The SEC has proposed new rules for registered Investment Advisers that would require heightened diligence and monitoring of certain types of service providers. Comments on the draft are due December 27, 2022, subject to extension.
BACKGROUND & SUMMARY
The proposed rules create heightened due diligence and ongoing monitoring requirements for investment advisers for both third-party and affiliated-entity service providers performing certain functions that (1) are necessary for advisers to provide investment advisory services and (2) would reasonably have a material negative impact on clients (or the adviser) if such services were performed negligently (or not at all).
The proposed rules also create new recordkeeping requirements and reporting requirements reflected in changes to adviser registration and ADV forms.
POINTS TO CONSIDER
SCOPE: The proposed rule excludes service providers that are a “supervised person of the adviser.”[1] But note that service providers from affiliated entities are not automatically considered a supervised person of the adviser.[2] Additional exclusions cover service providers performing “clerical, ministerial, utility, or general office functions or services” and “the adviser’s lease of commercial office space or equipment, use of public utility companies, utility or facility maintenance services, or licensing of general software providers of widely commercially available operating systems, word processing systems, spreadsheets, or other similar off-the-shelf software.”[3]
DILIGENCE: Under the proposed rule, an adviser determining whether a particular service provider engagement is appropriate must adopt a due diligence process and perform a due diligence review that considers six specific factors before engaging the service provider, and the adviser must periodically perform that due diligence review to determine whether the service provider engagement remains appropriate. Further, if the service provider is engaged to make and or keep the adviser’s required books and records, the proposed rule requires the adviser to obtain four specific assurances covering their ability to meet the requirements of the adviser’s recordkeeping obligations, provide appropriate access to electronic records, and ensure the availability of records if the service provider’s operations or relationship with the adviser cease.”[4]
ADVISORY: The proposed rules will require advisers to give special consideration to their index and other ratings or specialized research providers. The proposed rule draws a distinction between providers of indexes and ratings/research that are used by an adviser to provide investment advice, and providers of commonly available index products used “solely as a comparison benchmark for performance and not to inform the adviser’s investment decisions as part of its advisory services.”[5]
BLG is available to discuss further.
[1] The proposed rule and rule amendments were published in the Federal Register on October 26, 2022, under IA-6176 “Outsourcing by Investment Advisers”.
[2] https://www.sec.gov/rules/proposed/2022/ia-6176.pdf. p. 26; Proposed rule 206(4)-11(b).
[3] Id. p. 26.
[4] Id. p. 25.
[5] Id. p. 25.
[6] Id. p. 26.