4.............................................            6           33
5.............................................            5           37
6.............................................            6           40
7.............................................            6           51
8.............................................            6           61
9.............................................            5           73
Largest.......................................            2           88
------------------------------------------------------------------------
Source: Form ADV, Part 1A, Item 1J(2) and 1L. The table shows the within-
  size-decile percentage off all RIAs. Item 1J(2) may undercount the
  Chief Compliance Officer figure since it excludes those employed by a
  registered investment company. Item 1L may overcount the Record
  Keeping estimate since it does not exclude branch offices. All data
  reflects updated records as of July 2022.

    Table 6 below provides further information on the extent to which
adviser use of service providers varies across advisers as a function
of the type of client to which the registered investment adviser
attributes a majority of their RAUM.

 Table 6--Adviser Use of Additional Service Providers by Majority Client
                                  Type
------------------------------------------------------------------------
                                               Chief
               Client type                  compliance    Record keeping
                                            officer (%)         (%)
------------------------------------------------------------------------
High net worth individuals..............               4              30
Pension and profit-sharing plans........               5              44
Banking or thrift institutions..........               7              42
Charities...............................               4              54
Other investment advisers...............               9              45
Investment companies....................              13              68
State/municipal entities................               5              62
Pooled investment vehicles..............               5              76
Non-high net worth individuals..........               6              32
Foreign institutions....................               0              76
Business development companies..........              19              79
Insurance companies.....................               8              67
Corporations............................               6              48
Other client types......................              15              55
------------------------------------------------------------------------
Source: Form ADV, Part 1A, Item 1J(2) and 1L. Item 1J(2) may undercount
  the Chief Compliance Officer figure since it excludes those employed
  by a registered investment company. Item 1L may overcount the Record
  Keeping estimate since it does not exclude branch offices. All data
  reflects updated records as of July 2022.

3. Applicable Law Impacting Use of Service Providers
    Advisers who use service providers, whether a related-person or
third-party service provider, may currently conduct activities related
to each of the proposed obligations, such that varying degrees of due
diligence, risk mitigation and management, monitoring, recordkeeping,
and other oversight-related activities may already occur in the
marketplace. Certain advisers may currently conduct some or all of the
proposed activities to satisfy a variety of legal requirements.\140\
---------------------------------------------------------------------------

    \140\ In addition to regulatory requirements, advisers may
already currently conduct some or all of the proposed activities
solely as a matter of good business practice.
---------------------------------------------------------------------------

    First, an adviser who has outsourced a function to a service
provider remains liable for its obligations, including under the
Advisers Act or other Federal securities laws.\141\ Advisers' fiduciary
duty comprises a duty of loyalty and a duty of care, the latter of
which includes providing investment advice in the best interest of the
client, based on the client's objectives.\142\ For example, where an
investment adviser has the responsibility to select broker-dealers to
execute client transactions, the adviser is obligated to seek to obtain
``best execution'' of client transactions given the circumstances
pertaining to the transactions.\143\
---------------------------------------------------------------------------

    \141\ See supra section I.A.
    \142\ Id.
    \143\ See Standard of Conduct Release, supra footnote 21, at
section I.A. (``When seeking best execution, an adviser should
consider `the full range and quality of a broker's services in
placing brokerage including, among other things, the value of
research provided as well as execution capability, commission rate,
financial responsibility, and responsiveness' to the adviser.'')
(quoting Interpretive Release Concerning the Scope of Section 28(e)
of the Securities Exchange Act of 1934 and Related Matters, Exchange
Act Release No. 23170 (Apr. 28, 1986)); Commission Guidance
Regarding Client Commission Practices under Section 28(e) of the
Securities Exchange Act of 1934, Exchange Act Release No. 54165
(July 18, 2006), available at https://www.sec.gov/rules/interp/2006/34-54165.pdf.
---------------------------------------------------------------------------

    Where an investment adviser fails to satisfy its obligations,
including fulfilling its fiduciary duty to clients or complying with
the Advisers Act and other Federal securities laws, its conduct may
result in potential liability under the antifraud provisions of the
Federal securities laws. Investment advisers are subject to Section 206
of the Advisers Act, which prohibits engaging ``in any act, practice,
or course of business which is fraudulent, deceptive, or
manipulative.'' \144\ Section 206(4) specifically empowers the
Commission to adopt rules defining fraudulent acts and practices and to
prescribe means reasonably designed to prevent their occurrence. In
addition to the antifraud provision of the Advisers Act, investment
advisers are also subject to other antifraud provisions under the
Federal securities laws and misconduct

by an adviser may result in liability under such other provisions,
including Section 17 of the Securities Act of 1933 and Section 10(b) of
the Securities Exchange Act of 1934 and rule 10b-5 thereunder.\145\
---------------------------------------------------------------------------

    \144\ 15 U.S.C. 80b-6(4).
    \145\ See 15 U.S.C. 77q; 15 U.S.C. 78l; and 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    Second, investment advisers registered with the Commission are
required to adopt and implement written policies and procedures
reasonably designed to prevent violation of the Federal securities
laws. The Commission has said that Rule 206(4)-7 requires advisers to
consider their fiduciary and regulatory obligations under the Advisers
Act and to formalize policies and procedures to address them.\146\ The
rule does not enumerate specific elements that advisers must include in
their policies and procedures and each adviser should adopt policies
and procedures that take into consideration the nature of that firm's
operations.\147\ Registered investment companies are subject to similar
compliance procedures and practices pursuant to rule 38a-1 under the
Investment Company Act of 1940 and to the extent certain advisers have
clients that are registered investment companies, the adviser and
certain specified service providers may be subject to relevant
provisions of the rule.\148\
---------------------------------------------------------------------------

    \146\ See Compliance Programs of Investment Companies and
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec.
17, 2003), at section II.A.1 (adopting rule 206(4)-7), available at
https://www.sec.gov/rules/final/ia-2204.htm.
    \147\ See id.
    \148\ Rule 38a-1 requires policies and procedures to provide for
oversight of certain service providers to the registered investment
company, including its investment advisers, principal underwriters,
administrators, and transfer agents. The rule also requires the
registered investment company's board of directors, including a
majority of its independent directors, to approve its investment
adviser's policies and procedures based on a finding that the
policies and procedures are reasonably designed to prevent violation
of the Federal securities laws by the registered investment company
and the adviser. In addition, the registered investment company is
required to review its policies and procedures, as well as those of
its investment adviser, annually. See 17 CFR 270.38a-1.
---------------------------------------------------------------------------

    As discussed, many investment advisers outsource various functions
supporting the adviser's services and processes. Investment advisers
who presently outsource covered functions may already conduct any or
all of the proposed required due diligence and monitoring obligations
with respect to outsourced covered functions. Further, such advisers
may already incorporate these practices into their written policies and
procedures. However, while there is an existing framework under which
advisers may oversee certain service providers, there is no existing
provision under the Advisers Act expressly requiring due diligence and
monitoring for those service providers.\149\
---------------------------------------------------------------------------

    \149\ Certain entities may be subject to particularized
requirements under other regulatory regimes. For example, firms that
are dually registered broker-dealers are subject to FINRA Rule 3110
which requires members to, among other provisions, establish and
maintain a system to supervise the activities of each associated
person that is reasonably designed to achieve compliance with
applicable securities laws and regulations. This supervisory system
must, among other requirements, designate an appropriately
registered principal with authority to carry out the supervisory
responsibilities of the member for each type of business in which it
engages for which registration as a broker-dealer is required. See,
e.g., Rule 3110 Supervision, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/3110.
---------------------------------------------------------------------------

    For example, advisers may already conduct some due diligence and
monitoring with respect to service providers relating to the handling
of sensitive client information in complying with their obligations
under applicable laws. Section 204A of the Advisers Act requires
advisers to maintain and enforce written policies and procedures with
the aim of preventing the firm or any person associated with the firm
from misusing material non-public information, with rule 204A-1
thereunder requiring, among other things, that an adviser's code of
ethics set forth requirements that certain advisory personnel report
personal securities trading and that the adviser's supervised persons
must comply with Federal securities laws.\150\ Thus, some investment
advisers may currently conduct due diligence and monitoring in
enforcing their code of ethics, which encompasses certain aspects of
the adviser's relationship with service providers.
---------------------------------------------------------------------------

    \150\ See 15 U.S.C. 80b-4a and 17 CFR 275.204A-1. However, rule
204A-1 is intended to apply only to ``access persons'' of an
investment adviser and does not apply to unrelated third parties.
---------------------------------------------------------------------------

    Third, investment advisers use Form ADV to register with the SEC,
register with one or more state securities regulators, and amend those
registrations.\151\ Form ADV elicits detailed information concerning
the adviser and its owners, business practices, employees, and
disciplinary history. While Form ADV requires reporting on certain
parties, such as the adviser's industry affiliations and certain
clients, it does not currently require reporting on all service
providers that perform what would be covered functions under the
proposal.
---------------------------------------------------------------------------

    \151\ Form ADV also serves as a reporting form for exempt
reporting advisers.
---------------------------------------------------------------------------

    Fourth, the Federal securities laws require investment advisers,
registered investment companies, and others to make and keep books and
records. The recordkeeping requirements are a key part of the
Commission's regulatory program for advisers and funds, as they allow
us to monitor adviser and fund operations, and to evaluate their
compliance with the Federal securities laws. Existing Rule 204-2, which
would be amended by the proposal, currently provides certain
requirements for books and records to be maintained by investment
advisers while various rules under the Investment Company Act of 1940,
as amended, provide similar requirements for specified records to be
maintained by registered investment companies.\152\ To the extent
certain advisers have clients that are registered investment companies,
those advisers may be subject to relevant recordkeeping obligations
under the 1940 Act. For example, if the board of directors of a
registered investment company has designated performance of fair value
determinations to the adviser under rule 2a-5 of the 1940 Act, the
adviser is obligated to maintain the records required by the related
recordkeeping provision.\153\ Rule 204-2 details the types of required
records as well as the manner, location and duration of records to be
maintained by registered investment advisers. For example, rule 204-
2(g) permits investment advisers to use electronic storage media for
records required to be maintained under Rule 204-2. However, the rule
does not prescribe specific requirements for when an adviser outsources
one or more of the required recordkeeping functions to a third party.
Commission staff has addressed third-party recordkeeping in two staff
letters, which include certain similar components to the proposed
amendments to rule 204-2.\154\ Although it is not required by rule,
advisers who presently outsource covered functions may already make and
keep relevant books and records with respect to their oversight of
service providers.\155\
---------------------------------------------------------------------------

    \152\ See infra section V.E.; see, e.g., 17 CFR 270.31a-1, 17
CFR 270.31a-2, 17 CFR 270.31a-3, 17 CFR 270.31a-4.
    \153\ See 17 CFR 270.2a-5; 17 CFR 270.31a-4.
    \154\ See OMGEO NAL, supra footnote 25, at n.3 (citing First
Call and National Regulatory Services, SEC Staff No-Action Letter
(Dec. 2, 1992)); First Call NAL, supra footnote 25.
    \155\ See infra section V.A.2.
---------------------------------------------------------------------------

