SEC Guidance for Investment Adviser Due Diligence When Using Services Providers

July 10, 2012

Due diligence can be defined as the level of judgment and care a reasonable person would take before entering into an agreement or transaction.  As part of an effective compliance program investment advisers must conduct due diligence not only when selecting investments for clients but also when outsourcing services to third-party service providers.   The importance of outside service provider due diligence was discussed as an examination focus area by the  U.S. Securities and Exchange Commission (“SEC”) during their 2009 CCOutreach Regional Seminars.   During the seminar, the SEC noted that “advisers should review each service provider’s overall compliance program for compliance with the federal securities laws and should ensure that service providers are complying with the firm’s specific policies and procedures.”  During a routine examination,  SEC examiners will  “review an adviser’s disclosures, contracts with clients, and contracts with service providers to determine whether the services and reporting obligations are consistent with disclosures and that all obligations are adequately addressed and overseen by the adviser.”

The SEC went on to state that due diligence requires that investment advisers outsourcing services investigate and examine the service providers to ensure they are following securities laws and complying with their agreement.  Signs that an investment adviser is deficient in its due diligence include “failing to adopt or maintain policies and procedures relating to the firms’ use of service providers; inadequate oversight of services providers; and/or failing to disclose any affiliations and related conflicts of interest related to the use of a service provider.”

SEC examiners also look at whether “the investment adviser represents that the service provider is independent when, in fact, the firms are under common control or otherwise have a close connection that should be disclosed, the investment adviser periodically verifies that the fees deducted from client accounts are consistent with contractual terms, and if the investment adviser recommends other managers to clients, does the adviser have policies and procedures regarding researching and monitoring separate account managers and mutual funds.”

Due diligence should not be completed on a one-time basis, but investment advisers should regularly investigate and review their service providers. Some examples of due diligence the SEC has observed from investment advisers include:

  • Periodically reviewing the qualifications and oversight capabilities with respect to the specific services that the adviser has delegated to the service provider
  • Evaluating the effectiveness of the reports prepared by the service provider for the adviser and the appropriateness of the frequency with which the reports are produced
  • Ensuring that the service providers are performing all contracted functions
  • Verifying that its service providers are aware, compliant, and current with regard to the federal securities laws and firm policies and procedures
  • Making periodic on-site visits to the service provider’s facilities to view operations in action

If your firm has questions on how to meet its fiduciary duty to perform due diligence on third-party service providers, Jarrod James – Vice President and Senior Compliance Consultant with RIA Compliance Consultants, Inc. and Michael Forker – Compliance Consultant with RIA Compliance Consultants, Inc., will be presenting their webinar, “Conducting Service Provider Compliance Due Diligence,” on July 12, 2012, at 12:00pm CDT.   Please register online for the webinar or you can contact us to set up a time to speak with one of our compliance consultants.

Posted by Bryan Hill
Labels: Due Diligence, SEC, Webinar