Investment advisers registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 have generally included as part of their compliance policies and procedures "business continuity plans" intended to mitigate the risks of business disruptions, and to protect client interests from being placed at risk as a result of situations adversely impacting the ability of the adviser to provide continuing advisory services. Such plans and procedures to a lesser extent may also address transitioning the management of client portfolios to another investment adviser if necessary. Concerned, however, that investment adviser plans and procedures in place vary widely, and some are not sufficiently robust to address and mitigate operational risks to which clients may be subjected in times of stress and business disruption, on June 28, 2016 the U.S. Securities and Exchange Commission (SEC) announced a rule proposal to require all SEC registered investment advisers to adopt and implement written business continuity and transition plans that include certain specific components in order to facilitate robust business continuity and transition planning. As for transition planning, the proposed rule would mandate that advisers have a plan of transition that specifically accounts for the possible winding down of the adviser's business, or the transition of the adviser's business to others, in the event the adviser is unable to continue providing advisory services.
The Rule proposal, which now proceeds to a comment period, has implications outside the asset management industry. For example, investment fiduciaries who regularly engage investment advisers and managers, such as trustees for ERISA plans or private foundations, should also take note. As part of their fiduciary responsibilities in selecting and monitoring outside advisers, investment fiduciaries must be aware of their advisors' business continuity and transition plans and, if the proposed SEC rule becomes final, be in a position to assess the content and effectiveness of those plans relative to their own requirements and expectations in the event of a disruption in their advisers' operations.
THE SEC RULEMAKING PERSPECTIVE
The newly proposed rule is part of a larger on-going SEC initiative aimed at modernizing and enhancing regulatory safeguards for the investment management industry, which today includes some 12 million investment advisers registered with the SEC that collectively manage over $67 trillion in assets. Although SEC registered investment advisers range from small financial services firms to the largest institutional asset managers, the SEC has concluded that all investment advisers, regardless of size and scope of operations, generally share certain fundamental operational risks arising from internal and external business continuity events. Such operational risks, as observed by the SEC Staff, include technological failures with respect to systems and processes, and the loss of adviser or client data, personnel, or access to the adviser's physical location(s) and facilities. Investment advisers with insufficiently robust planning have experienced interruptions in their key business operations and inconsistently maintain communications with clients and employees during periods of stress. The overall concern is that all SEC registered investment advisers must have operational procedures and policies that manage the risks associated with business continuity and transitions and increase the likelihood that clients are not harmed in the event of a significant disruption in their adviser's operations.
The root of the proposed SEC Rule requiring business continuity and transition plans is the fiduciary duty of investment advisers to their clients. As assessed by the SEC, an adviser's fiduciary obligations require it to take steps to protect its client interests from being placed at risk as the result of the adviser's inability to provide advisory services. The SEC reasons that the long recognized fiduciary duty of an investment adviser to act in the best interests of a client means that the adviser must safeguard the client's assets as appropriate, and certainly in times of stress. An adviser who is unable to provide continuing services after an event such as a technology failure, or natural disaster may put client interests at risk, and prevent the adviser from meeting its fiduciary obligations. The SEC notes, for example, that such risk could include the risk of loss if an adviser lacks the ability to make trades in a portfolio, or is unable to receive or implement directions from clients. A summary of the proposed Rule follows.
SUMMARY OF THE PROPOSED RULE
The newly proposed SEC Rule --Rule 206(4)-4 under the Investment Advisers Act of 1940-would make it unlawful for an SEC registered investment adviser to provide investment advice unless the adviser adopts and implements a written business continuity and transition plan, and reviews that plan at least annually. As proposed, the requisite business continuity and transition plan must be composed of policies and procedures reasonably designed to address the operational and other risks related to a significant disruption in the investment adviser's operations, specifically including:
- Business continuity after a significant business disruption; and
- Business transition in the event the investment adviser is unable to continue providing investment advisory services to clients.
The plan, to be based on risks particularly associated with the adviser's operations, must specifically address:
- Maintenance of critical operations and systems, and the protection, backup, and recovery of data, including client records;
- Pre-arranged alternate physical location(s) of the adviser's office(s) and/or employees;
- Communications with clients, employees, service providers, and regulators;
- Identification and assessment of third-party services critical to the operation of the adviser.
The required plan of transition must account for the possible winding down of the investment adviser's business or the transition of the investment adviser's business to others in the event the investment adviser is unable to continue providing investment advisory services, and must include:
- Policies and procedures intended to safeguard, transfer, and/or distribute client assets during transition;
- Policies and procedures facilitating the prompt generation of any client-specific information necessary to transition each client account;
- Information regarding the corporate governance structure of the adviser;
- The identification of any material financial resources available to the adviser; and
- An assessment of the applicable law and contractual obligations governing the adviser and its clients, including pooled investment vehicles, implicated by the adviser's transition.
The proposed rule mandates a review of the plan, at least annually, for adequacy and effectiveness of its implementation. In addition, the proposed rule would mandate specific books and records to be maintained by the investment adviser:
- A copy of the investment adviser's business continuity and transition plan formulated in accordance with the new rule that is in effect, or at any time within the past five years was in effect; and
- Any records documenting the investment adviser's annual review of the business continuity and transition plan.
PROCESS AND LOOKING AHEAD
The proposed Rule has been published, with an initial 60-day period during which comments may be submitted to the SEC. There is no projected timetable as to when a final rule would be adopted. As noted earlier, many if not most SEC registered investment advisers already have business continuity plans included as part of their compliance policies and procedures, although that is not so common with specific transition plans. The newly-proposed business continuity plan requirement should not impose a significant burden as advisers review and revamp their existing plans to conform to the specific content requirements of the proposed Rule. However, transition plans pose more of a challenge.
In proposing the Rule, the SEC has expressly stated that it does not propose that investment advisers adopt "resolution plans" or "living wills" as those advance planning requirements came into being for certain financial institutions under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Also, in proposing the transition plan requirement, the SEC notes that in the normal course of business advisers have routinely transitioned client accounts without any significant impact to themselves, their clients, or the financial markets. The SEC further notes that some "non-routine disruptions" at large advisory businesses that have resulted in transitions to new advisers or new ownership have proceeded without adverse impacts. Nevertheless, the SEC references several instances in which transitions of funds under stress were not seamless or without problem. Accordingly, the SEC believes that proper planning for possible distress and other significant disruptions in an adviser's operations is essential so that, if an entity has to exit the market, it can do so in an orderly manner, with minimal or no impact to its clients.
Transition plans will obviously be tailored to the particular adviser, the scope of its business and the unique attributes of its advisory clients. Methods by which an adviser chooses to exit the business and transition clients will also vary. In the end, the main focus in formulating a transition plan may be, as the SEC suggests, assessing and planning for potential impediments associated with whatever method may be undertaken and mitigating potential negative effects on clients. The uncertainty associated with such planning will likely be fodder for comments on the proposed Rule.
The SEC also stresses that, due to increased use of third party service providers, such as custodians, brokers and dealers, pricing services and technology vendors, advisers should also ensure that their outside service providers maintain adequate business continuity and transition plans. Likewise, trustees for ERISA plans and private foundations, who have fiduciary responsibilities in selecting and monitoring outside advisers and investment managers, should be attuned to the proposed requirements and be prepared to review their advisers' plans as part of their normal due diligence and review processes.