The SEC has proposed a new rule and rule amendments, Outsourcing by Investment Advisers (proposed rules), which would prohibit registered (or required to be registered) investment advisers (investment advisers or adviser) from outsourcing certain services and functions without conducting due diligence and subsequently requires periodic monitoring of the service providers. The public comment period is open until December 27, 2022 or 30 days after publishing in the Federal Register, whichever is later.
Many investment advisers engage third-party service providers to perform certain functions or services, many of which assist the adviser to comply with Federal securities laws. These functions may include providing investment guidelines, portfolio management, models related to investment advice, indexes, or trading services or software among other functions. Outsourcing these functions can be of benefit but could also be harmful if there is a lack of appropriate oversight or if not performed properly.
Outsourcing does not diminish the investment adviser’s obligations under the Investment Advisers Act of 1940 and other Federal securities laws. As the investment adviser retains responsibility for its advisory services, regardless of what functions have been outsourced, the proposed rules are being introduced to ensure the investment adviser’s legal obligations continue to be met notwithstanding the adviser does not perform all of the functions internally. Accordingly, for ‘covered functions’ performed by the ‘service provider’ the proposed rules would require investment advisers to:
- Satisfy specific due diligence elements (a total of six defined elements) before retaining a service provider; and
- Subsequently carry out periodic monitoring of the service provider’s performance and reassess the retention of the service provider in accordance with the same due diligence elements (the six defined elements).
‘Covered functions’ has two parts:
- A function or service that is necessary for the adviser to provide its investment advisory services in compliance with Federal securities laws, and
- That if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or the adviser’s ability to provide investment advisory services.
Covered functions do not include clerical, ministerial, utility or general office functions/services.
‘Service provider’ can be an entity or person that performs one or more covered functions and is not a supervised person of the adviser.
The proposed rules would also require advisers to:
- Conduct due diligence and monitoring for certain third-party recordkeepers and obtain reasonable assurance that the third-party recordkeepers will meet certain standards.
- Maintain books and records related to the proposed rules’ oversight obligations and to report information about the service providers covered under the proposed rules on Form ADV.