9.3.1 Custody
It’s very common for investors to give broker-dealers and investment advisers custody, or physical possession, of their securities and funds. Besides physical possession, custody includes being able to appropriate (take control of) funds and securities and being able to automatically deduct money from an account or write checks from the account. Custody also may include cases in which an adviser has an ownership stake in the broker-dealer that maintains custody or in which an adviser is a general partner in a limited partnership or a managing member of an investment LLC. Some states prohibit advisers from taking custody, so firms should be sure to check with their state administrator before doing so.
Custody of client securities and money represents a huge responsibility for firms and a huge extension of trust by the public. To ensure that this trust is not misplaced and the public is protected, the SEC, NASAA, and state administrators have developed a number of model rules and standards that should be followed by investment advisers who take custody of client assets:
• Client securities and funds must be appropriately segregated, or set apart, from other securities, with proper records documenting how much each client has on deposit.
• Clients must receive regular statements (at least quarterly) of their account values. Statements should come from the qualified custodian directly, or if not, through the adviser.
• Client accounts and records must be audited at least once per year by an independent third party. The audit must be unannounced to the adviser, and the auditor must file its report with the administrator.
• No commingling, or mixing, of clients’ personal assets with those of their advisers should occur.
• The custodian must not misappropriate client funds or employ them for any use (business or personal) other than what the client intends and expects.
• Clients’ instructions regarding their acc