Asset Management Insights - December 2016

December 2016


SEC Proposes Rule to Require Expanded and Improved Client Continuity and Transition Plans

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By Ignacio Griego and Kyle Clark

Since the 2008 financial crisis, investment advisers have seen increased scrutiny and focus on fiduciary duty and security from governing bodies such as the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, and Financial Industry Regulatory Authority. This trend has continued through 2016 as the SEC has proposed a new rule and rule amendments to the Investment Advisers Act of 1940 (the “Act”) pertaining to business continuity and transition plans in key areas for registered investment advisors (RIAs).

Rule 206(4)-4 would require RIAs to adopt written business continuity and transition plans “reasonably designed to address operational and other risks related to a significant disruption in the investment adviser’s operations.” Proposed amendments to Rule 204-2 introduce recordkeeping requirements for business continuity and transition plans currently in use or in use during the last five years.

The comment period for the proposal closed on Sept. 6, 2016.


Proposed Rule

Business continuity has already been addressed in a very general sense via Rule 206(4)-7 of the Act, otherwise known as the Compliance Program Rule. The Compliance Program Rule asks RIAs to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Federal Securities Law, including the Act. Prompted by real-life interruptions in service, such as those caused by Hurricane Sandy, the SEC reviewed a number of advisers’ existing business continuity plans and issued a risk alert with its findings and areas for improvement in August of 2013, noting numerous deficiencies and wide variances in specificity.

Although many advisers updated their plans in response to the risk alert, the SEC took their findings one step further by proposing Rule 206(4)-4. The proposed rule provides specific guidelines for business continuity and transition plans, mandating annual reviews as well as setting forth the five areas of criteria listed below:

1. Maintenance of Critical Operations – Investment advisers will need to identify and prioritize critical functions and protocols to ensure there are redundancies in place to maintain operations. The SEC defines critical operations as those necessary for prompt and accurate processing of securities transactions on behalf of clients as well as valuation and maintenance of client accounts, including delivery of funds and securities. Additionally, the proposed rule requires investment advisers to have a succession or contingency plan in place with respect to key employees who perform functions essential to critical operations and systems, taking into account the duration of their expected absence, whether temporary or permanent. Lastly, investment advisers are required to include policies and procedures to address data security, backup and recovery in both electronic and hard copy formats, as a significant disruption could render electronic data inaccessible.

2. Physical Locations – Following the Northeast Blackout of 2003 and Hurricane Sandy, the physical locations of many firms were rendered inaccessible or lost power. To help stymie future disruption to the financial markets, the SEC is placing additional focus on firms’ physical locations and facilities. Advisers will be required to have pre-arranged alternate physical locations where employees can meet to conduct business and have access to material data. Setting up alternate locations in different geographies is recommended to diminish the risk of overlapping natural disasters or issues.

3. Communication – An adviser’s plan will need to include descriptions of the processes and protocols in place to facilitate communications with regulators, service providers, clients, and other employees in the event of a disruption in service. The communication plan should also focus on how employees are informed of these interruptions and outline who is responsible in various situations.

4. Third Parties – The proposed rule requires identification and assessment of all third-party services that are critical to the operation of the adviser. Business continuity plans should consider day-to-day operational reliance on the service providers as well as the existence of any backup processes or alternative providers. Advisers should prioritize third parties that are most critical to the adviser’s continued operations, such as those that have direct contact with clients, maintain critical records or have access to clients’ personally identifiable information.

5. Transition Plans – Lastly, the proposed rule requires advisers to describe the transition plan in detail in the event of a possible wind-down (e.g., sale of substantially all of the assets and liabilities, selling certain business lines, orderly liquidation of fund clients or separately managed accounts, etc.). Advisers should also address transitions for both normal and stressed market conditions with consideration for all clients, contractual obligations, counterparties, service providers and regulators that they report to. Most importantly, advisers will be required to develop a plan that includes procedures to safeguard and distribute client assets, and promptly generate client-specific information necessary to the transition, including information regarding corporate governance structure, identification of any material financial resources available and an assessment of the applicable law and contractual obligations governing the adviser and its clients.


BDO Observations

The proposed rule and amendments demonstrate the SEC’s continued emphasis on fiduciary duty. Spurred by recent weather-related incidents that have had a lasting impact on operations as well as mounting fear of cyber-attacks, the SEC is mandating that firms plan ahead and attempt to preempt any breakdowns in services. Looking beyond the SEC’s annual review requirement, all advisers can benefit from a business continuity and transition plan that is a “living document” that evolves over time with the business and is regularly updated with personnel changes.

The SEC found in their review of some advisers’ plans that lapses often occurred when the primary individual responsible for a specific function or procedure was unavailable and their replacement hadn’t been informed of their responsibility as backup. Therefore, with every new hire and departure, firms should clarify the chain of command for all operations and ensure each employee understands his or her roles and responsibilities in the event of an emergency.

Furthermore, BDO suggests expanding the transition plan to cover unforeseen capital movements, especially for firms with separately managed accounts and open-ended vehicles. Addressing the following questions will not only ensure advisers are better prepared at the onset of these unexpected capital events, but also able to provide a well-planned and measured response to prospective investors:
  • What is the plan in the event of a departure of an anchor investor?
  • Are there additional untapped sources of capital that can be drawn upon quickly in the event of an adverse market turn or key investor departure?
  • What is the level of assets under management that will trigger a wind-down in operations or, if applicable, transition to other forms of operations, such as to a family office?
  • Are current systems capable of scaling in the event of unforeseen growth?