IA Compliance:
Custody Awareness & Concerns
The following information reflects the views of NASAA’s Investment Adviser Section Resources and Publications Project Group. It does not necessarily represent the views of NASAA, and it is not intended as legal advice. Any questions should be directed to the appropriate state regulators.
What is Custody?
“Custody” is defined broadly by NASAA IA Model Rule 102(e)(1)-1, including when an investment adviser or a related person:
- holds, directly or indirectly, client funds or securities;
- has any authority to obtain possession of client funds or securities; or
- has the ability to appropriate any client funds or securities.
Examples of Custody
Business practices that may constitute custody include:
- Possessing client usernames and passwords for bank or investment accounts that could give the adviser the authority to obtain possession of client funds or securities from those accounts;
- Accepting more than $500 six months or more in advance of services;
- Serving as a power of attorney or trustee for a client;
- Holding a position as a managing partner of a limited partnership with a client (e.g., hedge fund or pooled investment vehicle);
- Using standing letters of authorization (SLOA) that permit the adviser discretion as to the timing, payee, or amount of funds to transfer;and
- Obtaining and storing client bank account or credit card information.
Additionally, there are two common forms of custody that are permitted by many jurisdictions without heightened custody requirements provided the adviser complies with the following regulatory safe harbor provisions:
- Direct deduction of fees from a client’s custodial account.
- There is a safe harbor for advisers who send an itemized fee invoice to the client concurrently with the custodian deducting the fee from the client’s account. Specific requirements may vary by jurisdiction.
- Receiving third-party checks or securities (e.g., stock certificates) from clients to forward to the custodian for deposit in their account.
- Upon receiving the funds or securities, advisers must document the receipt and forward the funds or securities to the custodian within 24 hours.
Implications of Assuming Custody
Due to the risks associated with assuming custody of client funds, advisers with custody must comply with additional recordkeeping and heightened regulatory requirements. These include:
- full disclosure of all forms of custody in the client agreement and Form ADV Parts 1 and 2A;
- higher net capital requirements for certain jurisdictions; and
- an annual examination by an independent certified professional accountant of all accounts for which the adviser has custody.
These heightened custodial requirements may be costly for an adviser, and most advisers avoid taking custody of client funds or securities to avoid the costly compliance requirements that come with it.
Best Practices for Avoiding Custody
Most advisers will find their compliance requirements easier to meet if they can avoid or mitigate having custody of client funds or securities. A good first step is to review the specific state regulatory authority’s custody rules and regulations to understand the definition, what constitutes custody, and custodial requirements. The adviser should evaluate whether its business practices provide the firm or its representatives with any direct or indirect access to client funds or securities. Custody should be addressed comprehensively in the firm’s written supervisory procedures.
When unsure, reach out to the applicable state securities regulator.
