Investor Bulletin: Custody of Your Investment Assets

SEC-registered investment advisers who have custody of their clients’ funds or securities must safeguard those funds as required by the SEC’s “custody rule.” The custody rule is designed to provide additional safeguards for investors against the possibility of theft or misappropriation by investment advisers who are registered with the SEC.  Despite the protections offered by the custody rule, investors still need to be proactive in ensuring the safety of their investments.

What is custody?

Custody by investment advisers means holding client funds or securities, directly or indirectly, or having the authority to obtain possession of them. For example, advisers have custody where the adviser has possession of client funds and securities or has power of attorney to sign checks on a client’s behalf, to withdraw funds or securities from the client’s account, including fees, or to otherwise dispose of a client’s assets for any purpose other than authorized trading.

What does the custody rule require?

The custody rule imposes a number of requirements on SEC-registered investment advisers to protect client funds and securities over which the adviser has custody.

Use of “qualified custodians” to hold client assets.  First, with certain limited exceptions, an investment adviser is required to maintain client funds and securities with a “qualified custodian.” Qualified custodians can be banks, registered broker-dealers, futures commission merchants, or certain foreign entities.  A qualified custodian either maintains client funds and securities in a separate account for each client under that client’s name, or in accounts that contain only client funds and securities under the name of the investment adviser as agent or trustee for the clients.

Notices to clients detailing how their assets are being held.  Second, if the investment adviser opens the custodial account, it must notify clients in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information.  Also, in any account statement sent by the adviser, the adviser must advise its clients to compare account statements sent by the adviser with the account statements sent by the custodian.

Account statements for clients detailing their holdings.  Third, investment advisers must have a reasonable basis to believe that the qualified custodians that maintain client funds and securities send account statements at least quarterly to the adviser’s clients directly. This permits advisory clients to compare the statements they receive from the custodian with any statements or other information they receive from their adviser and to determine whether account transactions, including deductions to pay advisory fees, are proper.

Annual surprise exams.  Fourth, if the investment adviser has custody of client assets, it must enter into a written agreement with an independent public accountant to examine those assets on a surprise basis every year. The accountant performing the “surprise” examination will contact some, or all, advisory clients to confirm their holdings with those listed on the records of the adviser.  An adviser that has custody solely because it has the authority to deduct advisory fees from client accounts is not required to obtain a surprise examination.

Additional protections when a related qualified custodian is used.  Fifth, if the custodian is also the investment adviser or is affiliated with the adviser in some way, the adviser must, among other things, obtain a report from the related qualified custodian that includes an opinion of an independent public accountant regarding the effectiveness of the custodian’s procedures for safeguarding client funds and securities every year.  Additionally, an adviser that uses a related qualified custodian is itself subject to annual surprise exams, as described in the preceding paragraph.

What does the custody rule mean for investors?

The custody rule is designed to enhance safeguards over client assets, but it is not a substitute for investor diligence and care.  The very purpose of requiring custodians to send account statements to clients at least quarterly is to make sure that clients have the information they need to review their holdings and monitor their investments.

In performing investor diligence and care, you should consider the following: