Dec. 26, 2022
December 26, 2022 I am writing to provide my personal comments with respect to the proposal by the Securities and Exchange Commission (Commission) to adopt a new rule under the Investment Advisers Act of 1940 (Advisers Act) to prohibit registered investment advisers (advisers) from outsourcing certain services or functions without first meeting minimum requirements. By way of background, I previously served as Californias Commissioner of Corporations, Interim Savings Loan Commissioner, and Deputy Secretary and General Counsel to the California Business, Transportation Housing Agency. I am a lawyer in private practice and have taught classes in Securities Regulation at the University of California, Irvine School of Law. I served as a member of the California Senate Commission on Corporate Governance, Shareholder Rights and Securities Transactions. I am a former co-chairman of the Corporations Committee of the Business Law Section of the California State Bar. I am a practice consultant to the leading treatise on California Securities Law Practice Under the California Securities Laws. I am writing in my personal capacity and not on behalf of any client or institution. 1. The Comment Period Is Inappropriately Brief. If adopted, the new rule would impose major new obligations on advisers. The release proposing the rule, Release Nos. IA-6176, (Release) includes 101 separate questions (many with subsidiary questions). The comment period ends in December, a month with several major religious holidays. Accordingly, the 30 day comment period will have the effect of limiting public comment and input. 2. The Commission Provides No Evidence Of An Increase In Outsourcing or Issues Related Thereto. The Commission claims to have observed an increase in such outsourcing and issues related to the outsourcing and advisers oversight. The Release elsewhere refers to the increase in the use of service providers. However, the Release is devoid of any data evidencing an increase in outsourcing by advisers. More specifically, the Release does not disclose over what period the Commission observed an increase or the amount of the observed increase. Moreover, the Commissions claim to have observed an increase is undermined by its own admissions in the Release. For example, the Commission admits that it has limited visibility into advisers outsourcing and thus the potential extent to which advisory clients face outsourcing-related risks and that it currently collects only limited information about an advisers use of certain service providers (emphasis added). If the Commission has limited v isibility as it claims, how was it able to observe an increase in outsourcing. The failure to provide creditable data undermines the very premise for the proposed rule changes and the Commissions economic analysis. The Administrative Procedure Act requires that the Commission articulate a rational connection between the facts found and choice made. Burlington Truck Lines, Inc. v. U.S., 371 U.S. 156, 158 (1962). Accordingly, adoption the proposed rule on the basis mere speculation would be arbitrary, capricious and an abuse of discretion within the meaning of 5 U.S.C. 706(2)(A). 2. The Commissions Proposed Definition of Covered Function Is Unclear Because The Reasonably Likely Standard Is Undefined And Undefinable. Proposed rule 206(4)-11(b) would adopt a two-part definition of covered function. The second part proposed by the commission would be if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the advisers clients or the on the advisers ability to provide investment advisory services. Significantly, the proposed rule does not define the term \"reasonably likely\". The likelihood that an event will occur (i.e., its probability) is simply a measure of the expectation that it will occur. A probability is neither reasonable nor unreasonable, it simply is. It is complete nonsense to say that an event is reasonably likely. Tellingly, the example provided in the Release fails to provide any meaningful guidance with respect to reasonableness: For example, if an adviser used a service provider for po rtfolio management functions that experienced a cyber-incident that caused an inability for the adviser to monitor risks in client portfolios properly, it would be reasonably likely to cause a material negative impact on the advisers clients and its ability to provide investment advisory services. This example simply posits that the performance failure will prevent the adviser from properly monitoring risks. Thus, the example illustrates only that when an event occurs it is reasonably likely to have occurred. 3. The Phrase Material Negative Impact Is Unclear. As proposed, it is unclear whether the material negative impact is to be determined with respect to a specific client or all of the clients of the adviser in the aggregate. Clients are likely to vary in size. Consequently, the impact of a failure may be inconsequential to a large client and consequential to a small client. 4. The Commission Does Not Provide A Rational Reason For Excluding Certain Functions. According to the Release, the Commission is proposing to impose due diligence and monitoring obligations on advisers as a means reasonably designed to prevent fraudulent, deceptive, or manipulative acts, practices, or courses of business within the meaning of section 206(4) of the Advisers Act . . .. However, the Commission is proposing to exclude certain functions, such as lease of commercial office space or equipment, use of public utility companies, utility or facility maintenance services, or licensing of general software providers of widely commercially available operating systems, word processing systems, spreadsheets, or other similar off-the-shelf software. The failure of these excluded functions could negatively impact on the advisers ability provide investment advisory services. Yet, the Commission does not explain why the failure to investigate and monitor these functions is not frau dulent, deceptive, or manipulative. As a result, the Commissions proposed classification is arbitrary, capricious and an abuse of discretion with the meaning of 5 U.S.C. 706(2)(A). 5. The Commission Should Not Require Written Agreements. The Commission has requested comment on whether it should require written agreements with service providers. The Release fails to provide any evidence that advisory clients have been harmed in the absence of such a requirement. Indeed, the Release notes that Based on staff experience, it is customary business practice for advisers to enter into written agreements with service providers that are performing a covered function. Accordingly, the adoption of a requirement that advisers enter into written agreements with service providers or to require disclosure on Form ADV would be arbitrary, capricious and an abuse of discretion within the meaning of 5 U.S.C. 706(2)(A).