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California’s New Custody Rule

Q1: What is it?

A1: The California Commissioner of Business Oversight (the “Commissioner”) has issued a new rule (the “Custody Rule”)  intended to protect client funds and securities. 

Q2: Does it affect me? 

A2: Investment advisers licensed or required to be licensed as such in California must comply with the Custody Rule. 

Q3: What if I am not licensed because I rely on the California private fund adviser exemption? 

A3: Private fund advisers who are not licensed or required to be licensed as investment advisers in California in reliance on the “California exemption” (including advisers who exclusively advise “venture capital funds”, as defined) are not subject to the new Custody Rule. 

Q4: What if I am registered with the SEC?  

A4: Advisors registered with the SEC may disregard the California Custody Rule because they are already subject to the SEC’s custody rule. 

Q5: When does the Custody Rule become effective? 

A5: The Custody Rule is effective April 1, 2014. 

Q6: I am an investment adviser licensed in California and I manage a fund.  I already have an “independent representative” who approves disbursements from the fund to me pursuant to a “disbursement procedures agreement” – can I continue with this arrangement to comply with the Custody Rule? 

A6: While the Custody Rule introduces a similar procedure applicable in certain circumstances (see Q11), the independent representative/disbursement procedures arrangement familiar to many California advisers is no longer a permissible method of compliance.  Advisors with questions or concerns about whether their fund legal documents or marketing materials give rise to a contractual obligation to continue to adhere to an independent representative/disbursement procedures arrangement should consult with legal counsel. 

Q7: Cut to the chase – I am an investment adviser licensed in California and I manage a fund - what must I do to comply with the Custody Rule? 

A7: An adviser or a related person who is a general partner of a limited partnership (or managing member of a limited liability company, or holds a comparable position for another type of pooled investment vehicle) must: 

  • Notify the Commissioner on Form ADV that it has custody of client funds and securities and that it intends to employ the use of the statement delivery and audit safeguards described below;
  • Maintain client funds and securities in qualified custodian accounts in the name of the fund;
  • Send to all limited partners (or members or other beneficial owners) at least quarterly a statement showing:  
    • Total additions to and withdrawals from the fund as a whole as well as the opening and closing value of the fund at the end of the quarter based on the custodian’s records,
    • A listing of investments at the end of the quarter prepared in conformity with the same requirements that apply to the condensed schedule of investments included in annual financial statements prepared in conformity with generally accepted accounting principles in the United States (“GAAP”), 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,
  • Prepare the Fund’s annual financial statements in conformity with GAAP;  
  • Engage an independent auditor that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board to audit the fund’s financial statements as of the end of its fiscal year.  Note that an auditor’s report that is other than unqualified (for example, due to a material departure from GAAP resulting from amortizing organization costs instead of expensing in the year incurred) will not satisfy the Custody Rule;
  • Distribute the audited financial statements to all limited partners (or members or other beneficial owners) and the Commissioner within 120 days of the end of its fiscal year (unlike the SEC’s custody rule, the California Custody Rule does not currently permit a later delivery date for a fund of funds; however, the Commissioner has announced it will consider whether to allow a later delivery date, presumably 180 days, for a fund of funds – stay tuned to see if the Commissioner amends the Custody Rule to allow for this);
  • Upon liquidation of the fund, distribute the fund’s final audited financial statements prepared in conformity with GAAP to all limited partners (or members or other beneficial owners) and the Commissioner promptly after completion of the audit; and
  • Enter into a written agreement with the independent auditor that requires the auditor to, upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, notify the Commissioner within four business days by the filing of Form ADV-E accompanied by a statement that includes:
  • The date of such resignation, dismissal, removal, or other termination, and the name, address and contact information of the independent auditor; and
    • An explanation of any problems relating to the examination scope or procedure that contributed to such resignation, dismissal, removal, or other termination.
     


Q8: What exactly is required to be presented in the quarterly listing of investments? 

A8: In defining the quarterly listing of investments, the Custody Rule cites a specific GAAP section which requires a “condensed schedule of investments” that does all of the following: 

  • Categorize investments by type, country or geographic region, industry, and (for derivative instruments for which the underlying is not a security), by broad category of underlying.
  • For each type and country or geographic region, report the percent of net assets that each such category represents and the total value and cost for each such category.
  • Disclose the name, shares or principal amount, value and type of both of the following:
    • Each investment (including short sales) constituting more than 5% of net assets, except for derivative instruments and
    • All investments (including short sales) in any one issuer aggregating more than 5% of net assets, except for derivative instruments.
  • Disclose the number of contracts, range of expiration dates, and cumulative appreciation (depreciation) for open futures contracts of a particular underlying, regardless of exchange, delivery location or delivery date, if cumulative appreciation (depreciation) on the open contracts exceeds 5% of net assets.  
  • Disclose the range of expiration dates and fair value for all other derivative instruments of a particular underlying regardless of counterparty, exchange or delivery date, if fair value exceeds 5% of net assets.
  • Provide both of the following additional qualitative descriptions for each investment in another nonregistered investment partnership whose fair value constitutes more than 5% of net assets:
    • The investment objective and
    • Restrictions on redemption (that is, liquidity provisions) 

In applying the 5% tests, total long and total short positions in any one issuer should be considered separately.


