The following is a summary of a proposed rule not yet effective. The proposed rule, if adopted, may impact investment advisers in many unanticipated ways – specifically when it comes to the use of third party service providers. The information provided is not intended to be legal advice and is for general educational purposes only. A full text of the rule can be found here.
Where We Are Heading – Investment Adviser Oversight of Certain Service Providers
As most of investment adviser compliance professionals already know, the Securities and Exchange Commission (“SEC”) has proposed rule 206(4)-11 (the “proposed rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) which would prohibit registered investment advisers (“advisers”) from outsourcing certain services or functions without first meeting minimum requirements.
In this post, we discuss the parameters of the proposed rule, including:
- Who is considered a “service provider”?
- What are “covered functions”?
- Is it appropriate to outsource the covered function?
- What are the ongoing monitoring requirements?
- What are the proposed changes to the ADV Disclosure Brochure?
- Are there any Additional Considerations?
Who is considered a “service provider”?
The proposed rule defines a service provider as a person or entity that performs one or more covered functions and is not an adviser’s supervised person as defined in the Advisers Act. Further, a covered function would not include clerical, ministerial, utility, or general office functions or services.
However, it appears unclear whether a supervised person acting as a service provider separate from his or her functions with your firm would be covered under the proposed rule. For example, you may have a supervised person who runs a portfolio management software company that your firm uses, and that service is considered a covered function under the rule. Would you be required to comply with the proposed rule because the individual is considered a supervised person and therefore technically outside of the proposed rule? Most likely yes. United Atlantic Legal Services (“UALS”) has asked for clarification on this point, in our comment letter to the SEC regarding this proposed rule. You can download our submitted comment via the link below.
What are “covered functions”?
Under the proposed rule, a covered function would be a function or service that is necessary for the investment adviser to provide under its investment advisory services, 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. Again, as noted above, a covered function does not include clerical, ministerial, utility, or general office functions or services.
Accordingly, the proposed rule is targeting those functions outsourced to service providers that meet two elements:
- those necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws; and
- those 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.
Examples of Covered Functions. In the proposed rule release the SEC gave the following as examples of potential covered function categories:
- 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.
Additionally, my compliance consulting colleagues will note that the SEC stated that ensuring that the adviser complies with the regulatory requirements applicable to its advisory services is a necessary part of providing those services and would be covered under the rule. As such, compliance functions, including outsourced chief compliance officers, would be considered a covered function under the proposed rule.
Example of Non-Covered Functions. As previously noted, a covered function does not include clerical, ministerial, utility, or general office functions or services. Further, the SEC states that it does not consider functions performed by marketers and solicitors to be covered functions. This is because such services are not used by an adviser to provide investment advice to its clients.
Is it appropriate to outsource the covered function?
Once an investment adviser indentifies a function or service as a covered function, the next step in the analysis is to determine whether it would be appropriate to outsource the covered function. If so, then one must analyze whether it would be appropriate to select the particular service provider. And finally, once selected, one must analyze whether it would be appropriate to continue to outsource the covered function. The six considerations under the proposed rule are:
- Nature and Scope of Covered Function – Identify the nature and scope of the covered function the service provider is to perform;
- Risk Analysis, Mitigation, and Management – Identify and determine how the service provider would mitigate and manage the potential risks to clients or to the investment adviser’s ability to perform its advisory services. The risk analysis and management derives from the engagement of a service provider in performing a covered function;
- Competence, Capacity, and Resources – Determine that the service provider has the competence, capacity, and resources necessary to perform the covered function in a timely and effective manner;
- Subcontracting Arrangements – Determine whether the service provider has any subcontracting arrangements that would be material to the service provider’s performance of the covered function. Additionally, identify and determine how the investment adviser will mitigate and manage potential risks to clients or to the adviser’s ability to perform its advisory services in light of any such subcontracting arrangements;
- Compliance Coordination – Obtain reasonable assurance from the service provider that it is able to, and will, coordinate with the adviser for purposes of the adviser’s compliance with the Federal securities laws; and
- Orderly Termination – Obtain reasonable assurance from the service provider that it is able to, and will, provide a process for the orderly termination of its performance of the covered function.
