On October 26, 2022, the Securities and Exchange Commission (SEC) proposed new Rule 206(4)-11 under the Investment Advisers Act of 1940 (Advisers Act), which would prohibit SEC-registered investment advisers from outsourcing certain services or functions to service providers without meeting minimum requirements. At the same time, the SEC also proposed certain related amendments to Rule 204-2 under the Advisers Act and Form ADV.

Proposed Rule 206(4)-11 (Proposed Rule) would require investment 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.

The proposed amendments to Form ADV are intended to collect census-type information about the service providers defined in the proposed rule. In addition, the proposed amendments to Rule 204-2 would include a new provision requiring any adviser that relies 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.

   1. BACKGROUND

In the proposing release for the Proposed Rule (the Proposing Release),¹ the SEC notes that investment advisers are outsourcing an increasing array of functions to affiliated and third-party service providers, including:

• investment research and data analytics;
• trading and risk management;
• compliance;
• collateral management;
• settlement services;
• pricing or valuation services;
• performance measurement;
• index providers;
• subadvisers; and
• technology platforms for offering robo-advisory services.

The SEC acknowledges that in many instances, service providers can perform functions that benefit advisers and their clients. The SEC expresses concern about the risk that investors could be harmed, however, when an adviser outsources a function that is necessary for the provision of advisory services without appropriate adviser oversight. The SEC asserts that the need for the Proposed Rule and the proposed related amendments has been demonstrated by various outsourcing issues that it has observed, including an adviser’s failure to perform due diligence before utilizing outsourced services to ensure that they performed as intended, an adviser’s failure to oversee a third-party vendor that did not properly safeguard customers’ personal identifying information and advisers that are unable to produce documents in a timely manner because of outsourcing. The SEC also expresses concern that: (a) it currently lacks visibility into advisers’ outsourcing and thus the potential extent to which advisory clients face outsourcing-related risks; and (b) when an adviser outsources its books and records obligations to a third party, the adviser may not be properly ensuring that it can comply with the SEC’s recordkeeping requirements.

The SEC states that in its view:

• outsourcing functions that are necessary for an adviser to provide advisory services to its clients, without further oversight by the investment adviser, can undermine the adviser’s provision of services and compliance with the Federal securities laws, and can directly harm clients; and
• it is a deceptive sales practice and contrary to the public interest and investor protection for an investment adviser to hold itself out as an investment adviser, but then outsource its functions that are necessary to its provision of advisory services to its clients without taking appropriate steps to ensure that its clients will be provided with the same protections that the adviser must provide under its fiduciary duty and other obligations under the Federal securities laws.

   2. PROPOSED RULE 206(4)-11

     a. Covered functions

The Proposed Rule would establish an oversight framework across SEC-registered advisers that outsource a “covered function”; that is, a function or service that:

• is necessary to provide advisory services in compliance with the Federal securities laws, and
• 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. 

The SEC states that functions or services that are related to an adviser’s investment decision-making process and portfolio management, such as providing investment guidelines (including maintaining restricted trading lists), creating and providing models related to investment advice, creating and providing custom indexes, providing investment risk software or services, providing portfolio management or trading services or software, providing portfolio accounting services, and providing investment advisory services to an adviser or the adviser’s clients (subadvisory services), meet the first element of the definition.

The SEC stated that the second element of the proposed definition of “covered function” limits the definition to those functions or services 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. Determining what is a material negative impact would depend on the facts and circumstances, but it could include a material financial loss to a client or a material disruption in the adviser’s operations resulting in the inability to effect investment decisions or to do so accurately.

The SEC is proposing to exclude clerical, ministerial, utility, and general office functions or services from the Proposed Rule.

The SEC is declining to propose a bright line test of what constitutes a covered function. It notes that certain functions may be covered functions for one adviser but not for another adviser, and so 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. For example, one adviser may choose to engage an index provider for the purposes of developing an investment strategy for its clients, which would be a covered function under the proposed rule, while another may license a widely available index from an index provider to use as a performance hurdle, in which case the proposed rule would not apply. 

