Proposed Revisions to California’s Custody Rule

The California Department of Corporations (“DOC”) recently issued an invitation for comments regarding proposed amendments to the California investment adviser custody rule, which sets forth requirements for investment advisers with custody or possession of clients’ funds or securities. Investment adviser custodial arrangements have received significant regulatory scrutiny of late in response to the Madoff fraud and other instances of misappropriation of client assets. The proposed changes to California’s custody rule will have a direct impact on many advisers due to the increase in the number of state registered advisers as a result of the Dodd-Frank Act.

The DOC’s proposed amendments to the custody rule are based on the recent amendments to the SEC custody rule and the NASAA model custody rule (which is designed to provide uniformity to the rules applicable to federal and state registered advisers). Accordingly, the DOC’s proposed amendments generally follow the recently proposed revisions to the NASAA model custody rule in that the proposed California amendments would require investment advisers to, among other things, undergo an annual surprise examination by an independent public accountant and maintain client funds and securities with a qualified custodian that sends account statements directly to clients. Additionally, like the SEC and NASAA rules, the California proposed rule provides exceptions from the independent verification requirement.  This includes advisers that have custody due to their authority to deduct advisory fees and advisers to private funds that are subject to annual audit by a PCAOB-registered accounting firm. The DOC’s proposal does, however, include some important deviations from the provisions of the NASAA model rule, including more relaxed account statement requirements for advisers to private funds in an effort to maintain the confidentiality of any proprietary trading models developed by the adviser.

The full text of the proposed amendments to the California custody rule is available here. Comments on the proposed revisions are due by August 5, 2011 and may be submitted to regulations@corp.ca.gov. For additional information, please contact Zac Rosenberg, Compliance Consultant by email at zachary.rosenberg@corecls.com or by phone at (619) 278-0020.