These are not trivial considerations, and they will need proactive participation by the service provider to ensure compliance. For example, the proposed rule requires investment advisers to obtain reasonable assurance from the service provider that it will coordinate with the adviser for purposes of the adviser’s compliance with the Federal securities laws and provide a process for orderly termination of its performance of the covered function. More than likely, these assurances are going to be manifested as contractual obligations between the service provider and the investment adviser. Of course, where there are legally binding contractual obligations there are corresponding penalties for breaches of those obligations. In other words, liability would increase for covered service providers under the proposed rule – not something service providers will be excited to hear.
What are the ongoing monitoring requirements?
In it proposed rule release, the SEC stated that once a service provider is engaged, the proposed rule would require the adviser to periodically monitor the service provider’s performance of the covered function and reassess the retention of the service provider in accordance with the due diligence requirements of the proposed rule. This periodical monitoring shall be completed in a manner and frequency such that the adviser can reasonably determine that it is appropriate to continue to outsource the covered function and that it remains appropriate to outsource it to the service provider.
So again, we would be looking at the criteria listed above and re-assessing the service provider on an ongoing basis. Investment advisers will, of course, want to assess higher risk service providers more frequently than those falling into a lower risk category. UALS has historically recommended that all of our clients rank their service providers on a risk matrix. This service provider assessment can be done in conjunction with the firm’s broader risk assessment. That’s why we recommend conducting it in conjunction with annual 206(4)-7 testing.
What are the proposed changes to the ADV Disclosure Brochure?
In addition, the proposed rule would amend Form ADV Part 1A to require advisers to:
- identify their service providers that perform covered functions;
- provide the location of the office principally responsible for the covered functions;
- provide the date they were first engaged to provide covered functions; and
- state whether they are related persons of the adviser.
For each of these service providers, the rule would also require specific information that would clarify the services or functions they provide. Note that the information would be publicly available, and the SEC believes it may benefit the public in supplementing the information available about the adviser and may provide investors with additional context in which to consider an investment adviser’s provision of advisory services. It is important to inform the service providers about the disclosure of their information. So, make sure you review any non-disclosure agreements that you may have in place with such service providers.
Additional Considerations
Finally, the proposed rule would amend the Advisers Act’s books and records rule to require advisers to make and retain specific records related to their due diligence assessment. Should the proposed rule become effective in its current format, then advisers will want to ensure that they have processes in place to memorialize their reviews of covered service providers and that such reviews, along with all supporting documentation, are maintained in the adviser’s books and records.
Much more to come on this proposed service provider oversight rule. Given the current timing of the proposed rule, advisers would likely see this rule come into effect very late 2023 or early 2024.
About the Author
Michael Rasmussen is the founder of United Atlantic Legal Services. He is a licensed attorney in Florida and registered solicitor in the United Kingdom. Michael has acted as General Counsel and Chief Compliance Officer to several investment advisers, including private fund managers, responsible for the management of billions of dollars in client assets.
Michael is also the founder of FinProLaw, an online learning platform where Michael has created several courses designed for investment adviser compliance professionals. These courses include:
- Investment Adviser Compliance Essentials for Chief Compliance Officers
- Investment Adviser Registration
- Foundations of Investment Adviser Compliance
- What is a “Security”?
- Investment Adviser Marketing Rule
- Regulation A – Exemption from Registration
- Regulation Crowdfunding – Exemption from Registration
- Regulation D – Exemption from Registration
Investment adviser firms who are also clients of United Atlantic Legal Services can receive many of these courses at a significantly reduced fee or, in some cases, at no expense. Contact us today or visit FinProLaw to learn more.
Please visit Michael’s website to learn more about Michael and his insights into the investment adviser industry. To learn more about Michael, check out his LinkedIn.