Chapter 5: Ethical Practices and Obligations - C. Customer Funds and Securities

Question 1

Client Contracts

Answer 1

NASAA model rules require that all advisory contracts that are entered into, renewed or extended are made in writing. This differs from the federal regulations under The Investment Advisers Act of 1940, which permits both written and oral contracts.

Such contracts must disclose all of the following information:

• The services being rendered;
• The term/time frame of the contract;
• The fees being charged;
• How the fees for services and advice are being computed;
• The amount of prepaid fee that will be returned for non-performance or early termination of the contract; and
• The extent of any discretionary authority granted to the adviser or its representatives.

If the contract has a provision for early termination, contract assignment, or discretionary trading authority, such provision must be stated in plain language with clear terms that the client can understand.

Question 2

Client contracts – investment advisory contracts

Answer 2

Investment advisers are prohibited from entering into, renewing, or extending an advisory contract unless the contract is in writing. The provisions of the contract must state that the investment adviser

• Will not be compensated on the basis of capital gains or capital appreciation of the funds in the contract. It is permissible for the compensation to be based on the total value of the assets under management averaged over a definite period of time;
• Cannot assign the contract without the consent of the customer; and
• Will notify the customer within a reasonable time of any change in the members of the partnership.

The state administrator can exempt any investment adviser from the previous provisions if it is deemed to be in the public’s best interest, and the exemption is consistent with the intent of the Uniform Securities Act.

Question 3

Required disclosures

Answer 3

An investment adviser or broker/dealer that maintains custody of a client’s funds must notify the Securities Administrator that such custody exists. Investment advisers provide notification on Form ADV. The adviser or broker/dealer must also do the following:

• On at least a quarterly basis, send statements which list
  - All securities the adviser has in custody for each customer
  - The number of shares;
  - The value of the account; and
  - All transactions that have occurred since the last statement was sent.
  - On an annual basis, an independent accountant must facilitate a surprise audit of the account and send a report to the State Securities Administrator.

Question 4

Form ADV-E

Answer 4

Form ADV-E must be filed with the SEC within 120 days of the surprise audit. The accountant may also be required to file the form with the state regulators.

Question 5

Investment advisors and custody of assets

Answer 5

If a broker/dealer or adviser has custody and the state does not have any rules against such custody, the broker/dealer or adviser would still be required to inform the state administrator of the fact that they are holding customer assets.

Under the Investment Advisers Act of 1940 and NASAA Model Rules, an investment adviser is considered to have custody of client funds when it directly or indirectly holds client funds or securities, or has the authority to withdraw funds or securities from a client’s account (except for authorized trading activity – receipt and delivery of securities).

For example, an adviser that is also a broker/dealer that holds clients funds and securities has custody. When client funds and securities are held by a third party custodian, such as a bank, the adviser is deemed to have custody if the adviser has power of attorney to withdraw funds or securities (including advisory fees) from a client’s account.

It is illegal for an investment adviser to hold custody of client funds and securities unless they are held by a qualified custodian in an account either in the client’s name or the name of the adviser as agent or trustee for its clients

Question 6

Qualified custodian

Answer 6

A qualified custodian includes financial institutions that have traditionally provided custodial services. These include

• Banks and savings associations;
• Registered broker/dealers;
• Registered futures commission merchants (for advisers that offer advisory services on futures); and
• Foreign financial institutions that customarily hold financial assets, as long as advisory client funds and securities are maintained in accounts that are separate from the institution’s proprietary accounts.

An investment adviser that opens an account with a qualified custodian on behalf of a client or makes changes to a client’s account information must promptly notify the client in writing. The notice must include the following:

• The custodian’s name and address; and
• The manner in which the funds or securities are maintained.

When advisory client funds are held by a qualified custodian the investment adviser is not required to send statements to clients as long as the adviser has a reasonable belief that the custodian is sending statements at least quarterly and the statements list all of the securities, the number of shares, the value of the account, and all transactions that have occurred since the last statement was sent.

When the adviser and the custodian are both sending client statements, then the investment adviser statements must contain a legend urging the client to compare the statements they receive from the adviser with the statements they receive form the custodian.

In addition, if an investment adviser is considered to have custody only because it deducts advisory fees from client accounts, the adviser is NOT required to have an annual surprise audit.

Question 7

Commingling

Answer 7

A client’s funds and securities may not be combined (or commingled) with the securities of any other account without the client’s expressed written consent.

In addition, at no time may the client’s funds or securities be commingled with either the investment adviser’s or broker/dealer’s proprietary accounts.

Question 8

Discretion and Trade Authorization

Answer 8

Any investment adviser who wishes to exercise discretionary authority over a client’s account must have authorization from the owner of that account. Discretionary authority exists when either the registered investment adviser (or its investment adviser representative) or a broker/dealer (or its agent) has the authority to choose any of the following on behalf of the client:

• Actions (buy or sell);
• Asset (security); or
• Amount (either the number of shares or the dollar amount).

Written approval for such authority from the client is required for both the broker/dealer and the investment adviser. The state administrator must be informed of the discretionary authority. While broker/dealers and their agents must have prior discretionary authority in writing, investment advisers and their representatives may effect a transaction based on verbal authority. However, investment advisers must obtain written discretionary authority from the client within 10 business days after the first trade based on verbal authority, unless the trade was based on a preset price, time, or volume.