(Article from Registered Funds Regulatory Update, January 2023)
For more information, please visit the Registered Funds Resource Center.
Background
In a split 3-2 vote on October 26, 2022, the SEC proposed an expanded oversight framework for advisers that outsource certain services or functions to service providers. Advisers are currently required under Rule 206(4)-7 under the Advisers Act to have policies and procedures reasonably designed to prevent violations of the Advisers Act and rules thereunder. According to the SEC, the proposed framework seeks to minimize systemic risks resulting from increasing outsourcing of advisory services or functions to service providers. The SEC acknowledged the evolution of the asset management industry over time, noting that many investment advisers provide full service wealth management and financial planning services and use electronic systems to provide those services and maintain records. Moreover, investment products, such as derivatives and ETFs, have evolved over time as well. At the same time, fee pressures for advisers have increased resulting in many advisers engaging service providers to perform certain processes and/or functions (e.g., investment research and data analytics, trading and risk management, and compliance).
Scope of Proposed Rule
New proposed Rule 206(4)-11 under the Advisers Act would, among other things, require advisers to conduct due diligence before outsourcing “covered functions” to service providers and would require extensive recordkeeping related to such diligence. A “covered function” is defined, as proposed, as a function or service that: (i) is necessary to provide advisory services in compliance with the federal securities laws, and (ii) if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services. Clerical, ministerial, utility, and general office functions or services would be explicitly excluded from the proposed rule.
Under the proposal, the term “service provider” is defined as a person or entity that: (i) performs one or more covered functions; and (ii) is not a supervised person of the adviser since such persons are already being directly overseen by the adviser. Notably, however, the proposal does not distinguish between third-party providers and affiliated service providers because, according to the SEC, the risks that the proposed rule are designed to address exist whether the service provider is affiliated or unaffiliated. The proposed rule also does not exclude service providers that are subject to other provisions of the Advisers Act, including SEC-registered advisers (e.g., sub-advisers), or other Federal securities laws.
Before retaining a service provider, an adviser would be required to “reasonably identify and determine through due diligence” that outsourcing the covered function to that service provider would be “appropriate” by considering: (i) the nature and scope of the covered function; (ii) potential risks resulting from the service provider performing the covered function, including how to mitigate and manage such risks; (iii) the service provider’s competence, capacity, and resources necessary to perform the covered function; (iv) the service provider’s material subcontracting arrangements related to the covered function; (v) coordination with the service provider for federal securities law compliance; and (vi) the orderly termination of the performance of the covered function. The adviser would be required to periodically monitor each service provider’s performance and reassess whether to retain such service provider.
Reporting Requirements
In addition, amendments to Form ADV would require extensive, census-type disclosure regarding in-scope service providers, including whether the service provider is a related person of the adviser, the date the service provider was first engaged to provide a covered function, and a check-the-box exercise through which advisers would disclose the category of covered function performed by the service provider.
ICI Comments
The ICI submitted a comment letter recommending that the SEC scrap the proposal. The ICI stated that the proposed rule is unnecessary because advisers’ fiduciary duties and other legal requirements already provide an appropriate legal framework for service provider oversight. In addition, the comment letter stated that the proposed rule is inappropriate and exceeds the SEC’s rulemaking authority. The comment letter also pointed to a lack of evidence supporting the new rule and an inadequate analysis of the costs and benefits and suggested that the SEC develop more information about the relationship between advisers and their service providers if it determines to proceed with rulemaking.
Outsourcing by Investment Advisers, SEC Release No. IA-6176 (Oct. 26, 2022), available at: https://www.sec.gov/rules/proposed/2022/ia-6176.pdf; Comment Letter of the Investment Company Institute Re: Outsourcing by Investment Advisers; File No. S7-25-22 (Dec. 23, 2022), available at: https://www.sec.gov/comments/s7-25-22/s72522-20153499-320873.pdf.