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SEC Wants a Higher Hurdle for RIAs’ Use of Third Parties

In the SEC proposal, RIAs would not be allowed to outsource to third parties unless they meet certain new requirements; some say the rule would be an extra burden for smaller advisors.

Registered investment advisors who outsource certain client-specific functions, like portfolio allocations, trading and investment management, to outside vendors are coming under greater scrutiny. If a new rule proposed by the Securities and Exchange Commission gets passed, RIAs will not be allowed to outsource to third parties unless they meet new requirements, including proof of a thorough due diligence process, ongoing monitoring and disclosure of the vendors used by the RIAs.

“Though investment advisors have used third-party service providers for decades, their increasing use has led staff to make several recommendations to ensure advisors that use them continue to meet their obligations to the investing public,” SEC Chair Gary Gensler said in a statement. “When an investment advisor outsources work to third parties, it may lower the advisor’s costs, but it does not change an advisor’s core obligations to its clients. Thus, today’s proposal specifies requirements for investment advisors designed to ensure that advisors’ outsourcing is consistent with their obligations to clients.”

The proposal lays out four requirements for investment advisors; first, that they must show they have a due diligence process for selecting third-party vendors prior to outsourcing any “covered functions,” and that they periodically monitor third-party performance. Second, advisors would be required to maintain ongoing books and records related to that oversight, and third, there would be a requirement on Form ADVs to provide "census-type" information about all third-party vendors.

Finally, if the RIA uses third-party providers for record-keeping, the RIA has to show they've conducted adequate due diligence in the selection process and provide ongoing monitoring for those vendors to make sure they meet "certain standards."

Covered functions “can include providing investment guidelines, portfolio management, models related to investment advice, indexes or trading services or software,” the SEC stated. Custodians, which are retained through a written agreement directly with the client, would not be covered under the proposed rule.

In a statement on the new rule, Karen Barr, president and CEO of the Investment Adviser Association, said the proposed rules were “overly burdensome and prescriptive.”

“The proposal is also not adequately tailored to the range of firms it covers, including smaller advisors,” she said. “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.”

SEC Commissioner Hester Peirce said she did not support the rule-making, and argued that it was a solution looking for a problem and simply a repackaging of “existing fiduciary obligations into a new set of prescriptions for investment advisors.”

“Reducing the fiduciary duty to a set of prescriptions could undermine investor protection,” she said, in a statement. “Standing alone, the fiduciary duty requires one to act in the client’s best interest at all times. If the rule intends to define what constitutes the client’s best interest, the definition quite naturally will lead to exclusion of other alternatives. The rule thus may end up abrogating fiduciary duty and replacing it with our predefined approach to best interest—one not responsive to unique facts and circumstances.”

Peirce also points out the effects it could have on smaller advisors, who are already stretched thin on compliance resources. The rule will likely cause costs of third-party services to increase, and some advisors may no longer be able to afford the services, she said.

“Forcing strapped smaller advisors to DIY functions perhaps better performed by third parties is a recipe for investor harm, not investor protection. Other small advisors may consolidate in pursuit of economies of scale. With each new regulatory burden, we make it harder for small advisors to compete. If we insist on pursuing this regulatory initiative, we should carve out smaller advisors.”

A research report, done in conjunction with FlexShares, the ETF division of Northern Trust, earlier this year, found that 32% of RIAs outsourced investment management in 2022, up from 27% in 2020. On average, RIAs outsource about 50% of their assets under management, compared with 39% for independent broker/dealers. “This increased adoption may be a function of business size. As RIAs tend to be smaller enterprises, many need greater external support amid recent market disruptions,” the report said.

The SEC proposal will undergo a public comment period, which will either be 60 days after the publication on the SEC’s website or 30 days from the publication in the Federal Register, whichever is longer.

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