On October 26th, the SEC proposed a new rule and associated amendments under the Investment Advisers Act of 1940 that would prohibit registered investment advisers from outsourcing certain services and functions unless that investment adviser has performed the necessary due diligence. In addition, investment advisers who choose to outsource these services must monitor the service providers.
Investment advisers often employ third-party service providers in performing particular functions, many of which are required for the adviser to be in compliance with the federal securities laws. The needs for these functions, such as providing investment guidelines, portfolio management, creating models related to investment advice, or providing trading services or software, has only increased as investor interest has grown and compliance requirements have become more complex. The SEC believes outsourcing can be of benefit to both investors and investment advisors. However, without appropriate adviser oversight, outsourcing can be an avenue of risk to investors and the financial markets.
Accordingly, the new amendments will mandate that advisers satisfy due diligence requirements before retaining a service provider and subsequently to conduct periodic monitoring of the service provider’s performance. Proposed rule 206(4)-11 establishes an oversight framework across SEC- registered advisers and defines a “covered function”. In this context, a “covered function” is a function or service that:
is necessary to be in compliance with the federal securities laws
would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide its services if not performed or performed with negligence
The rule explicitly excludes clerical, ministerial, utility, and general office functions or services.
Under the new rule, an investment adviser, before engaging a third-party service provider, would be required to determine through reasonable due diligence that outsourcing the covered function to that service provider would be appropriate by evaluating:
the function’s nature and scope
potential risks incurred through outsourcing, including methods of managing and mitigating such risks
the service provider’s competence, capacity, and resources
any material subcontracting agreements the service provider has in relation to the covered function
methods of coordination with the service provider to achieve federal securities laws compliance
termination of the outsourcing of the covered function
Also, under new Rule 206(4)-11, investment advisors must gauge and document how third-party service providers meet the following four standards:
the provider has implemented internal processes and/or systems for making and/or keeping records that meet the requirements of the recordkeeping rule applicable to the books and records being maintained on behalf of the adviser
the provider must create and maintain records that meet all of the requirements of the recordkeeping rule applicable to the adviser
the provider must provide electronic access to such records
the provider must ensure the continued availability of records even if the third party’s relationship with the adviser ends or its operations cease
Investment advisers would have to create and maintain records related to their due diligence and monitoring efforts and report census-type information about these service providers on Form ADV.
The public comment period will be open for 60 days after the date of issuance and publication on sec.gov or 30 days after the date of publication in the Federal Register, whichever period is longer.