An SEC proposal to prohibit advisors from outsourcing functions to third-party vendors without meeting due diligence and reporting requirements first would create “a new regulatory framework,” the Investment Adviser Association’s (IAA) general counsel Gail Bernstein said in a letter to the agency today.
The SEC recognized the benefits of the industry’s increased reliance on outsourcing in its proposal, which it passed in a 3-2 vote on October 26. Chief among the benefits is providing firms with access to expertise such as portfolio management, compliance and cyber security they may not have the expertise or staff to perform efficiently.
But the regulator said in its 233-page proposal that extensive regulation is needed to address the potential risks to investors of advisors' increased reliance on outside vendors to handle core functions that could harm investors’ performance and even assets if the vendor, or even one of its sub-contractors, falters or fails.
The proposal, which would impact some 15,169 SEC-registered advisors managing $128 trillion in assets, requires advisors to conduct due diligence before hiring a service provider, obtain “reasonable assurances” from providers that they meet standards and create and collect and provide census-type information about each provider for Form ADV.
“We have significant concerns with the proposal and have urged the SEC not to move forward and instead to consider alternative approaches to achieve its goals,” Bernstein said in a statement today.
Despite the Advisers Act giving the industry what she termed an “existing evergreen framework that ensures that ‘the buck stops’ at the adviser even as financial services evolve, and the fact that the Commission has not shown that the existing framework is lacking, the Commission has proposed a broad new oversight framework,” she said.
“While we understand the SEC’s objectives, we believe that the proposal is unnecessary. As fiduciaries, advisers are responsible today for all aspects of their advisory relationship, regardless of whether any functions or services are outsourced, and must already have programs in place to manage their outsourcing,” Bernstein added.
The IAA is not alone in opposing the proposal. Because of the prescriptive nature of the proposal—or as the SEC itself states “certain functions may be covered functions for one adviser but not for another adviser”—it’s ambiguity could result in the proposal being broadly and inconsistently [enforced] benefit of hindsight,” the industry law firm of Morgan Lewis said in a recent note to clients.
But the IAA is also critical of what it said was the “practical difficulties” of the agency’s attempt to extend indirectly extend its legal authority over service providers it has no independent jurisdiction over by requiring them to provide “reasonable assurances they’re able and willing to coordinate with an advisor for purposes of federal securities law.”
Many larger service providers do not offer the option to negotiate their service agreements and will not entertain alternative written documentation that could accommodate the proposed reasonable assurance due diligence requirements, Bernstein.
But “even if advisers had negotiating leverage, it is hard to believe that service providers would voluntarily subject themselves to potential legal or regulatory liability ... by providing assurances that they will be involved in the adviser’s compliance efforts,” said Bernstein, who argued that it seems more likely that service providers will either decline to provide the service or charge a sufficiently high price to cover their added liability.
The likelihood that many or most service providers would forgo working with the advisory industry entirely is unlikely, but the proposal “would result in advisors not being able to find a provider for a service that the firm believes is in the client’s best interest,” she concluded.