The Securities and Exchange Commission (the “SEC”) has proposed new rule 206(4)-11 (the “Proposed Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”).1 If adopted, the Proposed Rule would require registered investment advisers (“advisers”) to conduct due diligence before outsourcing covered functions (as defined below) to a service provider (as defined below), and to periodically monitor the performance and reassess the retention of the service provider. Corresponding proposed amendments would require advisers to report census-type information about their use of service providers. In addition, proposed amendments to the Advisers Act books and records rule would require advisers that rely on a third-party recordkeeper to conduct due diligence and monitoring of the third party, and to obtain reasonable assurances that the third party will meet certain standards.
Proposed Definition of Covered Function
The Proposed Rule would define a “covered function” as a function or service that: (1) is necessary for the adviser to provide its advisory services in compliance with the Federal securities laws; and (2) 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.
Proposed Definition of Service Provider
The Proposed Rule would define a “service provider” as a person or entity that: (1) performs one or more covered functions; and (2) is not a supervised person of the adviser.
Service Provider Oversight and Recordkeeping
Before engaging a service provider to perform a covered function, the Proposed Rule would require an adviser to reasonably determine through due diligence that outsourcing the covered function to that service provider would be appropriate by considering six factors: the nature and scope of the covered function; risk analysis, mitigation, and management; competence, capacity, and resources; subcontracting arrangements; compliance coordination; and orderly termination.
In addition, the Proposed Rule would revise the Advisers Act books and records rule to require an adviser to make and keep a list or other record of covered functions that the adviser has outsourced to a service provider and the name of each service provider, along with a record of the factors that led the adviser to list it as a covered function. In addition, the Proposed Rule would require that the records be maintained in an easily accessible place throughout the time period that the adviser has outsourced a covered function to a service provider, and for a period of five years thereafter.
Due Diligence and Recordkeeping Requirements
The Proposed Rule would require advisers to conduct reasonable due diligence before engaging a service provider to perform a covered function. Advisers would be required to reasonably identify and determine that it would be appropriate to outsource the covered function, that it would be appropriate to select the service provider, and, once selected, that it is appropriate to continue to outsource the covered function.
The Proposed Rule would amend the Advisers Act books and records rule to require advisers to make and retain specific records related to their due diligence assessment. Additionally, the amendments would require a copy of any written agreement entered into with a service provider regarding covered functions to be maintained in an easily accessible place while the adviser outsources the covered function and for a period of five years thereafter.
Once a service provider is engaged, the Proposed Rule would require the adviser to periodically monitor the service provider’s performance of the covered function and reassess the retention of the service provider in accordance with the due diligence requirements of the Proposed Rule.
Proposed amendments to the Advisers Act books and records rule would require advisers to make and keep records documenting the periodic monitoring of a service provider of a covered function, to be maintained in an easily accessible place while the adviser outsources the covered function and for a period of five years thereafter.
Proposed Amendments to Form ADV
The Proposed Rule seeks to amend Form ADV Part 1A to require advisers to identify their service providers that perform covered functions. New Item 7.C. would require advisers to indicate whether they outsourced any covered functions to a service provider, and advisers would report more detailed information about each service provider in new Section 7.C. of Schedule D.
Enhanced Oversight of Third-Party Record Keepers
The proposed amendments to the Advisers Act recordkeeping rule would require an adviser that relies on a third-party recordkeeper (e.g., a cloud service provider) to reasonably determine through due diligence that it would be appropriate to outsource recordkeeping, and to select a particular third-party recordkeeper, by complying with the six due diligence elements specified in the Proposed Rule. The adviser would be required to periodically monitor the performance and reassess the retention of the third party. In addition, an adviser would be required to obtain reasonable assurances that the third party will meet four standards specific to recordkeeping.
Transition and Compliance
The Proposed Rule would require advisers to comply with the Proposed Rule, if adopted, starting ten months from the rule’s effective date (the “compliance date”). The ongoing monitoring requirements, if adopted, would apply to existing engagements beginning on the compliance date.
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The Proposed Rule is currently in a public comment period.2 In its notice of proposed rulemaking, the SEC included a series of questions seeking industry feedback on the Proposed Rule and amendments.