    Fifth, Regulation S-P: Privacy of Consumer Financial Information
(``Regulation S-P'' or ``Reg S-P'') provides requirements to adopt
written policies and procedures reasonably designed to: (i) insure the
security and confidentiality of customer records and information; (ii)
protect against any

anticipated threats or hazards to the security or integrity of customer
records and information; and (iii) protect against unauthorized access
to or use of customer records or information that could result in
substantial harm or inconvenience to any customer.\156\ All registered
investment advisers who are financial institutions or creditors with
covered accounts are also subject to Regulation S-ID: Identity Theft
Red Flags (``Regulation S-ID'' or ``Reg. S-ID''), under which they are
required to develop and implement a written identity theft program that
includes policies and procedures to identify relevant types of identity
theft red flags, detect the occurrence of those red flags, and to
respond appropriately to the detected red flags.\157\
---------------------------------------------------------------------------

    \156\ See 17 CFR 248.30.
    \157\ 17 CFR 248.201(d)(2); 17 CFR pt. 248, subpt. C, app. A.
See also infra section V.E.
---------------------------------------------------------------------------

    Sixth, some advisers may be subject to additional regulatory
regimes that implicate customer information safeguards. For example,
advisers to private funds may be subject to the Federal Trade
Commission's Standards for Safeguarding Customer Information (``FTC
Safeguards Rule'') that contains a number of modifications to the
existing rule with respect to data security requirements to protect
customer financial information.\158\ Additionally, advisers that are
affiliated with banks may be indirectly subject to safeguarding
standards that include a requirement for a data breach response plan or
program.\159\ Advisers who anticipate needing to comply with these
privacy regulations may already conduct any or all of the proposed
required obligations with respect to service providers who are
responsible for customer information.
---------------------------------------------------------------------------

    \158\ 16 CFR pt. 314; see also 86 FR 70308 (Dec. 9, 2021) (Jan.
10, 2022, effective date; Dec. 9, 2022, applicability date for
certain provisions).
    \159\ See 70 FR at 15752, available at https://www.federalregister.gov/d/05-5980. Specifically, The Banking
Agencies' Incident Response Guidance provides, among other things,
that when an institution becomes aware of an incident of
unauthorized access to sensitive customer information, the
institution should conduct a reasonable investigation to determine
promptly the likelihood that the information has been or will be
misused. If the institution determines that misuse of the
information has occurred or is reasonably possible, it should notify
affected customers as soon as possible.
---------------------------------------------------------------------------

    Lastly, registered investment advisers are subject to a variety of
disclosure requirements that they must make to their investors,
including certain disclosures vis-[agrave]-vis the registration forms
of the funds they advise. For instance, open end funds register using
Form N-1A, and closed end funds register using Form N-2.\160\ A fund's
registration form includes information related to its basic operating
structure, including its advisers and some of its service providers.
However, there are no particularized requirements for these fund
registration documents to discuss fund outsourcing, due diligence, or
monitoring practices.
---------------------------------------------------------------------------

    \160\ See Form N-1A, available at https://www.sec.gov/about/forms/formn-1a.pdf; see Form N-2, available at https://www.sec.gov/files/formn-2.pdf.
---------------------------------------------------------------------------

C. Broad Economic Considerations

    As discussed above, investment adviser clients and investors rely
on the delegated asset management industry, which includes investment
advisers registered or required to be registered with the Commission,
for a wide variety of wealth management and financial planning
functions to their advisers, including tax, retirement, estate,
education, and insurance services.\161\ These services are critical for
investors to plan for the future and diversify their investment risks.
Investment advisers are responsible, under existing regulatory
regimes,\162\ for a wide variety of functions in order to provide these
advisory services. Over time, investment advisers have in turn
outsourced certain functions that are necessary for the adviser to
provide its investment advisory services in compliance with the Federal
securities laws as a response to competitive pressures, growing demand
for advisory services, and increasingly complex client demands.\163\
---------------------------------------------------------------------------

    \161\ See supra section I.A.
    \162\ See supra section I.A, III.B.3.
    \163\ See supra section I.A, III.B.2.
---------------------------------------------------------------------------

    Without a minimum and consistent framework for identifying,
mitigating, and managing risks to clients, outsourcing can lead to
client harm through the channels described above, such as clients being
misled, their adviser making investment decisions based on incorrect
data, having sensitive information misappropriated, potential or actual
conflicts of interest, or failures to provide records for regulatory
oversight.\164\ While many advisers may be aware of the risks and
account for them appropriately when deciding whether and how to engage
or continue to use service providers, our staff has observed that not
all advisers provide a sufficient level of oversight with respect to
their service providers, despite the existing fiduciary duty and other
legal obligations applicable to advisers.\165\ This is because, while
advisers and funds face relevant competitive market forces and
therefore have private reputational incentives to maintain some level
of oversight of service providers,\166\ market failures can lead their
chosen levels of oversight to be sub-optimally low, both from the
perspective of what each individual adviser's clients and investors
would prefer, and from the perspective of optimal levels of oversight
for broader or systemic operational risks.
---------------------------------------------------------------------------

    \164\ See supra section III.B.2.
    \165\ See supra section I.A, III.B.3.
    \166\ See supra section III.B.2.
---------------------------------------------------------------------------

