What is Custody Rule?

B is correct. When an adviser's only custody is the authority to deduct fees directly from client accounts, the adviser has custody, so client assets must be held by a qualified custodian. However, this limited custody for fee deduction does not trigger the surprise examination requirement, and the Form ADV Part 1A instructions tell an SEC-registered adviser in this position to answer "No" to the Item 9.A(1) custody question.

A is incorrect because the SEC rule excepts from the annual surprise exam an adviser whose custody arises solely from fee deduction authority. The SEC created this exception to avoid unnecessarily burdening advisers whose only "custody" is standard fee deduction. C is incorrect because the authority to deduct fees from client accounts is a form of custody under the rule, even though Thomas doesn't have physical possession. The custody rule defines custody broadly to include any capacity to access client funds. D is incorrect because the SEC Custody Rule sets no net worth minimum. The $35,000 figure comes from the NASAA model rule for state-registered advisers with custody, and that rule exempts advisers whose custody arises solely from direct fee deduction only if they comply with the state custody rule's fee deduction safeguards and the related recordkeeping rule.

B is correct. The SEC Custody Rule defines qualified custodians as: (1) banks or savings associations, (2) registered broker-dealers, (3) futures commission merchants (FCMs), and (4) certain foreign financial institutions. The custodian holds the assets either in a separate account under each client's name or in accounts holding only clients' assets under the adviser's name as agent or trustee. (A mutual fund's transfer agent may be used in place of a qualified custodian for that fund's shares.)

A is incorrect because registration as an adviser does not make a firm a qualified custodian. An adviser can act as one only if it is itself a bank, broker-dealer or other listed institution, and then it needs an accountant registered with the Public Company Accounting Oversight Board (PCAOB) for the surprise exam and an annual internal control report. C is incorrect because while FDIC insurance is a feature of many qualified custodians (banks), not all FDIC-insured institutions qualify, and broker-dealers (which can be qualified custodians) are covered by SIPC, not FDIC. D is incorrect because net worth does not make an adviser a qualified custodian; only the listed types of institutions qualify.

C is correct. The custody rule requires that clients receive account statements at least quarterly (every 3 months). These statements must be sent by the qualified custodian directly to clients, not by the adviser. This ensures independent verification of account holdings and transactions.

A is incorrect because monthly statements are not required (though they exceed the minimum), and the adviser cannot send the required custody statements. They must come from the independent qualified custodian. B is incorrect because while quarterly is the correct frequency, the statements must be sent by the qualified custodian, not the adviser. Allowing the adviser to send the statements would undermine the custody rule's purpose of independent oversight. D is incorrect because quarterly (at least every 3 months) is required, not annually. Annual statements would not provide sufficient investor protection or timely detection of discrepancies.

A is correct (the exception). Discretionary authority (the power to make investment decisions, such as buying and selling securities, without prior client approval for each transaction) does not constitute custody. Discretion and custody are separate concepts. Having discretion means you can make trading decisions; having custody means you can access, possess, or control client assets.

B creates custody: Serving as trustee gives the adviser control over trust assets and is explicitly defined as custody. Trustees have legal authority to manage and distribute trust assets, which gives them possession and control. C creates custody: Power of attorney that authorizes withdrawal of funds or securities constitutes custody because the adviser has the ability to move client assets. D creates custody: Authority to directly deduct fees from client accounts is a form of custody (though under the SEC rule it qualifies for an exception from the surprise examination requirement when it is the adviser's only custody; state rules add written authorization and other conditions).

B is correct. Statements 1, 2, and 3 are all accurate custody rule requirements.

Statement 1 is true: Advisers with custody must arrange for an annual surprise examination by an independent public accountant. Since Summit serves as trustee (custody beyond mere fee deduction), the surprise exam requirement applies. The accountant verifies that client assets match records.

Statement 2 is true: Clients must receive account statements at least quarterly, and these must be sent by the qualified custodian (Fidelity) directly to clients. This provides independent verification of account holdings and protects against fraud.

Statement 3 is true: Summit, whose custody as trustee goes beyond fee deduction, must report it on Form ADV Part 1A Item 9, including information about the qualified custodian and custody arrangements. This disclosure alerts regulators to conduct appropriate oversight.

Statement 4 is false: The SEC custody rule imposes no net worth minimum, and the NASAA model rule for state-registered advisers with custody sets $35,000, not $100,000. The surprise examination, qualified custodian use, and Form ADV disclosure are the core federal requirements.