SEC Turns Spotlight On Advisors' Outsourcing

Tom Burroughes Group Editor 31 October 2022

SEC Turns Spotlight On Advisors' Outsourcing

The regulator, which wants to force Registered Investment Advisors to ensure that all outsourced functions meet minimum due diligence requirements, has warned of risks, including conflicts of interest, unless changes are made. Outsourcing has been a strong trend in wealth management.

The Securities and Exchange Commission has drawn political heat for its busy rulemaking and agenda but appears in no mood to slow down. One of the regulator’s latest moves is to propose that RIAs cannot outsource certain services and functions without carrying out due diligence, and monitoring service providers.

The SEC said it proposed a new rule under the Investment Advisers Act of 1940 to ban RIAs from outsourcing certain services or functions without first “meeting minimum requirements.”

“There is a risk that clients could be significantly harmed…when an advisor outsources to a service provider a function that is necessary for the provision of advisory services without appropriate advisor oversight,” the SEC said in a 232-page document (ref 17 CFR Parts 275 and 279).

With many multi-family offices structured as RIAs and regulated by the SEC (in contrast to single-family offices), the change will impact a part of the family offices sector along with advisors more generally. 

“The risk is in addition to any risks that would exist from the advisor providing these functions and should be managed. For example, a significant disruption or interruption to an advisor’s outsourced services could affect an advisor’s ability to provide its services to its clients,” it said.

“Outsourcing a service also presents a conflict of interest between an advisor providing a sufficient amount of oversight versus the costs of providing that oversight or the cost of the advisor providing the function itself. Poor oversight could lead to financial losses for the advisor’s clients, including through market losses and as a result of increased transaction costs or the loss of investment opportunities,” the regulator said.

Family Wealth Report, sister news service to this one, regularly covers stories of how breakaway teams of brokers and bankers quit to form independent RIAs, and have to outsource many of the functions which their old employers would have provided. A major decision is what to outsource and what to do in-house. As compliance costs have risen, along with client demands, the attractions of outsourcing have increased. The same dynamic applies to family offices, trusts and other entities – and not just in the US. Around the world, firms have looked at outsourcing as a way to handle costs and complexity. 

The SEC said in its consultation paper that as advisors seek to meet increasingly complex client demands and access to new asset classes, they are battling to do this efficiently. The scale of the sector is now vast: the SEC estimates that regulatory assets under management (“RAUM”) have increased from $47 trillion to $128 trillion over the past 10 years; while RAUM managed for non-high net worth advisory clients have increased from approximately $3.7 trillion to approximately $7 trillion.

“Many advisors are adapting to the changes discussed above by engaging service providers to perform certain functions. In some cases, service providers may support the investment advisor’s advisory services and processes. Supporting functions may include, for example, investment research and data analytics, trading and risk management, and compliance,” the SEC noted.

The SEC warned that outsourcing has the “potential to defraud, mislead or deceive clients.” It said outsourcing necessary advisory functions could have a “material negative impact on clients, such as: inaccurate pricing and performance information that advisory clients rely on to make decisions about hiring and retaining the advisor and that advisors rely on to calculate advisory fees; compliance gaps that enable fraudulent, deceptive or manipulative activity by employees and agents of such service providers to occur or continue unaddressed; or poor operational management or risk measurement that leads to client losses.”

The SEC said a service provider’s major technical difficulties could prevent an advisor from executing an investment strategy or accessing an account. Sensitive client information and data could be lost and damage clients, or client holdings or trade order information could be negligently maintained by a service provider and misused by the service provider’s employees or other market participants in trading ahead or front-running activities. 

Orion Advisor Solutions, a firm working with RIAs over outsourced functions, commented on the SEC move.

“Orion is reviewing the SEC proposal in detail so we can best support our advisor clients as they work to understand the rule. We will continue to review the proposed rule and monitor its progression as it advances through the process,” Kylee Beach, general counsel, Orion Advisor Solutions, said.

"Orion encourages all fiduciary advisors to perform appropriate due diligence on their service providers. Our perspective is that outsourced wealthtech can help advisors focus on their clients’ needs and fulfill their fiduciary responsibilities by maximising their time and leveraging technology to help ensure confidence in the decisions they are making and in the services they are providing to their clients," Beach said.

The SEC, under chairman Gary Gensler, has been chided for its surge of new rules and initiatives, which are reportedly said to be imposing heavy burdens on staff and causing increased staff turnover. The SEC Office of Inspector General noted that the volume of rulemakings on the SEC agenda increased by nearly two-thirds between spring 2017 and 2022. Gensler is arguably moving fast to get new rules on the books ahead of the November mid-term elections, particularly if Democrats lose control of Congress, frustrating his agenda.

Proposed rule
The SEC said the proposed rule would require advisors to “conduct due diligence prior to engaging a service provider to perform certain services or functions. It would further require advisors to periodically monitor the performance and reassess the retention of the service provider in accordance with due diligence requirements to reasonably determine that it is appropriate to continue to outsource those services or functions to that service provider.”

“We also are proposing corresponding amendments to the investment advisor registration form to collect census-type information about the service providers defined in the proposed rule. In addition, we are proposing related amendments to the Advisers Act books and records rule, including a new provision requiring advisors that rely on a third party to make and/or keep books and records to conduct due diligence and monitoring of that third party and obtain certain reasonable assurances that the third party will meet certain standards,” it said.

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