November 8, 2022 - While we have been focusing on the SEC’s latest liquidity management proposal (which, among other things, poses an existential threat to loan funds), in late October the SEC proposed yet another prescriptive rule that would expand the SEC’s reach into private funds and have significant implications for all Registered Investment Advisers (“RIAs”). Specifically, the SEC’s 232-page proposed rule on Outsourcing by Investment Advisers would require RIAs to conduct and document due diligence before hiring many types of third-party service providers, and then to conduct continued oversight of such providers. For RIAs that manage loan-related funds, the third-party servicers in scope could include pricing services, providers of Indexes and others. The proposed rule would also require extensive reporting and recordkeeping. Despite the novelty and importance of this proposal, the SEC has given stakeholders only 60 days to submit comments.
What kinds of third-party services would be covered? The rule would cover “Covered Functions” defined as “(1) a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and (2) that, if not performed or 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.”
What would the due diligence obligations entail? The RIA would have to consider 6 specific elements in determining whether it would be appropriate to engage a specific servicer:
“• The nature and scope of the services; • 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 subcontracting arrangements related to the covered function; • Coordination with the service provider for Federal securities law compliance; and • The orderly termination of the provision of the covered function by the service provider.”
What would the continuing monitoring responsibilities entail? The ongoing monitoring obligations would closely track the same six elements of the initial due diligence requirements.
What would the recordkeeping responsibilities entail? RIAs would have to maintain very extensive documentation regarding their due diligence and monitoring activities regarding each outsourced covered function. In addition, each covered outsourced service provider would have to comply with a comprehensive oversight framework including its own due diligence, monitoring and record-keeping functions, specifically relating to each of the six due diligence and monitoring elements described above. RIAs would have to retain these records for five years after the termination of any outsourced covered function.
What is the LSTA Doing? The LSTA intends to submit a comment letter on this proposal. We believe that the proposal is a cumbersome and costly “solution in search of a problem” that does not exist. It is extremely vague and broad, and it is not clear that the Commission has the statutory authority to impose this rule. Finally, we believe that the SEC has not adequately considered the impact these unnecessary changes would have on smaller advisers whose resources are limited.
For a comprehensive summary of the proposed rule, please see this recent memo from Willkie. For an excellent critique of the proposed rule, please see Commissioner Peirce’s dissenting statement.