SEC Proposes Rule Restricting RIAs On Outsourcing Services

RIAs would need to do due diligence and monitor vendors providing a host of services affecting investment management and their clients.

By Dorothy Hinchcliff

The Securities and Exchange Commission proposed a new rule today that would make it illegal for a registered investment advisor (RIA) to hire a third-party service provider without conducting due diligence and monitoring.

In general, the SEC said in the proposal, it would consider services related to investment decision-making and portfolio management to fall under the rule. Examples could be services involving investment guidelines, investment-advice models, custom indexes, investment risk software or services, portfolio management or trading services or software, and portfolio accounting.

Clerical or general office services would not fall under the proposed rule, the SEC said.

Why now?

The SEC says the rule is needed because of significant changes in the advisory business since Congress adopted the Investment Adviser Act of 1940.

“For instance, many advisers now seek to provide full-service wealth management and financial planning (e.g., tax, retirement, estate, education, and insurance), and they use electronic systems to provide those services and keep their records,” the SEC said. “Clients and investors also are seeking to invest in types of securities and other assets that were not commonly traded or did not exist at that time, including, for example, derivatives and exchange-traded funds. At the same time, fee pressures for advisers have increased.”

The result is that advisors are under pressure to meet increasingly complex client demands in a cost-effective way.

Not only that, but the demand for advisory services has grown. Regulatory assets under management have increased from $47 trillion to $128 trillion over the past 10 years, the SEC said.

Many advisors are adapting by turning to service providers. Outsourcing can benefit advisors and their clients, the SEC said. But an advisor who doesn’t provide appropriate oversight may significantly harm clients, it added.

An advisor’s failure to provide such oversight could hurt clients. For example, clients might face financial losses, miss out on investment opportunities, or get inaccurate pricing and performance information, the SEC said.

What the rule covers

More specifically, the rule would only apply to service providers who provide “covered functions.”

“Advisers outsource many services beyond their core advisory functions, and the failure of many of those functions could have little to no effect on an adviser’s clients,” the proposal says.

The SEC says the outsourced functions that would come under the rule must meet two elements:

• An advisor would use it to provide investment advisory services in compliance with federal securities laws.

• If the service was performed negligently or not at all, it would be reasonably likely to cause a material negative impact on the advisor’s clients or on the advisor’s ability to provide investment advisory services.

Retaining service providers

Whether an advisor had retained a service provider would depend on facts and circumstances, the SEC said.

“For example, an adviser that enters into a written agreement with a valuation provider to value all of its clients’ fixed income securities or with a subadviser to manage fixed income portfolios for several of its clients would be considered to retain a service provider under the proposed rule to perform a function that is necessary for the adviser to provide its advisory services,” the SEC said. “In contrast, custodians that are independently selected and retained through a written agreement directly with the client would not be covered by the proposed rule because the adviser is not retaining the service provider to perform a function that is necessary for the adviser to provide its advisory services.”

Form ADV amendment

The proposed rule would also amend Form ADV to require certain reporting and compliance requirements on investment advisers, including those that are small entities. In particular, advisors would have to disclose whether they outsource any covered functions to a service provider and report detailed information about those providers.

The SEC has set a deadline for comments of December 27, or 30 days after publication in the Federal Register, whichever is later. Comments may be submitted using the SEC’s form; or by email to Include File Number S7-25-22 in the subject line.

Latest news

Carson Group: Still Too Few Women in Wealth Management

Its latest report confirms the industry has made little progress in gender diversity despite a lot of talk.

Supreme Court Seems Wary of SEC’s In-House Tribunals Without Juries

The Supreme Court discussed a case involving a hedge fund manager in which the SEC brought a civil enforcement proceeding that charged he mislead investors.

Annuity Sales Continue March Upward

Annuity sales are set to have another record-breaking year, based on results in the third quarter.

Humana, Cigna in Talks to Merge

A deal would give Cigna a much greater foothold in the fast-growing market for managing federal Medicare plans for older Americans.

Aretha Franklin’s Sons Awarded Late Singer’s Real Estate

They now own the late singer's real estate after a judge ruled that a handwritten will found hidden in her sofa was the correct document.

The Wit and Wisdom of the Late Charlie Munger

Charlie Munger, Warren Buffett's deputy who helped transform Berkshire Hathaway into a conglomerate, will be remembered, in part, for comments like these.