Effective April 1, 2014, all investment advisers licensed (or required to be licensed) in California must comply with California’s amended custody rule. In many respects, the amended rule parallels the federal rule, applicable to SEC registrants. However, in several key areas California has imposed additional requirements on its registrants that will particularly impact fund managers. We summarize some key changes below.
It should be noted that California’s Exempt Reporting Advisers are not affected by the rule changes.
The baseline definition of custody in California is unchanged. Custody includes, without limitation:
- Holding, directly or indirectly, client funds or securities; or
- Having any authority to obtain possession of them, or having the ability to appropriate them, e.g.,
- Pursuant to a power of attorney or other arrangement (such as a clause in an investment advisory agreement or equivalent);
- As general partner, managing member or equivalent of a pooled vehicle.
Many California registrants are deemed to have custody under this broad definition. Advisers having custody must, among other things: arrange for client assets to be held by a qualified custodian such as a broker or bank; and make certain disclosures on Form ADV with respect to their custodial arrangements.
New Procedures for Fund Managers:
The amended rule clarifies that there are two routes for fund managers to comply with custody requirements: arrange for an annual audit of the fund, or retain a “gatekeeper” to evaluate and approve fund expenses. Some confusion prevailed under the old rule on whether a fund manager had to do both, but the new rule clearly establishes that these are distinct alternatives to comply with the state’s custody rule.
The amended rule also establishes additional procedures, regardless of the route that is taken:
The adviser must send to all investors a quarterly statement that includes the following:
- The total amount of all additions to and withdrawals from the fund as a whole;
- The opening and closing value of the fund at the end of the quarter based on the custodian’s records;
- A listing of securities positions on the closing date of the statement required to be disclosed under GAAP for non-registered investment partnerships (generally, any positions that represent 5% or more of the fund’s holding on the last day of the reporting period); and
- A listing of all additions to and withdrawals from the fund by the investor and the total value of the investor’s interest in the fund at the end of the quarter.
1. The Audit Route. This is similar to the practice under the prior rule. The amendment makes clear, however, that the CPA firm must meet certain qualifications and explicitly requires an audit upon liquidation of a fund.
- The fund manager retains an independent CPA that is registered with, and subject to regular inspection by the PCAOB to conduct an annual audit of the fund;
- Audited financial statements must be prepared in accordance with GAAP and distributed to all investors and the California Commissioner of Corporations (the “Commissioner”) within 120 days of the fund’s fiscal year end;
- A final audit is required upon liquidation of the fund, including distribution of the financial statements to the fund’s investors and the Commissioner;
- If the engagement with the CPA is terminated, the CPA must notify the Commissioner within four business days by filing Form ADV-E; the agreement between the fund/adviser and the CPA must include a requirement to this effect.
2. The Gatekeeper Route. The gatekeeper route is substantively similar to the prior “independent representative” procedure, except that it now requires a formal written agreement between the adviser and the “gatekeeper,” among other things. Under the amended rule, the gatekeeper is an independent attorney or accountant that is contractually obligated to act in investors’ best interests.
- The adviser must send the gatekeeper all invoices or receipts with details regarding calculations, such that he or she can:
- Review all fees, expenses and withdrawals from the fund;
- Determine that payments conform to the fund’s limited partnership or equivalent agreement; and
- Forward to the custodian approval for payments of the invoices, with a copy to the adviser.
- Client assets are subject to an annual “surprise exam” by an independent CPA (meeting the same qualifications as for the Audit Route discussed above).
The state’s amended custody rule is a step forward in that it largely harmonizes with rules applicable to SEC registrants, which helps to unify our understanding of what custody means and the implications for advisers, investors and service providers. However, the amended rule also imposes additional compliance requirements that may be challenging to meet. We recommend discussing any specific concerns with your service providers (including legal/compliance, audit and fund administration).