The state of California Department of Business Oversight, the state agency which oversees registered investment adviser (RIA) regulation, recently amended the custody rule (§ 260.237) that applies to California investment advisory firms that have “custody” of clients’ funds or securities. 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 effective date of this state of California RIA regulatory amendment is April 1, 2014.
The amended rule closely follows the current custody rule (17 CFR§275.206(4)-2) adopted pursuant to the Investment Advisers Act of 1940, as well as the current North American Securities Administrators Association (NASAA) model custody rule, with some modifications.
The new rule defines custody and includes specific examples such as:
- 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. (i.e. 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 or some similar type of arrangement where the investment adviser or adviser’s representative has legal ownership or access to client funds or securities. (i.e. Client asks you to be the trustee on their account, or you manage a hedge fund; since quite often an investment adviser to a hedge fund will be the general partner or managing member.)
- Receipt of client checks made payable to unrelated third parties if the checks are held for more than three business days. (Records must be kept to show checks were forwarded appropriately.)
While this is not a full and complete discussion of the new rule, as RIA compliance consultants, we would like to point out a few of the highlights and urge all investment advisers registered in California to take the time to fully read and digest the new rule.
- RIA firms with custody solely because of their ability to deduct their management fees directly from client accounts (i.e. direct fee deduction) will need to send their clients an invoice itemizing the fee, in addition to other 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 Certified Public Accountant (CPA) that is subject to the Public Company Accounting Oversight Board (PCAOB).
The text of the full rule can be found on the state of California’s website at http://www.dbo.ca.gov/.