SEC Proposes New Oversight Requirements for Certain Services Outsourced by Registered Investment Advisers

Author: Jessica Forbes, Philip Heimowitz, Tyler Kaufman, and Joanna D. Rosenberg

SEC Proposes New Oversight Requirements for Certain Services Outsourced by Registered Investment Advisers

On October 26, 2022, the Securities and Exchange Commission (“SEC”) proposed a new rule and rule amendments (the “Proposal”)[1] under the Investment Advisers Act of 1940 (the “Advisers Act”) that would prohibit investment advisers that are registered or required to be registered (“registered advisers”) from engaging certain service providers without conducting due diligence and periodic monitoring. The Proposal would also require registered advisers to conduct due diligence and monitoring for all third-party recordkeepers and obtain reasonable assurances that the recordkeepers will meet certain standards. Additionally, the Proposal would require registered advisers to maintain books and records related to these oversight obligations and to report in Form ADV census-type information about the service providers covered under the rule. The SEC is requesting comments on all aspects of the Proposal, which are due on the later of thirty days after the Proposing Release is published in the Federal Register or December 27, 2022. The Proposal is discussed at a high level below.

Regulation of outsourced service provider arrangements has also been a recent focus of the National Futures Association (“NFA”), the self-regulatory organization of the U.S. futures and derivatives industry. Effective as of September 30, 2021, NFA members, including registered commodity pool operators and commodity trading advisors, are required to adopt and implement a written supervisory framework that addresses key outsourcing-related risks in connection with their use of third-party service providers to fulfill their regulatory functions.[2]

Proposed Outsourcing Rule

1. Key Defined Terms. Proposed Rule 206(4)-11 (“Proposed Outsourcing Rule”) would establish a set of due diligence and monitoring obligations for registered advisers that outsource “Covered Functions” to “Service Providers.” The Proposed Outsourcing Rule would define “Covered Function” to mean a function or service that is necessary for the registered adviser to provide its investment advisory services in compliance with the Federal securities laws and that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the registered adviser’s clients or on the registered adviser’s ability to provide investment advisory services.[3] The SEC provides examples of potential Covered Function categories in the proposed amendments to Form ADV Part 1A (which are further discussed below). These examples are: Adviser/Subadviser; Client Services; Cybersecurity; Investment Guideline/Restriction Compliance; Investment Risk; Portfolio Management (excluding Adviser/Subadviser); Portfolio Accounting; Pricing; Reconciliation; Regulatory Compliance; Trading Desk; Trade Communication and Allocation; and Valuation. The Proposed Outsourcing Rule would exclude clerical, ministerial, utility, or general office functions or services from the definition of “Covered Function.”[4] The Proposing Release states that the determination of what is a Covered Function would depend on the facts and circumstances, and that certain functions may be Covered Functions for one registered adviser but not for another registered adviser.[5]

The Proposed Outsourcing Rule would define “Service Providers” to mean a person or entity that (i) performs one or more Covered Functions; and (ii) is not a supervised person, as defined in section 202(a)(25) of the Advisers Act, of the registered adviser.[6] The Proposing Release states that the Proposed Outsourcing Rule does not make a distinction between third-party Service Providers and affiliated Service Providers.[7] As a result, engagements with affiliated Service Providers would be subject to the due diligence and monitoring obligations of the Proposed Outsourcing Rule and the related recordkeeping requirements (each discussed in further detail below). Registered advisers would also be required to report information about affiliated Service Providers in connection with the amendments to Part 1A of Form ADV (also discussed below).

2. Due Diligence Obligations. The Proposed Outsourcing Rule would require a registered adviser, before engaging a Service Provider, to reasonably identify and determine that it would be appropriate to outsource the Covered Function and select that Service Provider, by considering the following:

• Nature and Scope. The Proposed Outsourcing Rule would require registered advisers to identify the nature and scope of the Covered Function the Service Provider is to perform.[8]
• Risk Mitigation and Management. The Proposed Outsourcing Rule would require registered advisers to identify, and determine how to mitigate and manage, the potential risks to clients or to the registered adviser’s ability to perform its advisory services resulting from engaging a Service Provider to perform the Covered Function.[9]
• Service Provider Competence, Capacity, and Resources. The Proposed Outsourcing Rule would require registered advisers to determine that the Service Provider has the competence, capacity, and resources necessary to perform the Covered Function in a timely and effective manner.[10]
• Subcontracting Arrangements. The Proposed Outsourcing Rule would require registered advisers to determine whether a Service Provider has any subcontracting arrangements that would be material to the Service Provider’s performance of a Covered Function, and to identify and determine how the registered adviser will mitigate and manage potential risks to clients or to the registered adviser’s ability to perform its advisory services in light of any such subcontracting arrangement.[11]
• Compliance Coordination. The Proposed Outsourcing Rule would require registered advisers to obtain reasonable assurances from a Service Provider that it is able to, and will, coordinate with the registered adviser for purposes of the registered adviser’s compliance with Federal securities laws.[12]
• Orderly Termination. The Proposed Outsourcing Rule would require registered advisers to obtain reasonable assurances from the Service Provider that it is able to, and will, provide a process for orderly termination of its performance of the Covered Function.[13]

