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.
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.
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.
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:
Most clients establish their own custodial accounts at firms such as banks or broker-dealers. Many advisory clients open their custodial accounts when they complete the custodian’s account-opening forms at the same time that they open an advisory account. An adviser can open a custodial account for a client as well. If it is not clear when you set up your account with a registered investment adviser who will maintain custody of your assets, ask the adviser to identify the custodian and provide you with the custodian’s contact information.
Check whether the account is under your own name or under the investment adviser’s name as agent for you. Note that the adviser is not permitted to name itself as the principal on an account which it has opened for you.
If your investment adviser is registered with the SEC and you do not receive a separate statement directly from a qualified custodian such as a bank or broker-dealer, you should contact your adviser and/or custodian to find out why.
If you notice a discrepancy, you should contact both the investment adviser and the custodian, preferably the supervisor of your advisory or custodial representative or a compliance officer. If the discrepancy is not resolved to your satisfaction or you continue to have concerns, contact the SEC (www.sec.gov/complaint/select.shtml). If your adviser is registered with a state, rather than with the SEC, contact your state securities regulator (www.nasaa.org).
Fees can have a material effect on your investment return. Ask your investment adviser about fees, including how the adviser’s fees compare to those of other advisers. Always consider fees when making an investment decision.
The custody rule is designed to provide additional safeguards for investors against possible theft or misappropriation by SEC-registered investment advisers. Regardless, you should exercise care when making investment decisions and remain vigilant in monitoring your investments.
For information on selecting an investment adviser, read the SEC’s Office of Investor Education and Advocacy’s publications Investment Advisers: What You Need to Know Before Choosing One and Investing Wisely.
The Office of Investor Education and Advocacy has provided this information as a service to investors. It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the meaning or application of a particular law or rule, please consult with an attorney who specializes in securities law.