Divided SEC proposes new requirements for investment adviser outsourcing

A divided SEC advanced a proposal Wednesday that would make investment advisers think more carefully before outsourcing certain services for their clients.

 In a 3-2 vote, the Securities and Exchange Commission proposed a regulation that would establish due diligence and monitoring obligations for advisers who hire a third party to perform a “covered function.”

The 232-page proposal defines a “covered function” as one that’s necessary to provide advisory services and that if not performed or poorly performed could harm clients or impede an adviser’s ability to serve clients. Examples of a covered function could include providing investment guidelines, portfolio management, advice models, custom indices, trading services and software, according to an SEC fact sheet.

Before outsourcing a covered function, an adviser would have to take several steps, including assessing potential risks and the service provider’s competence as well as its subcontracting arrangements. Advisers also would have related books and records requirements.

“There is a risk that investors could be harmed when an adviser outsources a function that is necessary for the provision of advisory services without appropriate adviser oversight,” the SEC fact sheet states. “The Commission has observed an increase in advisers outsourcing and issues related to the outsourcing and advisers’ oversight.”

SEC Chairman Gary Gensler said the proposal would ensure that advisers provide the same level of care for their clients whether they’re performing certain services themselves or turning to outside help.

“I think these rules, if adopted, would better protect investors by requiring that investment advisers take steps to continue to meet their fiduciary and other legal obligations regardless of whether they are providing services in-house or through outsourcing, whether through third parties or affiliates,” Gensler said at the SEC open meeting.

Gensler and the other two Democratic commissioners — Caroline Crenshaw and Jaime Lizárraga — voted in favor of putting the proposal out for comment. The Republican commissioners, Hester Peirce and Mark Uyeda, voted against releasing the proposal.

“Investment advisers are fiduciaries to clients, so why are we giving them step-by-step instructions on how to do their jobs?” Peirce said during the meeting. “The approach we are taking — incrementally displacing their judgment with our own — is neither statutorily grounded nor protective of investors. The actual number of advisers who think that they are off the hook when it comes to outsourced services likely is negligible and, even if it is not, we do not need new rules to hold them to account.”

The Investment Adviser Association also criticized the proposal.

“The proposed rules are overly burdensome and prescriptive and fail to recognize how little leverage firms have over many service providers,” IAA CEO Karen Barr said in a statement. “The proposal is also not adequately tailored to the range of firms it covers, including smaller advisers. It is also apparent that the SEC again has not appropriately considered the cumulative impact of its wave of new proposals on advisory firms of all sizes, nor has it provided sufficient time for meaningful feedback on these sweeping changes.”

The proposal is open for a 60-day comment period.

Also on Wednesday, the SEC adopted rules on clawing back executive compensation and providing tailored mutual fund shareholder reports and amended advertising rules for mutual funds and business development companies.