On October 26, 2022, the United States Securities and Exchange Commission (SEC) proposed a new Rule 206(4)-11 and amendments to Rule 204-2 under the US Investment Advisers Act of 1940 (Advisers Act), as well as changes to Form ADV, concerning the use of third-party service providers by investment advisers who are registered or must be registered under the Advisers (Advisers) Act.1

In an accompanying statement, SEC Chairman Gary Gensler said, “When an investment advisor outsources work to a third party, it can reduce the advisor’s costs, but it doesn’t change an advisor’s core obligations to their clients. [The proposed rule is] designed to ensure that the outsourcing of consultants is consistent with their obligations to clients.2

Summary

The proposed rule is designed to prohibit consultants from outsourcing “covered functions” to “service providers” (each as described below) without meeting minimum requirements, including the following:

  • Due diligence. Conduct due diligence on service providers prior to outsourcing;
  • Monitoring. Periodically monitor the performance of service providers;
  • Books and records. Make and keep books and records related to due diligence and control;
  • Third Party Record Keeping. Conduct due diligence and monitor third-party archivists and obtain reasonable assurances that they will meet certain standards; And
  • ADV form. Report the service providers on the ADV form.3

Functions Covered

“Covered Function” means a function or service that is necessary for the investment adviser to provide its investment advisory services in compliance with federal securities laws and which, if not performed or negligently performed, could reasonably cause an impact material adverse effect on the advisor’s clients or the advisor’s ability to provide investment advisory services.4

The SEC provides the following non-exclusive checklist of functions covered in the proposed changes to Form ADV: Advisor/Sub-Adviser, Client Servicing, Cyber ​​Security, Investment Restrictions/Guidelines Compliance, Investment Risk, Portfolio Management (Excluding Advisor /sub-adviser), portfolio accounting, pricing, reconciliation, regulatory compliance, trading desk, trade communication, and allocation and valuation.5

However, the proposal excludes from the definition of function held “office, ministerial, utility or generic functions or services”.6 For example, “lease[s] of commercial office space or equipment, utility use, service or facility maintenance services, or licensing to general software vendors of widely available commercially available operating systems, word processing systems, spreadsheets, or other software similar commercially available” would not be considered covered features.7

Determining whether an asset is a covered function is fact specific and may vary between consultants.

Service Providers

A “service provider” is a natural or legal person who (i) performs a covered function and (ii) is not a “subsidiary” of the consultant.8

While the SEC excludes the consultant’s “controlled persons” from the definition of service providers, it does not go so far as to exclude affiliates. The “risks that the proposed rule is intended to address exist whether the service provider is an affiliate or a non-affiliate… As such, even though the affiliate may be in a controlling relationship with the advisor, it remains important to the consultant to determine whether it is appropriate to retain the franchisee’s services and supervise the franchisee’s performance of a covered function.9

Similarly, ”

Requirements according to the proposed rule

Due diligence

The proposed rule would require consultants to conduct the following due diligence on service providers before engaging with them (or agreeing to add new functions or covered services to an existing engagement):

  • reasonably identify the covered function to be outsourced;
  • establish that it would be appropriate to outsource the covered function; And
  • determine that it would be appropriate to select the service provider to perform the function covered.11

The consultant would fulfill its due diligence obligations:

  • identify the nature and scope of the covered function to be performed by the service provider;
  • identify and determine how it will mitigate and manage the potential risks to clients or to the consultant’s ability to perform its consultancy services resulting from engaging a service provider to perform the function covered and engaging that service provider to perform the covered function;
  • ascertain that the service provider has the expertise, capacity and resources necessary to perform the function covered in a timely and effective manner;
  • determine whether the service provider has any subcontracting arrangements that would be relevant to the performance of the service provider’s function and identify and determine how the investment adviser will mitigate and manage potential client or capacity risks the investment adviser to carry out his advisory services in light of such subcontracting arrangements;
  • obtain reasonable assurance from the service provider that it is able to coordinate with the investment adviser and will do so for purposes of the investment adviser’s compliance with federal securities laws, as applicable to the function covered; And
  • obtain reasonable assurance from the service provider that it is able and willing to provide a process for the orderly cessation of its performance of the covered function.12

The consultant’s due diligence should be reasonably tailored to the identified service provider and the functions or services to be outsourced.13

Monitoring

The proposed rule would require consultants to periodically monitor the service provider’s performance of the function covered and to reassess the service provider’s retention in accordance with the due diligence requirements set out above and in such a manner and frequency that the consultants 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.14

Books and records

The proposed rule would amend Rule 204-2 (the Books and Records Rule) to require counselors to create and maintain true, accurate and up-to-date books and records for the following:

  • records of all covered functions outsourced to a service provider, including the name of each service provider and a record of the factors, corresponding to each function listed, which led the consultant to list it as a covered function;
  • records documenting the due diligence assessment conducted under Rule 206(4)-11, including any policies and procedures or other documentation relating to how the consultant will comply with its obligation to identify and determine how it will mitigate and manage potential risks to clients o to the consultant’s ability to perform his own consultancy services resulting from the engagement of a service provider to perform a covered function and from the engagement of that service provider to perform the covered function;
  • copies of written agreements, including any amendments, addenda, schedules and attachments, entered into with a service provider regarding the functions covered; And
  • records documenting the periodic monitoring of service providers required under Rule 206(4)-11.15

The proposed rule would require all of these records to be kept in an easily accessible place for as long as the investment adviser has outsourced a covered function to a service provider and for a period of five years thereafter.16

Third party recorders

The proposed rule would require any consultant who engages a third party to create and/or maintain the books and records required by Rule 204-2 to:

  • perform due diligence and monitor the third party as described in the proposed Rule 206(4)-11, with respect to the record keeping function, and create and maintain such records as prescribed above, as if record keeping were a function covered and the third party was a service provider; And
  • obtain reasonable guarantees that the third party:
    • adopt and implement internal processes and/or systems for creating and/or maintaining records on behalf of the consultant that meet all the requirements of Rule 204-2 applicable to the consultant;
    • compile and/or maintain the consultant’s records so as to satisfy all the requirements of Rule 204-2 applicable to the consultant;
    • for such advisor records made and/or maintained by the third party in electronic format, allow the investment adviser and SEC personnel to easily access the records via computer or systems during the required retention period described above; And
    • make arrangements to ensure the continued availability of such consultant records in the event that the third-party registrar’s relationship with the consultant is terminated.17

ADV form

The proposed rule would also amend the ADV form to collect information about the consultant’s relationship with service providers. Investment advisers will be required to disclose if they outsource covered functions to service providers and to indicate, in a new Section 7.C of Schedule D, the name and address of the service provider, if it is a person of the consultant, the date on which he was first engaged to provide a covered function and the type of covered function provided.

other considerations

The proposed rule, if adopted, would apply to any recruitment of new service providers made as of the date of compliance with the proposed rules and amendments. Continuous monitoring requirements, if adopted, would apply to existing commitments as of the compliance date.18

While the proposed rule does not require additional explicit written policies and procedures related to the oversight of the service provider, if the proposed rule were adopted, investment advisers would be required under the current 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.19

Conclusion

If the SEC’s proposed rules are adopted substantially as proposed, investment advisers will face the complex task of developing and implementing a due diligence and monitoring process, as well as books and records requirements, for service providers who perform covers. The proposed rule, if adopted, will require a careful examination of the facts and circumstances of an investment adviser’s practice and a tailored approach to compliance.

The comment period will remain open until December 27, 2022.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state law.

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