criminal liability.

FRC’s guide to duty of care vs duty of loyalty explains the two components of that duty. Custody failures usually breach both.

What Investors Can Do

Investors can protect themselves by knowing where their money is held. The account statements from the custodian, not the adviser’s own reports, are the definitive record of what the account contains.

Clients should check that the custodian’s statements arrive at least quarterly, and compare them with any report the adviser sends. Any gap between the two is a reason to ask questions straight away.

Assets held at a broker-dealer custodian are usually protected by the Securities Investor Protection Corporation if that firm fails, up to its limits. FRC’s guide to what a FINRA member firm is and how to check one explains how to confirm a broker-dealer custodian’s registration.

Worked Example: The Misdirected Certificate

A client posts a share certificate to her adviser’s office instead of to her custodian. The adviser receives it on Monday.

If the adviser returns the certificate to the client by Thursday, within three business days, it does not have custody. If it holds the certificate for a week, it has custody and must comply with the custody rule.

The safest course is to log the receipt, return or forward the certificate promptly and keep a record. That record is what the adviser will rely on if regulators ask.

Worked Example: The Fee Deduction

An adviser charges an annual fee of one percent of assets, deducted quarterly from client accounts at a broker-dealer custodian. Each quarter, it instructs the custodian to pay the fee.

The adviser has custody because it has authority to withdraw client funds. Under the SEC rule, it is exempt from the surprise examination, but it must still use a qualified custodian and ensure clients receive the custodian’s statements.

If the adviser were state-registered, it would also typically need written authorisation from each client and would send each client a statement showing how the fee was calculated. Fee deduction is the most common form of custody in practice.

Worked Example: The Trustee

An adviser’s president agrees to act as trustee of a client’s family trust, which the adviser also manages. As trustee, he can sign for the trust’s accounts.

Because a related person of the adviser holds a legal position giving access to the trust’s assets, the adviser has custody of those assets. It must apply the full custody safeguards, including the surprise examination.

Had the client appointed an independent bank as trustee, the adviser would not have custody through that role. The legal relationship decides the answer, not the size of the account.

The Exam Traps

The first trap is thinking custody requires physical possession. Authority to withdraw funds, including authority to deduct fees, is enough.

The second trap is treating a fee check made payable to the adviser as custody. Payment of the adviser’s own fee is not custody of client funds.

The third trap is forgetting the three-business-day window. Inadvertently received funds or securities returned within three business days do not create custody.

The fourth trap is confusing custody with discretion. Discretion is authority over investment decisions, while custody is access to the assets themselves.

FRC’s guide to Series 65 ethics and laws questions and exam traps covers more traps in this area. For the full list, see FRC’s guide to Series 65 exam traps and common mistakes.

A Memory Aid

Remember “hold it, reach it or own it.” Holding client assets, having authority to reach them or holding a legal role over them are the three ways to have custody.

For the safeguards, remember “custodian, quarterly, surprise.” Qualified custodian, quarterly statements direct to the client and an annual surprise examination.

Practice Questions

Question one: an adviser has authority to deduct its fees directly from client accounts. Does it have custody? Yes, authority to withdraw client funds is custody, although the SEC rule exempts fee-deduction-only custody from the surprise examination.

Question two: an adviser receives a client’s share certificate by mistake and returns it within two business days. Does it have custody? No, inadvertently received securities returned within three business days do not create custody.

Question three: how often must a qualified custodian send account statements directly to clients? At least quarterly.

Question four: an adviser’s principal acts as general partner of a limited partnership the adviser manages. Does the adviser have custody? Yes, acting as general partner gives the adviser custody of the partnership’s assets.

Question five: under the NASAA model rule, what minimum net worth must a state-registered adviser with custody maintain? $35,000.

Related Questions

Custody is one of several obligations that shape how an adviser runs its business. FRC’s guide to what a registered investment adviser is covers the registration side and the duties that come with it.

Get Exam-Ready

Custody questions reward candidates who can spot the source of custody in a short scenario and match it to the right safeguard. Once the three routes to custody and the three safeguards are clear, these become some of the most dependable marks on the exam.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any term and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the Series 7, the SIE or a combination, structured exam preparation turns topics like the custody rule into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply to advisory firms, hiring managers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

An investment adviser has custody when it holds client funds or securities, has authority to obtain them, or holds a legal role that gives it access to them. An adviser with custody must use a qualified custodian, ensure clients receive custodian statements at least quarterly and, unless an exception applies, undergo an annual surprise examination.

Remember “hold it, reach it or own it” and “custodian, quarterly, surprise,” and you will be ready for every version of this question the exam can ask.