RIA Compliance Blog
On October 26, 2022, the Securities and Exchange Commission (“SEC”) proposed a rule that would prohibit investment advisers from using certain third party service providers without additional due diligence and monitoring.
The proposed rule provides an oversight framework for investment advisers designed to ensure that any “covered functions” outsourced to third parties are consistent with the adviser’s obligations to their clients. A “covered function” is a function or service that is necessary to provide investment advisory services in compliance with Federal securities laws, and if the service is not performed or is performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or advisory services.
Covered functions would not include clerical, ministerial, utility, or general office services. The proposed rule does not define which services would qualify as covered functions, but instead indicated that this determination should be made based on the facts and circumstances of the relationship. Some functions may qualify as covered functions for one adviser but not for another, depending on the facts and circumstances. The proposed rule did indicate that some potential examples of covered functions could include the following: subadvisers, client services, cybersecurity, investment risk, portfolio accounting, and regulatory compliance. The proposed rule specifically indicated that outsourced compliance functions, such as outsourced chief compliance officers or making regulatory filings on behalf of the adviser, would be covered by the rule.
Before retaining the service provider, the oversight framework proposed by the SEC requires investment advisers to consider the nature and scope of the service provider’s services, risks associated with the service provider providing the service, the service provider’s competence, the service provider’s subcontracting arrangements, compliance with federal securities laws, and the orderly termination of the service. Thereafter, advisers would be required to periodically review the service provider’s performance. The proposed rule also has additional books and records requirements related to due diligence and proposes an amendment to Form ADV Part 1A requiring advisers to provide information about their service providers.
The SEC emphasized that there are many benefits to outsourcing these functions, including access to other areas of expertise, reduced risk, and providing staffing efficiencies. However, they also addressed the risk of harm to clients that may occur when services are outsourced, such as a disruption of the outsourced service that could affect an adviser’s ability to service its clients. A conflict may also exist between providing the amount of oversight required by the new rule and the cost of providing that oversight – poor oversight could result in client losses while excessive oversight could result in costs to the adviser.
The risk of harm to an adviser’s clients may be greater where the outsourced service provider provides a highly technical or proprietary service that the adviser may lack. The SEC provided an example of using an outsourced service that uses proprietary technology to measure portfolio risk or performance. The risk here would be heightened because the adviser may not be able to detect failures in measurements of risk or performance without having a plan in place to address these potential failures.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.