    These market failures provide the economic rationale for the
proposed rule because they indicate that, without Commission action,
clients and advisers have limited abilities and incentives to implement
effective reforms, such as those in the proposed rules, for several
reasons. First, there are a number of practical issues investment
advisers and their clients and investors may face in coming to
agreement on, measuring, and accounting for risks due to outsourcing.
Second, the client's inability to observe an adviser's effort in
oversight of service providers gives rise to principal-agent and moral
hazard problems that can contribute to an adviser exerting too little
effort on oversight of its service providers. These problems are
exacerbated by instances in which the adviser has limited visibility
into a service provider's operations. Lastly, in addition to the
effects from moral hazard and principal-agent problems, advisers'
individual incentives to exert effort into oversight are likely to be
lower than optimal where operational failures at service providers can
carry broader or systemic risks. This is because individual advisers do
not have incentives to consider the benefits that their oversight may
provide to the investment advisory industry as a whole, including (and
in particular) competing advisers. These difficulties are consistent
with the outcomes discussed above, in which the Commission has observed
operational failures by service providers affecting advisers' abilities
to deliver services to their clients, despite existing fiduciary duty
and other regulations,\167\ and we next discuss each of these
difficulties in turn.
---------------------------------------------------------------------------

    \167\ See supra section I.A.
---------------------------------------------------------------------------

    With respect to the practical issues that currently may limit the
ability or incentive of clients and advisers to adequately address the
risks of outsourcing: First, because of the substantial variety and
complexity of functions offered by service providers (such as client
servicing, investment risk management, pricing, and reconciliation,
among others), advisers and their clients may face difficulty in

coming to agreement on and developing a common, consistent set of
expected practices. These difficulties may be particularly pronounced
in the case of covered functions that are of significance to investment
performance but are new or experimental functions for which the adviser
has limited expertise or experience.\168\ Second, even if clients and
advisers agree on the adviser's obligations, clients may face risks
from rare but catastrophic operational events that are inherently
difficult to predict, and thus difficult to account for when
negotiating the terms of advisory services.\169\ While some degree of
operational risk is inevitable, we believe that the proposed rule may
help lower these risks through its due diligence and monitoring
requirements.
---------------------------------------------------------------------------

    \168\ For example, for an adviser who lacks experience in
algorithmic-based trading but has retained an algorithmic trading
firm and outsourced certain trading activity to that firm, clients
and investors may benefit substantially from new requirements for
risk analysis and due diligence on the part of the adviser. While
the adviser would not need to fully understand the technical
intricacies of the algorithmic trading service, it generally would
need to have a reasonable understanding of the service and its
associated risks, and be able to conclude that it can mitigate and
manage those risks. See supra section II.B for more discussion.
    \169\ See supra section III.B.2. While clients and advisers
could price these risks into their contracts for advisory services
through premiums for insurance coverage for operational failures,
this would require clients and advisers to agree on the scope of
coverage required.
---------------------------------------------------------------------------

    Additionally, principal-agent problems, moral hazard problems, and
related conflicts of interest in the relationships between clients,
advisers, and service providers may limit incentives for private reform
and the ability of these market participants to implement reform. The
investment adviser relationship is subject to agency problems,
including those resulting from conflicts, to the extent clients (the
principals) and investment advisers (the agents) have different
preferences and goals. Investment advisers may take actions that
increase their well-being at the expense of clients, thereby imposing
agency costs on their clients.\170\ Moreover, because an adviser's
oversight of a service provider cannot be observed (and thus cannot be
contracted for by the clients or investors), there is a moral hazard
problem that may make it difficult for clients and investors to induce
advisers to supply the proper amounts of oversight.\171\ Advisers may
therefore be able to avoid implementing reforms of service provider
oversight practices. It may also be likely for service providers to
avoid reforms, because minimal oversight on the part of the adviser may
open opportunities for service providers to pursue cost savings that
increase operational risks, or opportunities for other conflicts of
interest that could benefit the service provider or adviser at the
client's expense.\172\ These principal-agent problems, moral hazard
problems, and conflicts of interest may therefore be particularly
strong in the context of conducting due diligence and monitoring of
service providers, because clients have even less visibility into
service provider functions than they do adviser functions.\173\
---------------------------------------------------------------------------

    \170\ See Standard of Conduct Release, at 31-32, supra footnote
21. An adviser's fiduciary duty can mitigate these agency problems
and reduce agency costs by deterring investment advisers from taking
actions that expose them to legal liability.
    \171\ See supra section III.B.2, see also, e.g., Bengt
Holmstrom, Moral Hazard and Observability, 10 Bell J. of Econ. 1
(1979). (``It has long been recognized that a problem of moral
hazard may arise when individuals engage in risk sharing under
conditions such that their privately taken actions affect the
probability distribution of the outcome . . . . The source of this
moral hazard or incentive problem is an asymmetry of information
among individuals that results because individual actions cannot be
observed and hence contracted upon.''); Bengt Holmstrom, Moral
Hazard in Teams, 13 Bell J. of Econ. 2 (1982). (``Moral hazard
refers to the problem of inducing agents to supply proper amounts of
productive inputs when their actions cannot be observed and
contracted for directly.'').
    \172\ See supra section I.A.
    \173\ See supra section III.B.2.
---------------------------------------------------------------------------

