By David Mainzer

October 2010

One effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),  which came into effect on July 21, 2010, is expected to be an increase the number of investment advisers that are required to register with the State of California.  There are two primary reasons for this.  First, the Dodd-Frank Act increased the minimum amount of assets under management allowing investment advisers to register with the Securities and Exchange Commission (the “SEC”) from $25 million to $100 million.  As a result, SEC registered investment advisers with a presence (a place of business or more than 5 clients) in California that manage more than $25 million but less than $100 million will be required to transfer their registrations from the SEC to the California Department of Corporations (the “California DOC”).  Second, the Dodd-Frank Act eliminates the exemption from the SEC’s registration requirements for investment advisers with fewer than 15 clients.  As the analogous exemption in California requires that an investment adviser qualify for the SEC exemption, the California DOC is considering whether to require smaller hedge fund managers and other investment advisers in the $25 million to $100 million range to register with the California DOC.

Transition Period

The changes to the SEC investment adviser registration requirements contained in the Dodd-Frank Act are scheduled to take effect on July 21, 2011.  The SEC is working on rules to implement the transition of investment advisers with between $25 million and $100 million in assets under management from SEC to state regulation.  These rules are expected to be proposed by the SEC in November, 2010.  The California DOC has set a July 16, 2011 deadline for the transition. The California investment adviser registration requirements are being reassessed by the California DOC in light of the Dodd-Frank Act.  The following is a summary of certain of the current differences between the registration issues faced by SEC and California registered investment advisers.

Form ADV

Registering with the California DOC requires an investment adviser to file Form ADV with the Investment Adviser Registration Depository (“IARD”).  Currently, while SEC registered investment advisers are required to file only Part I of Form ADV on IARD, California registered investment advisers are required to file both Part I and Part II on IARD.  In last month’s Client Update, I discussed the changes to Part II of Form ADV, including a new SEC requirement that Part II be filed on IARD.  As a result, the federal and California requirements will be substantially the same with respect to Form ADV IARD filing requirements once the new SEC ADV Part II rules come into effect (January 1, 2011).

Investment Adviser Representatives

Under the California Corporate Securities Law of 1968 (the “California Securities Law”), each partner, officer, director (or any person with similar status or responsibilities) or other employee or associate (other than clerical or ministerial personnel) that provides investment advice (including managing client assets) or marketing services, or supervises persons that provide investment advice or marketing services, is an Investment Adviser Representative (an “IAR”).  This is presumed to include all of the investment adviser’s executive management and any person that owns 25% or more of the investment adviser.  The California Securities Law definition is different than the definition under the Investment Advisers Act of 1940, which generally defines IARs as those supervised persons who regularly communicate with more than a certain number of natural person clients.  As a result of the difference in the IAR definitions, California registered investment advisers will generally have more IARs than similarly situated SEC registered investment advisers.

IARs of California registered investment advisers, as well as IARs of SEC registered investment advisers that have a place of business in California, in each case other than those solely involved in marketing, are required to pass certain examinations (or qualify for an exemption) and must register with the California DOC.  In general, IARs must pass either (a) the FINRA Series 65 Examination, or (b) both of the FINRA Series 7 and Series 66 Examinations, in order to register with the California DOC.  The investment adviser is required to file Form U-4 on the FINRA Central Registration Depository (“CRD”) when an IAR is hired and file Form U-5 on CRD when the IAR is terminated (amendments are also required, where applicable, on Form U-4).

The additional cost and investment of time required to satisfy the FINRA examination requirements may be material to investment advisers required to register with the California DOC in 2011. They should plan accordingly.

Minimum Net Worth Requirements

California registered investment advisers (other than those also registered as broker-dealers) are required to maintain a minimum net worth of $35,000, if they have custody of client funds or securities, or $10,000 if they have discretionary authority over client accounts but do not have custody.  In addition, if a California registered investment adviser accepts prepayment of more than $500 of advisory fees six or more month in advance, the investment adviser is required to maintain a positive net worth (which is only relevant to investment advisers without custody or discretionary management authority).  California registered investment advisers are required to file a balance sheet and a minimum financial requirements worksheet with their application to the California DOC, and are thereafter required to file verified annual financial statements.  If a California DOC registered adviser’s net worth drops below 120% of the applicable minimum net worth requirements, certain interim reports must be filed on a monthly or more frequent basis.  If the California investment adviser has custody of client funds or securities, the annual financial statements must be audited by an independent accounting firm.

Custody of Client Funds and Securities

California DOC registered investment advisers that have custody of client funds or securities must retain an independent accounting firm to verify the funds and securities in the clients’ accounts.  The accountants must verify the funds and securities at least once during each calendar year, at a time chosen by the accountants without prior notice to the investment adviser.  The accountants are required to file a certificate with the California DOC promptly after each examination.  In addition, as noted above, California investment advisers are required to maintain a minimum net worth of $35,000 and file audited financial statements with the California DOC each year.

Sample Client Agreements; Other Documents

California registered investment advisers are required to file samples of their investment advisory agreements with their application to the California DOC.  The samples must include (a) a description of the services to be provided, (b) the term of the contract, (c) the advisory fees, (d) how any prepaid fees will be refunded, (e) whether the agreement provides the investment adviser with discretionary investment management authority (and, if not, an acknowledgment by the investment adviser that it must obtain client permission before effecting transactions on the client’s behalf) and (f) that the agreement may not be assigned by the investment adviser without the client’s consent.

Financial planners that receive commissions or other compensation from the sale of securities, insurance, real estate or other businesses, have a conflict of interest with their clients.  Any financial planner with such a conflict of interest, or another conflict, must provide written notice to his/her clients stating that the conflict exists and that the client is free to disregard the investment adviser’s recommendation and, for example, select another broker-dealer to execute trades on the client’s behalf.  This disclosure must be included in the investment management agreement or Part II of Form ADV (or both).

In addition to the foregoing, California registered investment advisers are also required to file a Customer Authorization of Disclosure of Financial Records, a Notification Regarding Compliance with Cash Solicitation Rule, a Conflict of Interest Disclosure a Performance Fees Disclosure, a Statement of Citizenship, Alienage, and Immigration Status, and certain other form documents with the California DOC at the time they file Form ADV on IARD.

Securities Filing

The California DOC expects that an investment adviser applying for registration in California will provide the California DOC with a copy of the securities filing(s) that the investment adviser made in connection with the issuance of its equity securities to its owners.  For example, this would include membership interests of an investment adviser that is a limited liability company or stock of an investment adviser that is a corporation.  Investment advisers, as with any other issuers of securities, must ensure that they have complied with the California Securities Law (and the regulations thereunder), the Securities Act of 1933 (and the regulations thereunder), and the securities laws and regulations of any other states, as applicable.


Investment advisers, whether or not registered with the California DOC or the SEC, are generally subject, among other things, to fiduciary duties to act in their clients’ best interests, requirements related to advertising and other communications to clients and other laws and regulations designed to protect clients and the public.  In addition, both SEC and California registered investment advisers are required to develop and maintain effective compliance policies and procedures designed to ensure that they comply with a wide range of legal requirements.  Finally, California registered investment advisers and their IARs may be required to register in other states as well – this article considers only the California requirements.  This article describes some of the more significant procedural requirements for California registered investment advisers, but does not address these or other potentially applicable regulatory issues.

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