Written by Allison Gill
Managing Director (U.S.)
Continuing with a very robust year for the introduction of new rules, the Securities and Exchange Commission (“SEC”) has issued a Release proposing a new rule (the “Proposed Rule”) under the Investment Advisers Act of 1940 to prohibit registered investment advisers from outsourcing certain services and functions without conducting due diligence and monitoring of the service providers. The Proposed Rule would also require the adviser to disclose information about these service providers on their Form ADV.
The Proposed Rule would require advisers to:
- Conduct due diligence prior to engaging a service provider to perform certain “covered functions” for the purpose of making a determination that it would be reasonable and appropriate to outsource those services to that provider; and
- Periodically monitor the performance of the service provider and reassess the retention of the service provider for the purpose of making a determination that it is reasonable and appropriate to continue to outsource to that service provider
Covered Functions
A “covered function” is defined as:
A function or service that is necessary for the investment 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 on the adviser’s ability to provide investment advisory services. A covered function does not include clerical, ministerial, utility, or general office functions or services.
The covered function test has two elements:
1. “Functions or services that are related to an adviser’s investment decision-making process and portfolio management.” The Release points to a broad interpretation of fact – certain of these functions may be covered functions for one adviser but not for another adviser, depending on the facts and circumstances.
Examples include:
- Providing investment guidelines (including maintaining restricted trading lists);
- Creating and providing models related to investment advice;
- Creating and providing custom indexes;
- Index providers;
- Providing investment risk software or services;
- Providing portfolio management or trading services or software;
- Implementation and allocation services;
- Providing portfolio accounting services;
- Providing investment advisory services to an adviser or the adviser’s clients (sub-advisory services); and
- Compliance, valuation and pricing services
2. The second element is less clear and relates to the definition – “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.”
Due Diligence and Ongoing Monitoring Requirements
Advisers outsourcing covered functions are required to undertake due diligence to confirm and document six aspects of the intended outsourced services, including:
- The nature and scope of the services;
- Potential risks resulting from the service provider performing the covered function, including how to mitigate and manage such risks;
- The service provider’s competence, capacity and resources necessary to perform the covered function;
- The service provider’s subcontracting arrangements related to the covered function;
- Coordination with the service provider for federal securities law compliance; and
- The orderly termination of the provision of the covered function by the service provider
The Proposed Rule requires documentation of an adviser’s third-party due diligence assessment, including “any policies or procedures or other documentation showing how the adviser would mitigate and manage the risks it identifies, both at a covered function and a service provider level.” The Proposed Rule also requires ongoing monitoring of the covered function services, assessments of the engaged service provider’s performance, and that an adviser retain records related with the monitoring and assessment of the service provider.
Recordkeeping
The Proposed Rule would require the adviser to maintain specific records which include:
- A list of service providers undertaking covered functions and the documented rationale, along with a copy of the written agreement with the provider;
- Specific records related to due diligence assessments of the service provider; and
- Monitoring records of the service provider
Comments on the Release must be received no later than 30 days after date of publication in the Federal Register or December 27, 2022, whichever is later. Given the lack of clarity on a number of aspects of the proposed rule, we anticipate that the industry will seek to understand the SEC’s expectations on a number of issues.
Click for more on our SEC Compliance services.
