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Private Investment Forum - Summer 2014


The New California Custody Rule- Are you in Compliance?



The State of California Department of Business Oversight (DBO), the state agency that oversees registered investment advisers (RIA), issued a new custody rule that applies to California investment advisory firms that have “custody” of clients’ funds or securities. The effective date of the new California Custody Rule is April 1, 2014.

Similar to the custody rule requirements for RIAs registered with the Securities and Exchange Commission (SEC), the new California Custody Rule contains three primary obligations: a) the placement of client assets with a “qualified custodian,” b) the delivery to clients of certain account statements by the qualified custodian, and c) examination requirements to verify the assets held with the custodian and/or the internal custody controls of the RIA.

The new requirements in California are, however, not identical to SEC requirements and accordingly, investment advisers registered in California should review their financial reporting requirements and speak with their service providers to ensure they are in compliance.

Similar to an SEC registered investment adviser firm, a state registered investment adviser firm is required to register as an investment adviser with each state securities regulator where it maintains a place of business or where the firm has more than 5 investment advisory clients unless otherwise exempt. Generally speaking, the SEC regulates investment adviser firms with more than $100 million in assets under management (and certain other investment adviser firms that meet other statutory criteria). The states regulate investment adviser firms with less than $100 million in assets under management and fee-only financial planners.

Private fund advisers who are not licensed or required to be licensed as investment advisers in California in reliance on the “California exemption” are not subject to the new California Custody Rule.The California exemption applies to advisers who advise solely qualifying private funds, file the same parts of Form ADV that an exempt reporting adviser must file with the SEC, are not subject to certain statutory “bad boy” disqualifications under SEC and California Department of Corporations rules, and pay the annual fee.

Advisers registered with the SEC may disregard the California Custody Rule because they are already subject to the SEC’s custody rule.

Custody Rule- Defined
The term “custody” is generally defined as a situation where an investment adviser holds, directly or indirectly, client funds or securities, or has the authority to obtain possession of them, or has the ability to appropriate them. The amended rule closely follows the old custody rule adopted pursuant to the Investment Advisers Act of 1940 with some modifications.The new rule defines custody and lists specific examples including:

  • Possession of client funds or securities unless received inadvertently and returned promptly.
  • Arrangements under which the RIA firm has the authority or ability to withdraw client funds or securities. (Advisory firms that collect management fees through direct fee deduction)
  • Arrangements such as trustee of a trust, general partner of a partnership, managing member of a LLC where the investment adviser or adviser’s representative has legal ownership or access to client funds or securities.
  • Receipt of client checks made payable to unrelated third parties if the checks are held for more than three business days.

New Reporting Requirements for Pooled Investment Vehicles
Under the new CA Custody Rule, RIAs with custody that manage pooled investment vehicles must also implement certain additional practices pursuant, including:

  • Maintaining client assets with a qualified custodian;
  • Engaging an independent party to act in the best interest of investors to review fees, expenses and withdrawals (gatekeeper requirement); and

    The independent representative may not have, or have had within the past two years, a material business relationship with the adviser. Also, the purpose for this safeguard is for the independent representative to act as the agent for an advisory client and is thus obliged to act in the best interest of the advisory client, limited partner, member or other beneficial owner.

  • Retaining an independent certified public accountant to conduct surprise examinations of assets.
The new custody rule requires CA licensed investment advisers that have “custody” of clients’ funds or securities to also perform the following:
  • File a Form ADV to state that the adviser has custody of client funds and securities and intends to meet the statement delivery and audit requirements;
  • Provide audited financial statements to all limited partners or members and the DBO no later than 120 days after the end of the fiscal year. The financial statements need to be prepared in accordance with US GAAP, audited by an independent auditor that is registered with the Public Company Accounting Oversight Board (PCAOB), and contain an unqualified opinion.

    Note- the California Custody Rule does not currently provide for a later delivery deadline of the audited financial statements for funds of funds (per current SEC custody rules); however, the DBO will consider a later delivery date in the future.
  • Send to all limited partners or members at least quarterly a statement showing:
    • A listing of investments at the end of each quarter prepared in conformity with GAAP;
    • Total additions and withdrawals to/from the fund and the opening and closing values of the fund at each quarter end;
    • All additions and withdrawals to/from the fund by each investor and the total value of the investor’s interest in the fund at each quarter end.

    Note- the quarterly shareholder reporting has typically included only a statement of the investors’ capital. To meet the requirements above, another column can be added to the statement to disclose the additions/ withdrawals and net income/loss for the fund as a whole. Additionally, Investment advisors should work with their administrators and consult with their accountants for the most efficient way to disclose portfolio holdings at quarter end in a manner similar to the year- end schedule of investments presented in the annual financial statements (show investment type, country, industry and specific positions >5%).

Exceptions to the Requirements
Investment advisory firms with custody because of their relationship to a pooled investment vehicle can avoid the “gatekeeper” requirement if subject to an annual audit performed by a CPA that is subject to the PCAOB.

Additionally, the Custody Rule provides an exception to the requirement that all client funds and securities be held by a qualified custodian for privately offered securities that are:

  • Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
  • Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
  • Transferable only with prior consent of the issuer or holder of the outstanding securities of the issuer.

The new California Custody Rule does not apply to assets held by registered investment companies, such as mutual funds, closed-end investment companies or exchange-traded funds (ETFs).

Under the new rule, RIAs that serve as advisers to pooled investment vehicles are deemed to comply with the surprise examination requirement with respect to the assets of such pooled investment vehicles by having an audit of the pool conducted by a PCAOB Accountant (in accordance with GAAP) and by delivering the audited financial statements to pool investors within 120 days of the pool’s fiscal year-end.

The new rule; however, does impose additional requirements on RIAs that serve as advisers to pooled investment vehicles. First, such RIAs must procure an audit upon liquidation of such pooled investment vehicles and distribute audited financial statements to investors in such vehicles promptly upon completion of the liquidation audit. Second, the liquidation audits of such pooled investment vehicles must be conducted by a PCAOB Accountant.

If the pooled investment vehicle does not timely distribute audited financial statements to its investors, the RIA must undergo an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to its investors at least quarterly in order to comply with the Amended Rule. If the RIA is subject to the annual surprise examination requirement, the Amended Rule requires such examination to verify privately offered securities held by the pool.

Practices under this new CA Custody Rule require specific implementation, and RIAs advising separately managed accounts will have different obligations than those generally outlined above. Certain RIAs also may qualify for exemptions under the Rule, and thus RIAs are encouraged to consult with legal counsel about their specific obligations under the new regime.




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