3. Monitoring Obligations. The Proposed Outsourcing Rule would require registered advisers to periodically monitor a Service Provider’s performance of the Covered Function and reassess the retention of the Service Provider in accordance with the due diligence requirements described above, and in a manner and frequency such that the registered adviser reasonably determines that it is appropriate to continue to outsource the Covered Function and that it remains appropriate to outsource it to the Service Provider.[14]

Amendment to the Books and Records Rule

The SEC also proposes to amend Advisers Act Rule 204-2 (“Proposed Books and Records Amendment”) to require registered advisers to make and keep certain books and records relating to their obligations under the Proposed Outsourcing Rule, including a list of Covered Functions that the registered adviser has outsourced to a Service Provider, records documenting the registered adviser’s due diligence assessment and periodic monitoring, any policies and procedures relating to compliance with the Proposed Outsourcing Rule, and copies of written agreements with Service Providers regarding Covered Functions.[15] Registered advisers would be required to maintain these books and records in an easily accessible place throughout the time period during which the registered adviser has outsourced a Covered Function to a Service Provider and for a period of five years thereafter.[16]

The Proposed Books and Records Amendments impose additional requirements on registered advisers that rely on third parties to make and/or keep any required books and records relating to their obligations under the Proposed Outsourcing Rule. The Proposed Books and Records Amendments would require registered advisers to perform due diligence and monitoring as prescribed in the Proposed Outsourcing Rule with respect to the recordkeeping function, and make and keep the records required by the Proposed Books and Records Amendments, in each case as though the recordkeeping function were a Covered Function and the third party were a Service Provider.[17] Registered advisers would also be required to obtain reasonable assurances from the third-party recordkeeper that it will (i) adopt and implement internal processes and/or systems for making and/or keeping records on behalf of the registered adviser that meet all of the requirements of the Proposed Books and Records Amendments, (ii) make and/or keep all such records, (iii) allow the registered adviser and the staff of the SEC to access any electronic records easily through computers or systems during the required retention period; and (iv) make arrangements to ensure the continued availability of the registered adviser’s records in the event that the third party ceases operations or the relationship with the registered adviser is terminated.[18]

Form ADV

In connection with registered advisers’ obligations under the Proposed Outsourcing Rule, the SEC is proposing to add new questions to Part 1A of Form ADV. Registered advisers that outsource Covered Functions to Service Providers would be required to report, among other things, the name of the Service Provider, the date the Service Provider was first engaged to perform a Covered Function, and the location of the Service Provider’s office principally responsible for the Covered Function. As described above, registered advisers would also be required to select from a list the type of Covered Function the Service Provider is engaged to provide.

Existing Staff No-Action Letters; Transition and Compliance Dates

The Proposing Release states that the staff of the Division of Investment Management is reviewing certain no-action letters relating to investment adviser electronic recordkeeping to determine whether any such letters should be withdrawn in connection with the Proposal. The SEC proposes a ten-month transition period to provide time for registered advisers to come into compliance with the Proposal, if adopted.

[1] Outsourcing by Investment Advisers, Release No. IA-6176 (Oct. 26, 2022) (“Proposing Release”).

[2] See NFA, Notice I-21-13, Effective date for Interpretive Notice regarding Members’ use of third-party service providers (Mar. 24, 2021). See also Client Memo, NFA Announces Effective Dates for New Requirements for Member Firms, Fried, Frank, Harris, Shriver & Jacobson LLP (May 25, 2021).

[3] See proposed rule 206(4)-11(b).

[4] Id.

[5] Proposing Release at 21.

[6] See proposed rule 206(4)-11(b).

[7] Proposing Release at 26.

[8] See proposed rule 206(4)-11(a)(1)(i).

[9] See proposed rule 206(4)-11(a)(1)(ii).

[10] See proposed rule 206(4)-11(a)(1)(iii).

[11] See proposed rule 206(4)-11(a)(1)(iv).

[12] See proposed rule 206(4)-11(a)(1)(v).

[13] See proposed rule 206(4)-11(a)(1)(vi).

[14] See proposed rule 206(4)-11(a)(2).

[15] See proposed rule 204-2(a)(24).

[16] See proposed rule 204-2(e)(4).

[17] See proposed rule 204-2(l)(1).

[18] See proposed rule 204-2(l)(2).