    Lastly, because operational failures at service providers can carry
broader or systemic risks, advisers' individual incentives to exert
effort into oversight are likely to be lower than optimal from a
societal standpoint. For instance, when a function is provided to many
advisers by a small number of service providers,\174\ each adviser may
not take into account the broader, systemic operational risk associated
with that service provider's failure when determining the level of
oversight that they individually, or privately, find optimal.\175\ For
example, an investment adviser may not take into account the benefits
that its own oversight of a service provider creates for its
competitors. Moreover, to the extent that broader or systemic
operational failures reduce client confidence in markets, there may be
even greater differences in each adviser's privately optimal level of
oversight and the optimal level of oversight from a societal
standpoint. This is because an operational failure at a service
provider for one adviser may reduce client confidence in other
advisers, and advisers may not account for the additional impact of
their service provider's operational failures on client trust in the
investment advisory industry as a whole, including (and in particular)
competing advisers.
---------------------------------------------------------------------------

    \174\ See supra section III.B.2.
    \175\ See Andreu Mas-Colell, et. al., Microeconomic Theory
(Oxford University Press)(1995), at Chapter 11, for a general
discussion of externalities. Through the lens of the theory of
externalities and public goods, we believe that due diligence is
equivalent to a public good supplied at a suboptimal quantity, which
may be improved by the current proposed rule.
---------------------------------------------------------------------------

    The proposed rules would therefore impose a set of minimum and
consistent obligations on investment advisers registered or required to
be registered with the Commission in the course of their outsourcing
processes. These obligations are designed to address the risks and
market failures described above in the context of outsourcing core
advisory functions. These reforms are designed to promote a more
comprehensive framework to address--and thereby reduce--risks to
advisers and their clients that result from an adviser's use of service
providers. These reforms also are designed to give the Commission and
advisers' clients better information for oversight of advisers' use of
service providers.
    The scope of the proposed rule would be limited to investment
advisers registered or required to be registered who have retained a
service provider to perform a covered function. The proposed rule would
restrict its scope to a covered function to provide sufficient
oversight in those specific circumstances where the function or service
is one that is necessary for the adviser to provide advisory services
in compliance with the Federal securities laws, and that, if not
performed or performed negligently, would be reasonably likely to cause
a material negative impact on the adviser's clients or on the adviser's
ability to provide investment advisory services. A service provider
would be a person or entity that performs one or more covered functions
and is not a supervised person as defined in the Act. Excluding
supervised persons from the definition of a service provider allows
advisers to avoid the costs of complying with the proposed rule in
those circumstances where the service provider is subject to the
supervision and control of the adviser and the requirements of the rule
would be duplicative.
    Clients and investors would benefit from this minimum and
consistent regulatory framework for identifying, mitigating, and
managing risks associated with outsourced functions. They would benefit
through reduced risks of operational failures including broad or
systemic operational failures, reduced risk of fraud associated with
outsourced functions, reduced risks from potential or actual conflicts
of interest, improved confidence for clients and investors that
advisers will be able to carry out their regulatory obligations,

and greater regulatory transparency and resulting effectiveness of the
Commission's client and investor protection efforts.\176\ Clients and
investors may additionally benefit from a reduction in operational risk
as a result of service providers electing to update or reform their
operations in response to adviser oversight. These benefits may vary
across advisers and across covered functions. For example, benefits may
be minimal for advisers who outsource very few covered functions. By
contrast, and as mentioned above, benefits may be substantial for
advisers who outsource functions that are of significance to investment
performance but are new or experimental functions for which the adviser
has limited expertise or experience, such as algorithmic-based trading
or use of predictive data analytics.
---------------------------------------------------------------------------

    \176\ See supra section I.A, III.B.2; see also infra section
III.D.4. For example, the Commission staff have observed some
advisers unable to provide timely responses to examination and
enforcement requests because of outsourcing.
---------------------------------------------------------------------------

    The costs of the proposed rules would include the costs of meeting
the minimum regulatory requirements of the rules, including the costs
to advisers of updating, as appropriate, their compliance programs in
response to the due diligence, monitoring, and record keeping
requirements. For SEC-registered investment advisers, the costs would
also include the costs of updating their Form ADV filings to include
the new required reporting. To the extent advisers currently outsource
covered functions, the cost of outsourcing covered functions is
typically borne by advisers--some or all of which, may be passed on to
clients. Under the proposed rule, compliance costs would be borne by
advisers that currently outsource covered functions or that may
outsource covered functions in the future. For example, and as an
initial matter, advisers would incur costs associated with determining
if outsourced functions are subject to the requirements of the proposed
rule. Those advisers, in turn, may attempt to pass costs on to their
clients. The ability of advisers to pass compliance costs to their
clients may depend on the willingness of clients to incur those
additional costs. Further, service providers of covered functions would
incur costs outside of their normal course of business as a result of
adviser requests for information to comply with their due diligence and
monitoring requirements of the proposed rule. These costs would likely
lead to some service providers charging additional fees to advisers,
some or all of which may be passed on to advisers' clients.
    We believe the costs of the proposed rules would be limited by
several factors. First, some advisers may already meet certain portions
of the obligations that would be required under the proposed rules in
the course of complying with existing legal obligations,\177\ and their
costs would only include the costs associated with obligations they do
not already meet. Second, certain advisers may determine that the costs
of completing a function themselves with equal efficiency and quality
as their service provider are less than the costs of the service
provider plus the regulatory oversight costs. For these advisers, the
costs of the proposal would be no greater than the costs associated
with transitioning to completing the function themselves, as this
choice would place the covered function in the purview of a supervised
person of the adviser, and therefore outside of the scope of the
proposed rule. However, this mitigating factor may be less relevant for
smaller advisers, who may be less able to perform their outsourced
functions themselves with equal efficiency and quality as their service
provider.
---------------------------------------------------------------------------

    \177\ See supra section III.B.3.
---------------------------------------------------------------------------

    Our discussion in section III.D below describes in more detail how
each of the benefits and costs would result from each of the elements
of the proposed rules.

