Commissioner Adopts Rewrite Of Investment Adviser Custody Rule

by Allen Matkins
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To many, the words “custody” and “hide” would seem to have absolutely nothing in common.  Etymologically speaking, however, they are cognates (blood relatives).  Their common ancestor is the Proto-Indo-European etymon – “skeu”, meaning to cover or hide.  In Latin, this word became “custos”, meaning a guardian.  It’s easy to see how the ”skeu” might become “custos” because they both include a voiceless velar stop (i.e., a k sound), but “hide” has a glottal fricative (i.e., an h sound).   So, how can these words possibly be related?  The answer is that in Germanic languages, such as English, sounds shifted over time from stops to fricatives.  These sound changes were made famous, if not quite discovered, by Jacob Grimm and are now known in Linguistics as “Grimm’s Law”.  If the name Grimm sounds familiar, it is because Jacob was one half of the Brothers Grimm (or Die Gebrüder Grimm) who achieved great fame as collectors of folk tales, including Cinderella, Hansel & Gretel, and Rapunzel.

The linguistic relationship between the words “hide” and “custody” therefore seems to embody the idea that custodian might hide something for protection or for defalcation.  Custody implies safekeeping but at a deeper level carries the possibility of loss.

Recognizing the need to protect investors when investment advisers have custody, the California Commissioner of Corporations (nka Commissioner of Business Oversight) has had a custody rule, 10 CCR 260.237.  In 2011, the Commissioner issued an Invitation for Comments with respect to several rules, including the custody rule and in 2012 gave notice of a proposal to amend the rule.  Late last month, the Commissioner adopted her final amendments to the rule.  In general, the Commissioner has adopted the proposed NASAA Model Rule.  The new rule will require advisers with custody of client assets to maintain those assets with a qualified custodian.  In addition, the rule requires that PCAOB registered accountants perform certain audits and independent investigations.  Subject to certain exceptions, the rule requires advisers that are registered or required to be registered to:

  • Notify the Commissioner on Form ADV that the adviser “has or may have custody”;
  • Maintain funds and securities with a qualified custodian;
  • Give notice to clients of the identity and location of the qualified custodian;
  • 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
  • Have independent verification by actual examination by an independent public accountant.

Of course, there are a lot of details that I’ll try to address in future posts.  The Office of Administrative Law approved the rule amendments on December 30, 2013 (OAL File No. 2013-1113-01) and the new rule will take effect on April 1, 2014.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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