Section 4.3Laws, Regulations, and Guidelines

Custody Standards, Discretion & Codes of Ethics

Covers physical and indirect custody rules, surprise CPA examinations, oral discretion allowances, and SEC Code of Ethics requirements.

Key Exam Takeaways

Custody means holding, directly or indirectly, client funds or securities, or having authority to obtain possession of them.
Advisers with physical custody must use qualified custodians, ensure quarterly statements, and undergo an annual surprise CPA audit.
Oral discretion under state law is permitted for 10 business days after the initial transaction; after that, written discretion is mandatory.

Common Exam Traps

Returning inadvertent client assets or forwarding third-party checks within 3 business days prevents triggering statutory custody.
Broker-dealers require PRIOR written discretion; only investment advisers have the 10-business-day oral discretion grace period under state law.

Custody is broadly defined under SEC Rule 206(4)-2 and NASAA rules to include any arrangement where an adviser holds client funds or has authority to access them (such as fee deduction authority or full power of attorney). If an adviser maintains custody, assets must be kept at a qualified custodian (bank or broker-dealer) who sends quarterly account statements directly to clients.

Advisers with custody must undergo an annual surprise examination by an independent public accountant to verify client assets. The accountant files Form ADV-E with the SEC or state Administrator within 120 days. A safe harbor protects advisers who forward third-party checks or return inadvertent receipts within 3 business days.

Advisers must adopt a written Code of Ethics under Rule 204A-1. Access persons must report personal securities holdings within 10 days of joining the firm and annually thereafter, and file quarterly transaction reports within 30 days of quarter-end. Pre-clearance is required for IPOs and private placements.

🎯 Knowledge Checkpoint

Knowledge Checkpoint • Section 4.3

An advisory firm receives a $50,000 check from a client made payable to 'Charles Schwab & Co., Custodian' for deposit into the client's managed brokerage account. The adviser also mistakenly receives a stock certificate issued in the client's name. Under NASAA model rules and SEC custody guidelines, how must the adviser handle these two items to avoid inadvertently having statutory custody?