On October 26, 2022, the SEC proposed a new rule and rule amendments under the Investment Advisers Act of 1940 (the Advisers Act) to prohibit registered investment advisers (Advisers) from outsourcing certain services and functions without conducting due diligence and monitoring of the service providers.[1] The proposal is in response to the SEC’s observed increase in the number of Advisers outsourcing services and functions to service providers and the attendant risks of harm to clients posed by such outsourcing. 

Under the proposal, Advisers would be required to establish an oversight framework to cover functions or services that (i) are necessary for an Adviser to provide its investment advisory services in compliance with Federal securities laws and (ii) if not performed, or if 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 (Covered Functions).[2]

Before retaining a service provider to perform a Covered Function, 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, if any;
  • Coordination with the service provider for Federal securities law compliance; and
  • Whether the service provider can provide a process for the orderly termination of the performance of the Covered Function.

Additionally, the proposal would require Advisers to:

  • Periodically monitor a service provider’s performance and to reassess the selection of the service provider under the proposed rule’s due diligence requirements;
  • Maintain books and records related to such due diligence and monitoring; and
  • Report census-type information about service providers on Form ADV.[3]

The proposal would also require any Adviser relying on a third party recordkeeper to (i) satisfy the above due diligence and monitoring requirements with respect to such third party, and (ii) 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 the Advisers Act’s recordkeeping rule 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 the recordkeeping rule 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 cease.

If adopted, the proposal would require Advisers to be in compliance with the rule’s requirements starting ten months from the rule’s effective date.

Comments on the proposal are due on or before 30 days after publication of the proposal in the Federal Register or December 27, 2022, whichever is later.

[1] The SEC’s proposing release can be found here.  The proposal is not applicable to exempt reporting advisers.

[2] Clerical, ministerial, utility, and general office functions or services would be explicitly excluded from the proposed rule.

[3] Specifically, Advisers would be required to (i) identify service providers that perform Covered Functions, (ii) provide the location of the office principally responsible for the Covered Functions, (iii) provide the date they were first engaged to provide Covered Functions and (iv) state whether they are related persons of the Adviser. Advisers would also be required to provide specific information that would clarify the services or functions provided by each service provider.