Outsourcing has become a buzzword in the investment advisory industry. I have had many RIA firms tell me that they have outsourced bot their compliance and wealth management functions, allowing them to concentrate solely on marketing and gathering assets. In the words of noted ESPN football analyst Lee Corso… not so fast my friend.
Outsourcing may be an appropriate and strategy if one lacks the ability to perform the function being outsourced. However, the idea that the entity outsourcing the function has no ongoing responsibility is completely wrong, and leaves the outsourcing to all kinds of serious legal consequences.
With regard to the outsourcing of compliance duties, regulators have made it clear that entities who outsource their compliance duties still have a duty to monitor such third-parties and remain ultimately liable for their firm’s compliance with all applicable rules and regulations. Back in the 90’s, the NASD addressed this issues with regard to the popular OSJ system used by most indie broker-dealers, where one OSJ may have the responsibility of supervising 100 or more registered representatives in various offices. The NASD addressed these issue in Notice to Members 99-45, which essentially required indie broker-dealers to make drastic revisions in their supervisory programs to provide more meaningful field supervision of their brokers.
Two of the primary concerns with regard to the outsourcing of compliance duties has to do with the qualifications and experience of the third-party to whom the compliance duties are being outsourced and the lack of on-site supervision by the third-party. The qualifications and experience issue speaks for itself. The fact that most third-party compliance providers are not actually on-site has always raised concerns as to just how effective their compliance oversight can be, especially if they are providing such services to a large number of firms and brokers.
Outsourcing of wealth management responsibilities raises a number of potential issues, including possible double-dipping and quality control monitoring and supervision. Double-dipping refers to a situation where an investment advisory firm represents and contracts with a client to personally mange their asses, but instead outsources the actual management to a third-party.
Given the fact that the advisory firm is not actually managing the client’s assets, the advisory firm should reduce its fee accordingly to account for the actual management by the third-party. An obvious way for the advisory firm to address this issue is the modify their advisory contract to specify exactly what services they are, and are not, providing. Failure to do so could result in liability based on various grounds, including fraud, breach of fiduciary duty, and breach of contract.
Another issue with regard to outsourcing of wealth management duties has to do with the advisory firm’s fiduciary duty to provide ongoing monitoring of the third-party to whom the wealth management services were outsourced and, if necessary, to replace the third-party and, if necessary, to sue the third-party for damages. These ongoing duties are based primarily on the fact that clients generally select fiduciaries on the trust that they have in the person or entity. As a result, the law, while allowing outsourcing, requires the original fiduciary to keep ultimate responsibility for the management of the client’s account.
So to answer the original question, in many ways outsourcing is nothing more than a placebo since the advisory firm still has ultimate responsibility for proving ongoing services to ensure that the account is properly handled and, if not, the advisory firm can be held liable for violations of their fiduciary duty. If a client contracts directly with a third-party wealth management firm, then the advisory firm may not be liable for mismanagement by the third-party, but could still possibly be held liable for their recommendation of the third-party based on a failure to properly conduct due diligence on the third-party.
Both the NASD and FINRA have both recognized the potential issues with outsourcing. In NASD Notice to Members 05-48 and FINRA Regulatory Notice 11-48, the regulators addressed such issues. FINRA proposed a new rule, Rule 3190, to set out the requirement for the outsourcing of legal responsibilities. While the Rule has never been enacted and investment advisers and their advisory representatives may not be subject to FINRA, the Notices provide useful guidelines for investment advises of issues to address to avoid unnecessary liability exposure.