Q9: Is there a deadline for delivery of the quarterly statements? 

A9: The Custody Rule does not specify a deadline for delivery of the quarterly statements.  Advisors with questions or concerns about the timeliness of delivery of quarterly statements should consult with legal counsel. 


Q10: My fund owns certain privately offered securities that are not held in custody at a qualified custodian.  How do I comply with the Custody Rule in this instance? 

A10: Provided the adviser otherwise complies with all of the procedures outlined in Q7, 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; and
  • Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer. 


Q11: Are there alternative methods of complying with the Custody Rule? 

A11: The Custody Rule provides an alternative to having a fund’s financial statements audited and distributed within 120 days of the end of its fiscal year that entails: 

  • Having the qualified custodian send an account statement, at least quarterly, to each investor identifying the amount of funds and of each security in the account at the end of the period and all transactions in the account during that period including investment advisory fees;
  • Entering into a written agreement with an independent party to (i) review all fees, expenses and capital withdrawals from the pooled accounts (unlike former disbursement procedures agreements, this requires the independent party to review and approve all disbursements, not just those going to the general partner and related entities or persons); (ii) determine whether such payment is in accordance with the pooled investment vehicle partnership or membership agreement; and (iii) forward to the qualified custodian approval for payment; and
  • The adviser must engage an independent auditor to verify all client funds and securities of which the adviser has custody by performing a “surprise examination” at least once during each calendar year at a time chosen by the auditor without prior notice or announcement to the adviser.  The independent auditor must be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board.

In any event, these alternative procedures only enable the adviser to avoid having the fund audited; all of the other compliance requirements described in Q7, including delivery of the quarterly statements, still apply.  Also, this alternative is unavailable if the fund owns securities not held by a qualified custodian (see Q10), in which case the fund must be audited.


Q12: What are the annual audit and quarterly statement delivery requirements when a pooled investment vehicle invests as a limited partner in another related pooled investment vehicle (e.g., the two funds are under common or related control such as in a master/feeder relationship)? 

A12: In this instance, the investment adviser must distribute the quarterly statements and the annual audited financial statements to each of the ultimate beneficial owners of the related investor limited partnership.  In the master/feeder example, it is not sufficient for the master fund to distribute reports solely to the feeder fund; the master fund must distribute quarterly reports and annual audited financial statements directly to each investor in the feeder fund (in addition to the reports and audited financial statements that the feeder fund itself must deliver to its investors).  

Q13: How does the Custody Rule impact an adviser to separate accounts? 

A13: Advisers of separate accounts are generally deemed to have custody of client funds and securities and are required to comply with the procedures described in Q14 unless the adviser notifies the Commissioner on Form ADV that the following conditions are met: 

  • The adviser has custody solely as a consequence of its authority to make withdrawals from client accounts to pay its advisory fee;
  • The adviser has written authorization from the client to deduct advisory fees from the account held with a qualified custodian; and
  • Each time a fee is directly deducted from a client account, the adviser concurrently:
    • Sends the qualified custodian an invoice or statement of the amount of the fee to be deducted from the client’s account and
    • Sends the client an invoice or statement itemizing the fee.  Itemization includes the formula used to calculate the fee, the value of the assets under management on which the fee is based, and the time period covered by the fee.  

Q14: What are the requirements for an adviser with custody of separate account client funds and securities?

A14: Advisers with custody of separate account client funds and securities who do not meet the conditions described in Q13 must meet the following requirements: 

  • A qualified custodian must maintain client funds and securities in a separate account for each client under that client’s name; or in accounts that contain only the adviser’s client’s funds and securities under the investment adviser’s name as agent or trustee for the clients;
  • The adviser must notify clients in writing of the qualified custodian’s name and address and the manner in which the funds and securities are maintained promptly upon the opening of the account and following any changes to this information;
  • The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each client for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period including investment advisory fees; and
  • The adviser must engage an independent auditor to verify all client funds and securities of which the adviser has custody by performing a “surprise examination” at least once during each calendar year at a time chosen by the auditor without prior notice or announcement to the adviser.  The independent auditor must be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board.

The new Custody Rule is complex and introduces new administrative burdens on investment advisers and this FAQ is not intended to provide legal advice.  In order to be ready to comply with the Custody Rule on April 1, 2014, we recommend you contact your EisnerAmper service team for assistance.  We can answer your questions or refer you to legal counsel as appropriate.  We can also help you identify suitable resources, including our outsourced CFO services if we do not already serve as your auditor, to assist you with preparing the required statements and maintaining your accounting records. 

 

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