Former Deputy Director of the SEC’s Office of Compliance Norm Champ sat down with Ontra COO Ben Levi to discuss recent regulatory developments and how advisers can prepare for the evolving regulatory landscape.
SEC proposes rule for outsourcing by investment advisers
On October 26, 2022, the U.S. Securities and Exchange Commission proposed an amendment to the Investment Advisers Act of 1940 related to the engagement of outsourced service providers. The proposed rule (Rule 206(4)-11) would require registered investment advisers to perform due diligence on certain service providers and third-party recordkeepers, maintain books and records related to those service providers, and update Form ADV.
The SEC indicated it based the proposed amendment on its observation that advisers have increased their use of service providers in recent years. The proposed rule appears to have been prompted by the SEC’s belief that more oversight of service provider engagements is necessary to protect investors.
In the press release, SEC Chair Gary Gensler noted, “When an investment adviser outsources work to third parties, it may lower the adviser’s costs, but it does not change an adviser’s core obligations to its clients. Thus, today’s proposal specifies requirements for investment advisers designed to ensure that advisers’ outsourcing is consistent with their obligations to clients.”
Part 1: Vetting service providers for covered functions
The proposed rule would require advisers to conduct due diligence before hiring a service provider to perform a covered function, as well as monitor and periodically reassess whether the adviser should continue to retain that outsourcing partner.
What is a service provider?
The SEC defines a service provider as a person or entity that performs one or more covered functions and is not a supervised person of the adviser as defined in the Advisers Act.
What is a covered function?
As currently drafted, the SEC’s proposed rule would cover only a subset of an adviser’s business and legal outsourcing relationships. Asset managers would need to carefully evaluate which outsourced services meet the SEC definition of a covered function based on the specific facts and circumstances.
The SEC defines a covered function as 1) a function or service necessary for the adviser to provide investment advisory services in compliance with U.S. securities laws; and 2) those that, if the adviser does not perform the function or performs it negligently, would likely negatively impact the adviser’s clients or the adviser’s ability to provide advisory services.
What might the SEC consider a covered function? Initial commentary suggests services related to the adviser’s investment decision-making process, portfolio management, and regulatory compliance would likely be within the purview of the new rule.
The proposed rule appears to specifically exclude clerical, ministerial, utility, and general office functions from the definition of covered functions.
What due diligence would the rule require?
The SEC’s proposed amendment would create additional obligations for advisers, including:
- Identifying the nature and scope of the covered function the service provider would perform;
- Identifying and determining how the adviser would mitigate and manage the potential risks to its clients or ability to perform its advisory services;
- Determining whether the service provider has the competence, capacity, and resources necessary to perform the covered function in a timely and effective manner;
- Determining whether the provider has any subcontracting arrangements that would be material to the provider’s performance of the covered function, and identifying and determining how the adviser would mitigate risks in light of a subcontracting arrangement;
- Obtaining reasonable assurance from the provider that it can and will coordinate with the adviser to comply with the securities laws; and
- Obtaining reasonable assurance from the provider that it can and will provide a process for terminating its performance of the covered function.
Part 2: Advisers’ recordkeeping requirements
In addition to conducting due diligence on service providers, the SEC is proposing to revise the Books and Records rule (Rule 204-2).
The proposed rule would require advisers to make and keep certain records documenting those diligence efforts, such as:
- Records of covered functions the adviser has outsourced;
- Names of service providers;
- Records of the factors that led the adviser to list something as a covered function; and
- Documentation of the adviser’s due diligence assessment of service providers.
Part 3: Form ADV
The SEC is also proposing to amend Form ADV Part 1A.
Advisers would need to:
- Identify their service providers;
- Detail the services and functions each provider performs;
- Provide the location of the office responsible for the covered functions;
- Provide the date the adviser first engaged the service provider; and
- State whether the service provider is a related person to the adviser.
Part 4: Vetting third-party recordkeepers
Another part of the proposed amendment relates to advisers’ use of service providers to perform recordkeeping functions. The proposed rule would require advisers to conduct due diligence before hiring a third party to perform a recordkeeping function as if recordkeeping were a covered function. Advisers would also have to monitor the third-party recordkeeper as they would any other service provider performing a covered function.
Additionally, advisers would need to obtain reasonable assurances that the third party would:
- Implement internal processes or systems for keeping records that meet the requirements of the recordkeeping rule applicable to the books and records maintained on behalf of the adviser;
- Keep records that meet all of the requirements of the recordkeeping rule applicable to the adviser;
- Provide access to electronic records; and
- Ensure records remain available if the adviser ends its relationship with the third party.
Proposed compliance date
The proposed compliance date is 10 months from the rule’s effective date. If adopted, the proposed rule would apply to any engagement of new service providers on or after the compliance date. Ongoing monitoring requirements would apply to existing engagements as of the compliance date.
The public comment period for the proposed rule will be open until December 27, 2022, or 30 days after publication in the Federal Register, whichever is longer.
Ontra is an alternative legal services provider in the United States. We are not a law firm and do not provide any legal services, legal advice, or referral services. We do not provide any legal representation to clients, nor do we participate in any legal representation of clients. The contents of this article are for informational purposes only. For assistance, please consult your legal advisers.
Proactively manage your contractual compliance
The Treasury Department released the first Enforcement and Penalty Guidelines for the Committee on Foreign Investment in the U.S.
Learn how GPs can prepare for the regulatory scrutiny on fee and expense provisions in side letters.