In Service of the Investor: Statement on Outsourcing by Investment Advisers

I am happy to support today’s proposed rule, which would establish certain minimum standards to which an adviser must adhere when they outsource core advisory duties to third parties. Outsourcing, a trend which appears to cross a variety of services and functions in the asset management space,[1] can introduce efficiencies in an adviser’s ability to carry out its functions. For example, service providers may give the adviser or its clients access to certain specializations that the adviser otherwise does not have in-house. Outsourcing may also have associated cost savings that can be passed along to investors.

But, when an adviser outsources certain functions, it can also open investors up to key vulnerabilities – vulnerabilities about which an investor may not even be aware.

There is, of course, risk of investor harm. Outsourcing to third party providers – who may not be subject to the duties imposed by the Advisers Act or U.S. securities laws (or any U.S. laws in the case of certain off-shore providers) – carries concomitant risk that sensitive investor information could be misused or lost; compliance gaps might enable fraudulent advisory activities; or, vendors could front-run investor opportunities, just to name a few. Along with state securities regulators, we have brought some key enforcement actions where inadequate oversight of third party providers has led to investor harm.[2]

In addition to the potentially heightened risk of investor harm, the use of a service provider can more generally reduce an adviser’s control of, or visibility into, the performance of core advisory functions.[3] It can lead to conflicts of interest, where the adviser’s goals in outsourcing certain functions and of reaping cost-savings may not be aligned with investor expectations about the advisory services being performed or the oversight of those services, among other potential conflicts of interest.[4] The potential misalignment between the expectations of clients and advisers, coupled with the lack of transparency, can lead to further moral hazard problems.[5]

Further, if an adviser is dependent on a service provider for a number of services, any disruption in the relationship could have widespread effects on the advisory services provided.[6] Or, if a third party provider is servicing wide swaths of the asset management industry, disruption could have systemic effects.[7]

These are just to name a few of the risks that may accompany outsourcing of key advisory functions. And, all of these risks may be exacerbated when the services being rendered are fundamental to the advice being provided, as is more and more often the case today – for example where an adviser subcontracts out portfolio management services to a sub-adviser, or where an index provider creates a bespoke index for a portfolio of assets.[8]

When an adviser outsources a core function, that adviser does not check its fiduciary duties at the door. In no uncertain terms, the onus is on the investment adviser to ensure that its obligations under the securities laws are fulfilled, even for those functions that it may outsource.

Further, it is a fair expectation of the reasonable investor that, where an investment adviser outsources functions necessary to the performance of its advisory services, there will be effective oversight over those services. As we say in the release, a lack of effective oversight under such circumstances “would be misleading, deceptive, and contrary to the public interest.”[9]

These are the issues that we address today. Where an adviser outsources certain covered functions necessary for its provision of investment advisory services in compliance with the securities laws, it must: perform crucial due diligence to reach the conclusion that outsourcing this function, to this service provider, is appropriate; engage in ongoing monitoring and oversight of the service provider’s performance; ensure that books and records attendant to the services are adequately maintained and available for inspection; and, disclose certain information on its Form ADV related to these service providers.

These requirements would go a long way to protecting investors and mitigating the risks attendant to these core outsourced relationships. I am looking forward to reviewing comment letters on this subject – and here are some things that I would ask commenters to consider:

• Today we are not requiring that advisers who outsource core functions have agreements in writing with their service providers. Is that in line with investor expectations?
• Additionally, should there be further disclosures relating to outsourcing, beyond the census-type data we propose to be listed in the Form ADV? For example, should we require additional, more specific disclosure of fees or expenses? And, do investors currently have adequate insight into the conflicts of interest that may be presented by the service provider relationships and services? What are investors’ expectations in these regards?

As always, I want to thank the staff. You have been busy and it has not gone unnoticed. And, although you have been immersed in a number of rulemaking efforts, there has been no sacrifice in the quality of your work product or the insightful nature of your advice and comments. Many thanks to the teams from the Division of Investment Management, the Division of Economic and Risk Analysis, the Office of the General Counsel, and the staff in the Chair’s Office.