Investment Advisers and Outsourcing

Outsourcing is definitely one of the hot topics with investment advisers.  Most investment advisers I talk to about outsourcing feel that outsourcing asset management and/or compliance responsibilities will allow them to concentrate more on building up their assets under management and, consequently, their fees.

While outsourcing may allow an  investment adviser to concentrate more on asset gathering, advisers need to realize that outsourcing certain responsibilities does not relieve them of their ongoing fiduciary duties in connection with such duties.  Since fiduciary duties are personal in nature, an investment adviser cannot simply delegate fiduciary responsibilities to another and walk away. 

First of all, a fiduciary has a legal duty to monitor third parties to whom the adviser has delegated responsibilities to protect the client against unauthorized or unsuitable activity.  Furthermore, an investment adviser has a duty to redress any harm caused to a client as a result of such improper activity, including an obligation to sue the offending third-party if necessary. 

What many investment advisers do not understand is that third-party assets managers often include language in their master advisory contracts with investment advisers that states that the investment adviser, not the third-party asset manager, remains liable for the suitability of the third-party asset manager’s programs.  On more than one occasion I’ve had the unfortunate duty to tell investment advisers that such language was hidden in the master contract and that they faced liability for not continuing to monitor the client’s account.  Proactive investment advisers who take the time to review such contracts or have such contracts reviewed by an attorney can often negotiate to have such language removed, as asset managers will rarely walk away from potential accounts.

As a former RIA compliance director at one of the largest  nation’s largest independent broker-dealers, I am often asked about outsourcing compliance responsibilities.  First, I’m not sure that such would be acceptable by the SEC, FINRA or state regulators in light of the Royal Alliance decision several years ago.  The decision basically raised issues regarding the ability of a broker-dealer to provide effective compliance oversight to a large network of branch offices spread out over the entire country.  Two of the issues raised by the regulators were the ability to supervise daily activity without having an actual physical presence in the respective branch offices and the sheer number of representatives being supervised.

Assuming that a compliance outsourcing system can be created that would be acceptable to the regulators, investment advisers need to understand that in the event that the third-party compliance provider makes an error, the investment adviser would most likely still have ultimate responsibility for such a mistake, as the courts and the regulators have consistently held that advisers who choose to outsource advisory responsibilities do so at their own risk, regardless of the terms of their contract with the third-party provider.

The bottom line is that outsourcing is yet another example of caveat adviser, another area of investment adviser law where being proactive is the sound course of action.  Taking the time to consult with someone experienced and knowledgeable in investment adviser law can help an adviser protect both their practice and their clients.

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