D. Benefits and Costs

1. Due Diligence
    The proposed rule would require advisers to conduct reasonable due
diligence before engaging a provider.\178\ Through this due diligence,
advisers would be required to: (i) identify the nature and scope of the
covered function the service provider is to perform; (ii) identify and
determine how it would mitigate and manage the potential risks to
clients or to the investment adviser's ability to perform its advisory
services, resulting from engaging a service provider to perform a
covered function and engaging that service provider to perform the
covered function; (iii) determine that the service provider has the
competence, capacity, and resources necessary to perform the covered
function in a timely and effective manner; (iv) determine whether the
service provider has any subcontracting arrangements that would be
material to the service provider's performance of the covered function,
and identifying and determining how the investment adviser will
mitigate and manage potential risks to clients or to the investment
adviser's ability to perform its advisory services in light of any such
subcontracting arrangement; (v) obtain reasonable assurance from the
service provider that it is able to, and will, coordinate with the
adviser for purposes of the adviser's compliance with the Federal
securities laws; and (vi) obtain reasonable assurance from the service
provider that it is able to, and will, provide a process for orderly
termination of its performance of the covered function.\179\
---------------------------------------------------------------------------

    \178\ See proposed rule 206(4)-11(a)(1).
    \179\ See supra section II.B. The benefits and costs of the
required recordkeeping provisions associated with due diligence are
discussed in section III.D.3.
---------------------------------------------------------------------------

a. Benefits
    A minimum and consistent due diligence framework would benefit
clients and investors through reduced risks of operational failures
including broad or systemic operational failures, reduced risk of fraud
associated with outsourced functions, and greater regulatory
transparency and resulting effectiveness of the Commission's client and
investor protection efforts.\180\ Clients and investors may
additionally benefit from a reduction in operational risk as a result
of service providers electing to update or reform their operations in
response to adviser oversight. These benefits may vary across advisers
and across covered functions. For example, benefits may be minimal for
advisers who outsource very few covered functions. By contrast, and as
mentioned above, benefits may be substantial for advisers who outsource
functions that are of significance to investment performance but are
new or experimental functions for which the adviser has limited
expertise or experience. Certain prongs of the proposed due diligence
requirement of the rule would provide further individualized
contributions to these benefits, to the extent that advisers do not
already complete each of the proposed requirements in response to the
competitive market forces they face, their reputational considerations,
or their fiduciary duties.\181\
---------------------------------------------------------------------------

    \180\ See supra section III.C.
    \181\ See supra sections III.B.2, III.C.
---------------------------------------------------------------------------

    First, because advisers must determine the nature and scope of any
covered function that a service provider is to perform,\182\ advisers
would be required to have a basic understanding of what the service
provider will do and how they will do it. This preliminary step would
enhance the effectiveness of any other component of an adviser's due
diligence process, including the

proposed required framework, by ensuring that the adviser has taken
basic steps to prepare to actively engage with the service provider to
address issues as they arise. These benefits may be particularly
pronounced in the case of new or experimental functions for which the
adviser has limited expertise or experience. Additionally, analyzing
the nature and scope of a covered function could allow for early
implementation of safeguards in response to identified vulnerabilities,
which could benefit clients by reducing the risk of harm arising from
preventable performance shortfalls by service providers. For example,
if an adviser seeks to outsource portfolio management activity, it may
discover through its nature and scope analysis that its clients'
personally identifiable information may be exposed, or that the service
provider would be subject to a conflict of interest with another
adviser. The adviser could then either take steps to mitigate and
manage these risks or choose to retain directly supervised persons to
manage its advisers' portfolios.
---------------------------------------------------------------------------

    \182\ See supra section II.B.1.
---------------------------------------------------------------------------

    Second, the proposed rule would require an adviser with an
outsourced covered function to identify and determine how it would
mitigate and manage the potential risks of outsourcing. This would
include an analysis of the general risks of outsourcing a covered
function, as well as the particular risks of the specific service
provider selected by the adviser.\183\ Potential client harm caused by
a service provider's failure to perform (or a service provider
performing negligently) the outsourced function could be significantly
mitigated, or even avoided, if the adviser conducts appropriate risk
analysis, mitigation, and management prior to outsourcing a function.
---------------------------------------------------------------------------

    \183\ See supra section II.B.2.
---------------------------------------------------------------------------

    Third, by requiring advisers to determine service providers have
the competence, capacity, and resources necessary to provide the
services they offer in a timely and effective manner, the proposed rule
could benefit advisers' clients through early identification of a
variety of risks associated with the service provider's business.
Clients and investors would benefit, because outsourcing an investment
adviser's function to a service provider without the necessary
competence, capacity, and resources to perform that function can
undermine the adviser's provision of services and mislead or otherwise
harm clients.
    We believe that the lack of any of these elements in a service
provider can hinder the ability of an adviser to outsource to that
service provider and also remain consistent with the adviser's
fiduciary duty to its clients. For instance, an adviser may discover a
service provider of a labor-intensive service has insufficient staff,
or that a service provider lacks sufficient specialized systems or
equipment to carry out a particular technical function. These
conditions may be contrary to the client's understanding of their
agreement with the adviser, because the adviser is responsible for
these operations even though the service is outsourced. In these cases,
both the adviser and its clients would benefit from the opportunity to
identify a more appropriate provider of the covered function in
question, though these benefits may be mitigated to the extent that
identifying such a provider is costly.\184\
---------------------------------------------------------------------------

