The SEC announced on October 26, 2022 that it is proposing a new rule under the Investment Advisers Act of 1940 (“Advisers Act”) to prohibit registered investment advisors from outsourcing certain services or functions without first meeting certain minimum requirements.
Under the proposed rule, advisors would be required to conduct due diligence prior to engaging a service provider to perform certain services or functions. Advisors that are outsourcing these services and functions would also be required to periodically monitor the performance and reassess the retention of the service provider.
Similarly, corresponding amendments are proposed to collect census-type information about the service providers defined in the proposed rule. Amendments to the Advisers Act are also proposed with regard to the books and records rule, including a new provision requiring advisors 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
Service Providers and Covered Functions
Under the proposed rule, a “service provider” is defined as a “person or entity that performs one or more covered functions and is not an adviser’s supervised person.”
A “covered function” has two parts: (1) a function or service that is necessary for the advisor 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 advisor’s clients or on the advisor’s ability to provide investment advisory services. Clerical, ministerial, utility, or general office functions or services are excluded from the definition. Custodians that are independently selected and retained through a written agreement directly with the client would not be covered by the proposed rule because the advisor is not retaining the service provider to perform a function that is necessary for the adviser to provide its advisory services.
The SEC provided the following examples of potential covered function categories that an advisor may wish to consider in the amendments it is proposing to Form ADV, Section 7.C of Schedule D:
- 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
- Valuation.
Next Steps
The SEC will seek comments regarding these proposed rules relating to the outsourcing of services and functions by registered investment advisors. Once comments have been reviewed, a final rule and adopting release may be issued.
A copy of the proposed rule can be found here.
For more information about the proposed rules discussed above, please contact NCA Compliance.
Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc., a compliance consulting firm providing a wide range of customized compliance solutions for investment advisors. Ms. Nelson previously worked for the Securities and Exchange Commission and a large investment manager in New York.
