Nov 16 -- The Securities and Exchange Commission (“Commission” or “SEC”) is proposing a new rule under the Investment Advisers Act of 1940 (“Advisers Act”) to prohibit registered investment advisers (“advisers”) from outsourcing certain services or functions without first meeting minimum requirements. The proposed rule would require advisers to conduct due diligence prior to engaging a service provider to perform certain services or functions. It would further require advisers to periodically monitor the performance and reassess the retention of the service provider in accordance with due diligence requirements to reasonably determine that it is appropriate to continue to outsource those services or functions to that service provider. We also are proposing corresponding amendments to the investment adviser registration form to collect census-type information about the service providers defined in the proposed rule. In addition, we are proposing related amendments to the Advisers Act books and records rule, including a new provision requiring advisers that rely on a third party to make and/or keep books and records to conduct due diligence and monitoring of that third party and obtain certain reasonable assurances that the third party will meet certain standards.
Comments should be received on or before December 27, 2022.
The proposed rule would establish a set of minimum and consistent due diligence and monitoring obligations for an investment adviser outsourcing certain functions to a service provider. Proposed rule 206(4)-11 under the Advisers Act would apply to advisers that are registered or required to be registered with us and that outsource a covered function. The definition of a covered function has two parts: (1) a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and (2) 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. Clerical, ministerial, utility, or general office functions or services are excluded from the definition. 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 also would require the adviser periodically to monitor the service provider's performance and reassess the selection of such a service provider under the due diligence requirements of the rule. Each of these elements is included in the rule to address specific areas of risks and concerns that we have observed, as described above. Although the proposed rule does not require additional explicit written policies and procedures related to service provider oversight, if the proposed rule were adopted, advisers would be required under existing rule 206(4)-7 to have policies and procedures reasonably designed to prevent violations of the Advisers Act and rules under the Act, and this requirement would apply to the proposed rule.
In addition, we are proposing to require advisers to make and keep certain books and records attendant to their obligations under the proposed oversight framework, such as lists or records of covered functions and records documenting their due diligence and monitoring of each service provider. The requirement to make and keep such books and records would help advisers monitor, and determine whether to modify, their approach to outsourcing a particular function. These records would also assist the Commission and its staff in evaluating adviser representations about their services and the extent to which an adviser complies with the rule.
We are also proposing to add a new provision in the recordkeeping rule requiring every investment adviser that relies on a third party to make and/or keep books and records required by the recordkeeping rule to conduct due diligence and monitoring of that third party consistent with the requirements under proposed rule 206(4)-11 and obtain reasonable assurances that the third party will meet four standards. These standards address the third party's ability to: (i) 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; (ii) make and/or keep records that meet all of the requirements of the recordkeeping rule applicable to the adviser; (iii) provide access to electronic records; and (iv) ensure the continued availability of records if the third party's operations or relationship with the adviser cease. The requirements are intended to protect required records from loss, alteration, or destruction and to help ensure that such records are accessible to the investment adviser and the Commission staff while allowing investment advisers to continue to contract with a wide variety of service providers to assist with recordkeeping functions.
Finally, we are proposing amendments to Form ADV that are designed to improve visibility for the Commission and advisory clients relating to service providers that perform covered functions. New item 7.C. in Part 1A and Section 7.C. in Schedule D would require advisers to provide census-type information about these providers. These disclosures would provide more information about outsourced functions, enabling clients to make better informed decisions about the retention of an adviser and enabling the Commission and its staff to identify and address risks related to outsourcing by advisers and oversee advisers' use of service providers better.