    \184\ These circumstances may particularly arise in the context
of affiliated service providers where a parent entity determines
that an adviser must purchase services or otherwise consume services
from the parent or from another affiliate. The adviser that is
outsourcing, if permitted to do its own analysis, might have opted
to use a different provider or not to outsource at all.
---------------------------------------------------------------------------

    Fourth, operational risks may be heightened in instances where a
service provider uses many subcontractors or when a service provider
switches subcontractors for arrangements that are material to the
performance of the covered function. The proposed rule is designed to
mitigate this heightened risk by including subcontracting arrangements
in the scope of an adviser's required due diligence and requiring the
adviser to mitigate and manage potential risks in light of the
subcontracting arrangements, provided the subcontracting arrangement is
material to the service provider's performance of the covered function.
This additional layer of required due diligence can provide more
oversight and visibility into the full set of functions managed by
service providers. For example, this component of the proposed due
diligence would provide greater oversight and visibility into an
arrangement in which a service provider that provides trading platform
services engages a subcontractor to write software code, test the
software, or retrieve data for use on the trading platform.\185\ In
turn, clients and investors may benefit from the opportunity to
evaluate the risks presented by a service provider that might otherwise
be hidden in the service provider's set of subcontractors.
---------------------------------------------------------------------------

    \185\ See supra section II.B.4.
---------------------------------------------------------------------------

    Fifth, by requiring advisers to obtain reasonable assurance from
their service providers of coordination for purposes of the advisers'
compliance with the Federal securities laws, the proposed rule would
likely improve confidence for clients and improve communications
between advisers and service providers. When advisers set clear
processes and ground rules with their service providers in order to
remain compliant with the Federal securities laws, clients may have
additional confidence that their advisers will be able to carry out
their regulatory obligations. Additionally, obtaining such reasonable
advance assurance from service providers may lead to more efficient and
effective lines of communication between advisers and their service
providers. This improved communication between advisers and service
providers may be especially helpful to advisers to mitigate client harm
in times of market stress and where a service provider is not be
directly subject to the Federal securities laws and therefore is
unaware of the potential impact of their services on the adviser's
compliance with those obligations.
    Sixth, the orderly termination requirement may have the benefit of
mitigating the risk to clients that advisory services are abruptly
disrupted due to an agreement between the client's adviser and a
service provider being terminated. It also may decrease the risk that
an adviser will find itself unable to comply with the Federal
securities laws in the event of such a disruption. By compelling
advisers to prepare for an orderly termination, the rule may prevent
heightened costs of staying compliant with the Federal securities laws
or maintaining good business practices in a disorderly termination.
Further, by potentially increasing the protection of confidential or
sensitive information during or after termination, such as the return
or destruction of documents or revocation of service provider access or
privileges, the rule may give clients and investors more confidence in
procuring advisory services from registered investment advisers.
Finally, to the extent that the rule requires reasonable assurance of
termination rights and processes, the rule may reduce costly legal
disputes between these parties. For example, these risks may be
heightened in the case where an adviser terminates a service provider
covering valuation services, where the process of transitioning client
accounts may result in those accounts falling out of compliance with
valuation requirements. By compelling advisers to prepare for an
orderly termination, the

rule would help to protect clients from inaccurate valuations of their
assets, it would help to protect clients from misappropriation of
confidential or sensitive information regarding their portfolio
holdings, and it would help to ensure proper transfer and retention of
records, among other protections.\186\
---------------------------------------------------------------------------

    \186\ See supra section II.B.6.
---------------------------------------------------------------------------

    The magnitude of the benefits would depend on the extent of
advisers' current due diligence functions that they complete in
response to the competitive market forces they face, their reputational
considerations, or their fiduciary duties.\187\ Advisers that currently
engage service providers may already have the proposed processes or
similar processes in place.\188\ To the extent advisers currently have
processes in place that would be in compliance with the proposed rule,
the client and investor protection benefit of the proposed due
diligence processes would be diminished.\189\
---------------------------------------------------------------------------

    \187\ See supra sections III.B.2, III.C.
    \188\ See supra section III.B.3.
    \189\ With respect to the proposed compliance coordination
requirements in particular, advisers that engage service providers
today may already be taking steps to mitigate the risk that these
arrangements do not impede an adviser's ability to remain compliant
with the Federal securities laws. The benefits of the proposed
compliance coordination requirement would therefore be lessened the
more advisers currently satisfy the proposed requirement.
---------------------------------------------------------------------------

b. Costs
    Similar to the benefits, the magnitude of the costs would depend on
the extent of advisers' current due diligence on their covered
functions.\190\ However, most advisers would likely face certain
minimum costs, as even an adviser who conducts little outsourcing or
who already conducts substantial due diligence in accordance with their
fiduciary duty would likely still undertake a careful review in order
to confirm that they are in compliance with the rule.\191\
---------------------------------------------------------------------------

    \190\ See supra section III.B.3, III.C.
    \191\ For example, an adviser who already conducts substantial
due diligence would still need to review their due diligence
processes to confirm that their processes constitute appropriate
risk analysis, mitigation, and management. See supra section II.B.2.
---------------------------------------------------------------------------

    Service providers would also face increased costs as a result of
these due diligence requirements, which may be partially or fully
passed on to advisers. These would include costs to service providers
who respond to requests from advisers for information or otherwise
participate in the adviser's due diligence, costs to service providers
to update or reform their operations, as well as costs to negotiate or
re-negotiate service arrangements. These requirements would involve
senior business, legal and compliance personnel, external costs for
counsel, and potential costs for hiring of additional personnel to help
with these burdens. Any portion of the resulting costs that is not
borne by service providers would ultimately be passed on to
advisers,\192\ and may in turn be passed on to clients and investors.
---------------------------------------------------------------------------

