SEC Proposes New Service Provider Oversight Rules

On October 26, 2022, the United States Securities and Exchange Commission (“SEC”) proposed Rule 206(4)-11 (“Proposed Rule”).  If adopted, the rule would prohibit registered investment advisers from outsourcing certain services and functions without conducting initial due diligence and ongoing monitoring of the service providers, among other requirements.

Under the Proposed Rule, it would be unlawful for an investment adviser to retain a service provider to perform a “covered function” without conducting certain due diligence and monitoring of the service provider.  A covered function is defined in the proposed rule as a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the federal securities laws, and if 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.

The Adopting Release to the Proposed Rule states determining what constitutes a covered function depends on “the facts and circumstances,” as the proposed rule is meant to encompass functions or services that are necessary for a particular adviser to provide its investment advisory services.  To make things more confusing the Adopting Release states certain functions may be covered functions for one adviser but not for another adviser.  Therefore, certain persons or entities that perform functions on behalf of advisers may be a service provider in the scope of the rule with respect to one adviser but not for another adviser.  Several examples of potential covered functions provided in the Adopting Release include subadvisory relationships, client services, cybersecurity, investment guideline/restriction compliance, investment risk, portfolio management, portfolio accounting, pricing, reconciliation, regulatory compliance, trading (including trade desk and communication/allocation) and valuation.

The Proposed Rule covers service providers that perform one or more covered functions.  Clerical, ministerial, utility, or general office functions or services are excluded from the definition of covered function.

Before engaging a service provider to perform a covered function, the adviser would have to reasonably identify and determine through due diligence that it would be appropriate to outsource the covered function, and that it would be appropriate to select that service provider, by complying with six specific elements. These elements address:

• 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 would also require advisers to (a) periodically monitor a service provider’s performance and reassess the selection of such a service provider under the due diligence requirements of the rule, and (b) maintain books and records demonstrating adherence to the proposed rule’s oversight framework, such as lists or records of covered functions and records documenting due diligence and monitoring of each service provider;

One of the more onerous requirements of the proposed rule would require advisers to obtain reasonable assurances third party service providers will meet four standards, including:

• adopt and implement internal processes and/or systems for making and/or keeping records that meet the requirements of the recordkeeping rule applicable to the adviser in providing services to the adviser;
• make and/or keep records that meet all of the requirements of the recordkeeping rule applicable to the adviser;
• provide access to electronic records; and

• ensure the continued availability of records if the third party’s operations or relationship with the adviser cease.

These elements likely would need to be negotiated by advisers with each service provider and should be a part of agreements with service providers.  The negotiation balance of power, however, will make this a challenging task for smaller advisers working with the industry’s largest service providers.

The Proposed Rule also includes amendments to Form ADV that would require advisers to provide census-type information about covered service providers in a new item 7.C. in Part 1A of the Form ADV and Section 7.C. in Schedule D of the Form ADV.  The proposal states these disclosures will provide more information about outsourced functions, enabling clients to make more informed decisions about the retention of an adviser and enabling the SEC and its staff to identify and address risks related to outsourcing by advisers and to better oversee advisers’ use of service providers.

The Proposed Rule is open for public comment for a relatively short period of time.  Comments are due by December 27 or 30 days after publication in the Federal Register, whichever is later.  In remarks published alongside the proposed rule’s adopting release, SEC Chairman Gary Gensler stated he is particularly interested in comments around the definition of covered functions of a service provider.  Interestingly, the Chairman describes the Proposed Rule as taking a principles-based approach to defining that term.  Commissioner Peirce, on the other hand, describes the entirety of the Proposed Rule as providing advisers with “step-by-step instructions” where an adviser’s fiduciary duty already requires advisers to faithfully serve their clients, including use and oversight of any third-party service providers.

The Proposed Rule is highly prescriptive and if adopted will pose additional costs and burdens particularly on smaller advisers who rely on service providers in order to remain in business.  As Commissioner Peirce points out, the proposal may also stifle innovation and opportunities for new service providers to emerge who could add tremendous value to the industry.  Industry groups such as the Investment Advisers Association have taken notice of the Proposed Rule.  We encourage interested parties to review the Adopting Release, which may be found here and submit your comments or coordinate submission of any feedback with your industry representatives.  Please contact us for more information.