Examples of services that the SEC suggest could be covered functions (as opposed to simply outsourced relationships) include:

• 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.

     b. Service provider

An investment adviser would be required to comply with the Proposed Rule if it retains a service provider. The term “service provider” is defined as a person or entity that: (1) performs one or more covered functions; and (2) is not a supervised person of the adviser. A service provider can be affiliated or a third-party. 

     c. Due diligence

Before retaining a service provider to perform a covered function (either beginning a new engagement or adding a new covered function to an existing engagement), an adviser would be required to reasonably identify and determine through due diligence that outsourcing the covered function to that service provider would be appropriate by considering:

• the nature and scope of the covered function;
• 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 material subcontracting arrangements related to the covered function;
• coordination with the service provider for Federal securities law compliance; and
• whether the service provider is able to, and will, provide a process for the orderly termination of the performance of the covered function.

     d. Monitoring

The Proposed Rule would require an adviser to monitor its service providers with a manner and frequency such that the adviser reasonably determines that it is appropriate to continue (i) to outsource the covered function and (ii) to outsource to the service provider. According to the SEC, the manner and frequency of an adviser’s monitoring would depend on the facts and circumstances applicable to the covered function, such as the materiality and criticality of the outsourced function to the ongoing business of the adviser and its clients.

     e. Books and records requirements

The SEC is proposing companion amendments to Rule 204-2 to require advisers to make and keep: (1) a list or other record of covered functions that the adviser has outsourced to a service provider, along with a record of the factors that led the adviser to list it as a covered function; (2) records documenting the due diligence assessment; (3) a copy of any written agreement with a service provider; and (4) records documenting the periodic monitoring of a service provider. These records would be required to be maintained throughout the time period during which the adviser has outsourced a covered function to a service provider and for a period of five years thereafter.

   3. Enhanced Oversight of Third-Party Record Keepers

The SEC proposes to require an adviser that relies on a third-party recordkeeper to conduct due diligence and monitoring of that third party consistent with the requirements under the Proposed Rule. An adviser would also be required to obtain reasonable assurances that the third party will meet four standards, which address the third party’s ability to:

• adopt and implement internal processes and/or systems for making and/or keeping records that meet the requirements of Rule 204-2 applicable to the books and records being maintained on behalf of the adviser;
• make and/or keep records that meet all of the requirements of Rule 204-2 applicable to the adviser;
• provide access to electronic records; and
• ensure the continued availability of records if the third party’s relationship with the adviser or its operations ends.

   4. Proposed Amendments to Form ADV

The SEC is proposing to amend Item 7 of Part 1A of Form ADV to require an adviser to disclose whether it outsources any covered function, and if so, to provide additional information on Schedule D. The proposed amendments would add Section 7.C. to Schedule D of Part 1A to require advisers to disclose the following for each service provider to which a covered function is outsourced: legal name, primary business name, legal entity identifier (if applicable), whether the service provider is a related person of the adviser, date the service provider was first engaged, location of the service provider’s office primarily responsible for the covered function, and the covered function(s) that the service provider is engaged to perform.

   5. TRANSITION AND COMPLIANCE

The SEC would require advisers registered or required to be registered with the SEC to comply with the Proposed Rule and amendments, if adopted, starting ten months from their effective date (the Compliance Date). Exempt reporting advisers would not be subject to the proposal. The Proposed Rule, if adopted, would apply to any engagement of new service providers made on or after the Compliance Date. The ongoing monitoring requirements, if adopted, also would apply to existing engagements beginning on the Compliance Date.

   6. CONCLUSION

The Proposed Rule and related proposed amendments, in our view, raise nearly as many questions as they answer. Are the outsourcing problems that the SEC cites in the Proposing Release widespread or merely a few anecdotal outliers that are unrepresentative of outsourcing arrangements in general? Are there certain types of outsourcing relationships that have been more prone to abuses than others? How will the proposed due diligence and monitoring requirements interact with existing guidance pursuant to other SEC obligations such as the investment company and investment adviser compliance rules? 

And, perhaps most importantly, the Proposed Rule appears to prohibit an adviser from outsourcing a covered function unless it can satisfy the Proposed Rule’s due diligence and monitoring requirements. However, the rulemaking fails to address the scenario in which an adviser may not be able to clearly satisfy of all the due diligence or monitoring requirements, but a service provider is nonetheless better able to perform the relevant covered function than the investment adviser itself.

Comments on the Proposed Rule and related proposed amendments are due by December 27, 2022, or, if later, 30 days after publication in the Federal Register.

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