November 28, 2022 - We have previously summarized the SEC’s recent proposed rule on Outsourcing by Investment Advisers (the “Proposed Rule”) that would require Registered Investment Advisers (advisers) to conduct extensive due diligence before hiring many (if not most) types of third-party service providers, and then to conduct ongoing oversight of such providers. Since loan fund advisers rely extensively on outsourced third-party servicers (including pricing services, indexes, technology solutions, etc.) the implications for them are vast. In our preliminary summary, we suggested that the Proposed Rule was both vague and broad, would be cumbersome and costly and that the SEC had not adequately considered the impact these unnecessary changes would have, particularly on smaller advisers whose resources are limited. Following, we dive deeper into some of the most serious issues and concerns raised by the Proposed Rule.
A review of the basics: What does the Proposed Rule say? Briefly, the Proposed Rule would prohibit advisers from outsourcing certain “covered functions” to service providers without meeting several minimum requirements, including, conducting initial due diligence and periodic ongoing monitoring on service providers, maintaining books and records related to the due diligence and monitoring, conducting due diligence and monitoring on third-party record-keepers, and reporting all service providers to the SEC on form ADV. Skadden has provided a detailed summary of the requirements of the Proposed Rule here.
The SEC targets a non-existing problem. The SEC asserts that “more needs to be done to protect clients and enhance oversight of advisers’ outsourced functions,” but, as noted by MoFo in a recent memo, “an adviser already owes a fiduciary duty to its clients, a duty that applies even when the adviser outsources some core functions. Under existing interpretations and SEC exam and enforcement practices, an adviser continues to remain liable for performing functions related to its advisory services whether or not they are outsourced.” The Proposed Rule, they suggest, “appears to be a problem for which a solution already exists and is widely and commonly adopted by advisers.”
The definition of “Covered Function is vague. The Proposed Rule requires advisers to conduct due diligence before engaging any third-party servicer that provides a “Covered Function” which is 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.” But Schulte, in a recent memo, observes that “the types of relationships covered under the Proposed Rule are defined by new and vague standards”. That vagueness, they conclude, suggests that “advisers should take a critical eye to how the Proposed Rule might impact many of its critical third-party arrangements”. Moreover, they note that the second part of the covered function test is also unclear. “What is a function 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? Will it be possible for advisers to rule out certain services under this formulation?” As Mofo explains, the Proposed Rule requires “advisers’ chief compliance officers (CCOs) to make these determinations on a case-by-case basis based on the facts and circumstances of each outsourced covered function. To avoid being second-guessed, CCOs may err on the side of caution and treat each outsourced relationship as a covered function, which will significantly increase the costs of compliance, in terms of both monetary budgets and expanded working hours.” This is especially so given that that failure to satisfy the oversight and documentation requirements dictated by the Proposed Rule could be charged as fraud under the Advisers Act.
The Proposed Rule would fall heaviest on small advisers. Given the likelihood that a very significant proportion of outsourced services will be viewed as being in scope of the Proposed Rule, it would vastly expand the financial costs to advisers and greatly increase the human resources needed by an adviser to comply with the due diligence, monitoring, reporting and recordkeeping requirements. MoFo’s view, with which agree: “We expect this will have the greatest impact on smaller RIAs and contribute to existing industry trends towards RIA consolidation, driven in part by the ability of larger firms to leverage technology, centralized operations, and compliance infrastructure”. This concern is exacerbated by the cumulative impact of the SEC’s “Regulation Raceway” under which it has proposed numerous rules for advisers, each of which alone would significantly increase costs and the need for increased staff.
The Proposed Rule would impose significant costs on service providers. Service providers are not the direct focus of the Proposed Rule but are effectively covered nevertheless since they would be required to cooperate in the due diligence and monitoring processes to be engaged by advisers. The SEC acknowledges that services providers would incur costs that would either be absorbed or passed on to advisers (and that these costs would increase if the service provider subcontracted any of its services) but, notably, was unable to even estimate them.
Advisers are exposed to a significant gap in liability coverage. Under the SEC’s proposed Private Funds Disclosure Rule (which we have covered extensively here, here, here, here, and here), prohibits private fund advisers from seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund. Conversely, most third-party service providers contractually require advisers to hold them harmless from liability at a “gross negligence” standard. Thus, if the two rules are passed and an adviser is determined to have breached a fiduciary duty to investors because of the simple negligence of a third-party service provider, the adviser would be exposed for breach of duty but would have no recourse to the service provider.
Grandfathering. Advisers would have to determine whether any of their existing outsourced service arrangements are in scope as covered functions. If so, the Proposed Rule’ monitoring, recordkeeping and reporting requirements would apply to all such relationships as of the effective date of the proposed Rule.
The LSTA will continue to monitor and report on the Proposed Rule and is considering submitting a comment letter by the December 27th deadline.