The Securities and Exchange Commission (SEC) recently introduced new requirements for registered investment advisers regarding the oversight of service providers. The proposed rule, Rule 206(4)-11, aims to enhance investor protection by setting minimum standards for outsourcing services or functions. The SEC highlighted a growing trend in the use of third-party providers and expressed concerns about potential risks to investors.
Under the proposed rule, advisers must conduct due diligence on service providers, monitor their performance, and maintain related records. The rule covers various service providers, including fund administrators and chief compliance officers. While many advisers already perform due diligence on service providers, the new requirements may present additional challenges, such as determining which functions fall under the rule.
Additionally, the proposed rule may lead to increased obligations for both advisers and service providers. Advisers may need to enhance due diligence efforts, negotiate more stringent agreements, and adjust risk management practices. Comments on the proposed rule are open until December 27, 2022, with a compliance deadline expected ten months after the rule’s effective date.
The rule defines a “covered function” as a service critical to compliance with securities laws and essential for providing advisory services. The SEC provided examples of potential covered functions, such as portfolio management and regulatory compliance. Advisers are tasked with determining which functions meet the criteria based on their specific circumstances.
Moreover, the rule defines a “service provider” as an entity performing covered functions but excludes supervised persons of the adviser. The SEC emphasized that affiliation with an adviser does not exempt service providers from oversight. The rule also applies to subadvisers engaging service providers, extending compliance requirements.
Prior to engaging a service provider, advisers must conduct due diligence to assess the appropriateness of outsourcing a covered function. This involves evaluating the services, potential risks, and the service provider’s capabilities. The due diligence process must be tailored to each specific function and provider, posing challenges for advisers with limited options or transparency.
Advisers are also required to periodically monitor service providers and reassess their engagement based on initial due diligence findings. The monitoring frequency and extent should align with the function’s complexity and associated risks. Recordkeeping obligations under the rule mandate advisers to document covered functions outsourced and maintain relevant records.
Furthermore, the proposed rule introduces disclosure requirements on Form ADV, necessitating advisers to provide information on service providers performing covered functions. This aims to enhance transparency and enable better oversight of outsourced functions. The SEC seeks feedback on various aspects of the proposed rule, including concerns about public disclosure of service providers.
In conclusion, the SEC’s proposed rule on adviser oversight of service providers signifies a significant regulatory development in the investment advisory industry. The rule’s broad scope and detailed requirements may impact advisers’ operational practices, risk management approaches, and relationships with service providers. Compliance with the rule, if adopted, will require careful consideration and proactive adjustments by advisers to meet the new standards effectively.
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