December 21, 2022 - The LSTA this week submitted a comment letter to the Securities and Exchange Commission on its Proposed Rule on Outsourcing by Investment Advisers (the “Proposal”).  We previously summarized the Proposal here and below we will summarize the five principal points we make in the comment letter.

The Proposal is a “solution in search of a problem”.  Investment Advisers are already subject to a regulatory framework that sufficiently manages risks related to their service provider arrangements.  The Commission also fails to identify the supposed risks that it purports to address under the Proposal nor does it explain how the Proposal would improve outcomes for investors.  Investment Advisers are already have a fiduciary duty to act in their clients’ best interests and those duties do not disappear when delegated to a third party service provider. The Proposal is also overly prescriptive rather than principles based and would significantly increase costs while forcing advisers into taking approaches that might not make sense for their particular circumstances.

An antifraud rule is not an appropriate mechanism to regulate adviser outsourcing and vendor management, and the rule is too prescriptive.  The Proposal would create an inappropriate antifraud rule to address investment adviser vetting and oversight of service providers.  The Proposal contains numerous interpretive questions and vague standards that would make it challenging for advisers to apply.  For example, the definition of “covered function” itself is very vague and the appropriate levels of due diligence and monitoring are unclear and ambiguous.  This lack of clarity could lead to advisers being held to a “strict liability” standard whenever a provider commits an error.  Antifraud violations have very significant collateral consequences and, with so much room for interpretation, potential violations for minor infractions would be a constant threat to investment advisers.

The Proposal seeks to regulate indirectly service providers that are outside the Commission’s jurisdiction.  The Commission lacks jurisdiction over the service providers discussed in the Proposal but it effectively asserts that its jurisdiction should reach them even when they do not provide investment advice.  In order to be engaged by an investment adviser, a service provider would have to submit themselves and subcontractors to a significant amount of due diligence and monitoring, develop new processes to assist advisers and provide various assurances regarding their ability to coordinate with advisers in their compliance with the Proposal.  The Commission also fails to provide service providers with notice or opportunity to weigh in on these important issues.  And, by its own admission, the Commission is unable to quantify the costs to service providers associated with compliance with the Proposal.

The Proposal would disrupt arrangements between investment advisers and service providers and lead to increased costs for investors.  The due diligence requirements of the Proposal extremely complex, burdensome and prescriptive and would impose significant costs on investment advisers and service providers that will raise barriers to entry, especially for smaller investment advisers and service providers, which do not have the same resources as more established firms. These costs ultimately will be borne by investors. Some service providers may not be able or willing to abide by the Proposal’s requirements, making compliance by investment advisers virtually impossible and/or eliminating services providers from the market.  Service providers may question whether they somehow are exposed to liability for aiding and abetting an adviser’s violation of an antifraud rule, which may deter firms from providing these services. Instead, service providers may decide to or be forced to stop servicing investment advisers, leading to industry consolidation—a problem the Commission aptly identifies.

Investment adviser outsourcing is not an issue that is ripe for rulemaking.  The Commission has many tools at its disposal to solicit input from the industry and provide guidance to market participants that do not involve rulemaking. Based on the scant evidentiary basis for the Proposal and the numerous, fundamental questions embedded in the Proposing Release, the Commission should have taken more time and solicited more industry input in developing its views on and approach to investment adviser outsourcing to service providers. The Commission should instead consider alternatives to rulemaking to solicit feedback and discuss its expectations with market participants.  By leveraging the experience of industry members, the Commission can better develop practical solutions to real problems.

What’s next?  The comment period for the Proposal ends on December 27th.  The LSTA will likely engage with the staff of the Commission’s Investment Management Division sometime in the new year.  Given the plethora of rulemakings made by the SEC over the past year, it is difficult to predict when (or if) the Commission will consider a final rule.  We will continue to follow this matter closely.  If you have any questions, please reach out to Elliot Ganz.

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