Be Ready for SEC’s Proposed RIA Outsourcing Rule

The Securities and Exchange Commission is proposing a new rule under the Investment Advisers Act of 1940 that would require RIAs to satisfy specific requirements if they outsource certain services or functions. In addition, the proposed rule would impose due diligence and monitoring obligations for the engagement and retention of the service provider.

The SEC is also proposing changes to Form ADV and to the recordkeeping requirements under Rule 204-2. If adopted, advisors will be required to comply with the new rule 10 months from the rule’s effective date for new service provider engagements that occur on or after the compliance date. The ongoing monitoring obligations, however, would apply to existing arrangements beginning on the compliance date.

The SEC has received numerous comments on the proposed rule, Rule 206(4)-11, which were due Dec. 27, 2022, including criticism that the rule is unnecessary and burdensome. Nevertheless, investment advisors should become familiar with the proposed rule to ensure timely compliance if it is adopted.

The asset management industry has changed in many respects since the Advisers Act was adopted. In response to some of these changes, advisors have sought administrative and specialized expertise from outside service providers. While clients may benefit from certain outsourced services and functions, the SEC believes clients could also be harmed if outsourcing occurs without appropriate due diligence and oversight.

The proposed rule is intended to address these potential outsourcing risks by creating due diligence and monitoring obligations for investment advisors.

Current steps to take:

• Advisors should review the proposed rule and become familiar with the rule’s requirements.
• By reviewing current outsourcing policies and procedures, advisors can identify what, if any, changes they may need to make for compliance with the rule.
• Advisors should identify outsourced services and functions to determine whether they are a covered function.

Proposed Rule

The proposed rule applies to investment advisors who outsource a covered function. The definition of a “covered function” is broad and consists of two parts: a function or service that is necessary for the advisor to provide its investment advisory services in compliance with applicable laws, and if not performed (or if performed negligently), would be reasonably likely to cause a material negative impact on the advisor’s clients or the advisor’s ability to provide services. Clerical, ministerial, utility or general office functions or services are excluded from the definition.

If an investment advisor is considering whether to engage a service provider to perform a covered function, the advisor must assess the service provider to determine that it would be appropriate to engage the provider. The advisor’s assessment must address six specific elements:

1. The nature and scope of the services.
2. Potential risks resulting from outsourcing the function to the service provider, plus risk mitigation strategies.
3. The service provider’s competence, capacity, and resources to perform the covered function.
4. The service provider’s subcontracting arrangements related to the covered function.
5. Coordination with the service provider regarding compliance with applicable law.
6. The orderly termination of the service provider’s engagement.

On an ongoing basis, the investment advisor must monitor the service provider’s performance and assess the provider’s continued engagement pursuant to the proposed rule’s due diligence requirements.

Current obligations:

• Advisors owe a fiduciary duty to their clients that cannot be waived by engaging a third party to provide services and functions on the advisor’s behalf.
• When engaging a third-party service provider, advisors use written agreements to clearly identify roles and responsibilities, as well as business terms such as each party’s obligations when a service arrangement terminates.
• Advisors have an obligation to place their clients’ interest ahead of their own, which creates an inherent obligation to perform appropriate due diligence and ongoing monitoring of services providers.

If adopted, the proposed rule does not modify an advisor’s current obligations but provides the SEC with an additional cause of action to sanction advisors.

The proposed rule does not require explicit written policies and procedures related to an investment advisor’s oversight of the service provider. Nevertheless, the SEC believes that investment advisors would be required under the existing compliance procedures and practices rule — Rule 206(4)-7 — to have policies and procedures reasonably designed to prevent violations of the proposed rule and be required to make and keep books and records related to their oversight obligations.

Further, advisors relying on a service provider to make and/or keep records required under the Advisers Act must conduct due diligence and monitoring of the service provider that is consistent with the proposed rule and obtain reasonable assurances that the service provider:

• Adopts and implements internal processes and/or systems that meet the recordkeeping rule requirements applicable to the investment advisor.
• Makes and/or keeps records that meet all the recordkeeping rule requirements applicable to the advisor.
• Provides access to electronic records.
• Ensures the continued availability of records if the service provider’s operations or engagement cease.

The final component of the proposed rule would modify Form ADV and require investment advisors to provide census-type information about the outsourcing service provider. Through this change, the SEC seeks improved visibility for itself and advisory clients relating to the service providers, so that clients can make informed decisions about engaging an investment advisor and so that the SEC can identify and address risks related to outsourcing.

Challenges for Advisors

• Advisors will incur additional compliance and economic costs to ensure compliance with the proposed rule, if adopted.
• The determination of whether the selection of a service provider is prudent is based on an advisor’s facts and circumstance assessment of the service provider.
• Advisors will be required to include provisions that satisfy the rule’s requirements in service agreements with providers of covered functions.

While the proposed rule faces criticism from the industry, investment advisors should review the rule and their current outsourcing framework and be ready to meet the rule’s challenges if it becomes effective.

Spencer Fane attorney Beth Miller helps clients by identifying practical solutions to a wide variety of legal matters in the areas of employer-sponsored retirement plans, executive compensation, fiduciary obligations, and advisory services. She can be reached at bmiller@spencerfane.com or (913) 327-5124.