SEC approves clawback, reporting rules, gets pushback on outsourcing

Nov. 2 meeting will add more new rules to last week's proposal defining oversight of third parties critics said is  extraneous, possibly damaging to obligations under fiduciary duty

A week after an Inspector General report warning that even the SEC might not be able to keep up with the pace of its own regulatory agenda, the commission added more rules to an already long list and announced plans to do the same again this week.

During its open meeting Nov. 2, the SEC will tap the gas rather than the brake by considering final approval of a rule requiring enhanced reporting of proxy votes by investment companies that was first proposed in 2010.

They will also consider another brand-new set of rules defining how to approach liquidity and dilution management for open-end funds. The proposal includes swing pricing and other pricing changes that generated significant pushback when similar requirements were included in a money-market reform proposal posted in December.

Those additions will follow the final approval commissioners gave Oct. 26 to two pending sets of rules, one allowing the clawback of executive compensation following financial restatements, and the other requiring a more user-friendly set of performance reports aimed at consumers. They also approved a new proposal for rules defining how fund advisers should supervise the work of third parties offering critical services to the fund.

The new outsourcing rule proposal was approved for its initial round of public comment despite complaints from Commissioners Hester Peirce and Mark Uyeda that the new rule simply repeats existing regulations and staff guidance that make clear that fund advisers are responsible for oversight of a third-party’s work because the adviser’s fiduciary duty extends to work done by outsiders on behalf of the fund.

The proposal laid out specific due-diligence requirements for advisers to follow before selecting a service provider and to provide oversight that would guarantee both the provider’s work and record-keeping are adequate for the few critical functions considered important enough to be covered, according to the proposal announcement.

The SEC made recommendations to ensure that advisers continue to meet their obligations, but the new rule takes an extra step “designed to ensure that advisers’ outsourcing is consistent with their obligations to clients,” according to a statement from SEC Chair Gary Gensler.

Third parties provide critical services much more often than was the case in the past, which increases the need to ensure that the work of those firms is being supervised to an appropriate level, though which services qualify as critical depends enough on individual circumstances that regulators should rely on the judgment of advisers to identify which specific services should be covered, Gensler said.

Pushback to outsourcing rule

That explanation justifies the proposal of a new rule by acknowledging that it simply repeats requirements that have been well established elsewhere, making the rule being proposed completely extraneous, Peirce said.

“What precisely is the problem that we’re trying to correct?” Peirce asked during her response during the Oct. 26 meeting. “Are we aware of widespread investor harm due to advisers not overseeing their service providers?”

The regulation aims to create a minimum standard defining the type of oversight and recordkeeping that would be acceptable to the SEC.

“They are asking that minimum standards be adhered to rather than leaving it up to advisers,” Godin said.

The rule makes clear, however, that fund advisers should have a set of policies to follow that demonstrates appropriate oversight of the services and recordkeeping of third parties, which is almost certain to become one of the policies SEC examiners look for while evaluating a firm’s compliance efforts, said Laurence Godin, national practice lead for asset and wealth management at KPMG US, said during an Oct. 31 webinar focused on the Oct. 26 rule changes.

The rule is likely to add to confusion about oversight procedures rather than reduce it, Commissioner Uyeda said during his response.

The rule applies to “covered functions,” which it defines as one that is necessary to comply with federal securities laws, but this definition leaves fund advisers the task of identifying which functions are critical enough to be covered, he said.

Examples provided to show how the proposed rules would improve existing procedures cite recordkeeping failures that don’t involve third parties at all, or that involve simply a delay in providing records held by a third party in response to an SEC inquiry – without any explanation of how either situation would be improved under the proposed guidelines, Uyeda said.

“It’s clear that the SEC is concerned about the importance of oversight as it relates to registered investment advisers, but most RIAs have a fairly robust oversight system in place, at least for material outsourcing providers, according to Matthew Giordano, deputy lead partner in the public investment management practice at KPMG US.

“That may not be as true of smaller firms, and it’s not clear whether recordkeeping with third parties is as consistently tight as oversight,” Giordano said. “The examples cited in the rule about enforcement have to do with RIAs that couldn’t come up with records as quickly as the SEC would have liked because outsourcers were keeping the records, which could become a problem under this rule.”

Imposing a duplicative rule could prove destructive to effective regulation rather than simply confusing, Peirce said. One risk could be that it undermines the obligation inherent in an adviser’s fiduciary duty and replaces it “with our predefined approach to best interest – one that is not responsive to unique facts and circumstances,” Peirce said.

“We’re incrementally displacing their judgment with our own. It’s neither statutorily grounded nor protective of investors,” she said.

The commission appears to have sufficient authority to address the question of fund-adviser oversight of third parties, but not nearly a good enough reason to do so, according to a response from a spokesperson at the Investment Company Institute (ICI).

“The proposal seems to be unnecessary, and instead of providing investors additional protections, will result in complicated and costly regulatory overload, which is not in investors’ best interests,” the spokesperson said.