    \192\ The division of the service provider's direct costs
between the service provider and the adviser would depend primarily
on the relative bargaining power of the two parties. In certain
cases, the service provider may accommodate adviser requests without
charging additional fees or raising prices. This may particularly be
the case for smaller service providers, who may have less bargaining
power relative to their adviser customers. In other cases, the
service provider may charge the full amount of their increased costs
as a fee to the adviser. This may particularly be the case for
smaller advisers, who may have less bargaining power relative to
their service providers.
---------------------------------------------------------------------------

    These costs are likely to be high initially, and decline over time
as advisers develop their due diligence systems.\193\ However, ongoing
costs of the proposed due diligence requirements would not decline to
zero over time. Advisers would face ongoing annual due diligence costs,
separate from their monitoring costs, when they change service
providers, renegotiate contractual relationship with service providers,
change which of their functions they outsource, or implement other such
changes that require new due diligence. Advisers would also face
certain costs anytime they consider implementing such changes to their
business, even if they do not proceed with the change, because part of
their necessary evaluation of the business decision would include
evaluating the due diligence they would need to undertake.
---------------------------------------------------------------------------

    \193\ The costs estimated in this section are associated with
actually conducting the proposed due diligence requirements, and are
thus in addition to the PRA costs discussed below, which are limited
to the collection of information costs of the proposed recordkeeping
requirements associated with the proposed due diligence
requirements. See infra section IV.
---------------------------------------------------------------------------

    In addition, some advisers may choose to update their systems and
internal processes and procedures for due diligence in order to better
respond to this requirement. These updates may require the time and
attention of business and operational personnel, which may detract from
their regular functioning. Additionally, business and operational
personnel may incur costs that arise from negotiating contractual
safeguards with service providers in order to comply with due diligence
requirements. The costs of those improvements would be an indirect cost
of the rule, to the extent they would not occur otherwise, and they are
likely to be higher initially than they would be on an ongoing basis.
Finally, as noted in section III.C above, the collective costs of this
proposal are unlikely to exceed the cost to the adviser of providing
the covered function in-house, as this choice would place the covered
function in the purview of a supervised person of the adviser, and
therefore outside of the scope of the proposed rule.\194\ However, to
the extent that an adviser responds to the proposed due diligence rules
by providing a covered function in-house and does so less efficiently
or at a lower quality than a service provider would, this loss of
efficiency or quality would represent an additional burden of the
proposed rule. Similarly, there may be cases where advisers currently
have multiple service providers, but the due diligence costs would
cause an adviser to reduce its reliance to only a single provider, even
if it would result in less reliable or lower quality service to the
adviser's clients, because of the costs to properly diligence a
provider. Any portion of these costs that is not borne by advisers
would ultimately be passed on to clients and investors.
---------------------------------------------------------------------------

    \194\ See supra section III.C. However, this mitigating factor
may be less relevant for smaller advisers, who may be less able to
perform their outsourced functions themselves with equal efficiency
and quality as their service provider.
---------------------------------------------------------------------------

    Similar to the benefits, there would be individualized costs
associated with certain prongs of the proposed due diligence
requirements.
    First, because determining whether a function is a covered function
at all requires an analysis of the facts and circumstances of the
function,\195\ advisers generally may have to undertake legal and other
expenses to evaluate which of their functions are covered functions and
thus in the scope of the rule. This analysis may be particularly costly
for certain functions for which it may require thorough investigation
to evaluate whether the function is necessary for the adviser to
provide investment advisory services, or for which it may require
thorough investigation to evaluate whether there would be a material
negative impact on the adviser's clients or on the adviser's ability to
provide investment advisory services if the function was not performed,
or if performed negligently. Advisers may also face additional costs to
the extent they conservatively evaluate their outsourced functions, and
ultimately conduct the proposed required due diligence activities on
functions that may not be covered

functions.\196\ As such, any costs of the proposed rule to service
providers may additionally be faced by certain service providers who
would be outside the scope of the rule, to the extent that advisers
retaining their services conservatively determine they should exercise
additional due diligence on them.
---------------------------------------------------------------------------

    \195\ See supra section II.A.1.
    \196\ The Commission requests comment on whether the proposed
rule should explicitly list certain service providers or covered
functions that the rule would apply to. See supra section II.A.
---------------------------------------------------------------------------

    Second, for the purposes of the due diligence on nature and scope
of covered functions, time and personnel costs may be necessary to
obtain a sufficient understanding of the covered function to be
outsourced. Fundamentally, an adviser may outsource a covered function
if it is more efficient than devoting internal resources, or if the
service provider can provide higher quality operations.\197\ To a
lesser degree, the required nature and scope analysis may be costly,
particularly when more complex or technical functions must be
understood. This cost may present a necessary change in personnel
duties whenever covered functions are considered for outsourcing, or as
additional hiring of third-party experts to evaluate the processes of
potential service providers if the adviser lacks the requisite
experience to make an informed evaluation with available personnel.
Similarly, service providers may incur costs associated with responding
to requests for information from advisers, whether in the form of
internal staff time, or costs of third parties providing independent
assessments, and service providers may pass some or all these costs on
to advisers, who may in turn pass on these costs to their clients and
investors.
---------------------------------------------------------------------------

    \197\ See supra section III.B.2.
---------------------------------------------------------------------------

    Third, to the extent advisers' current processes for service
provider risk analysis, mitigation, and management differ from the
proposal, there would be direct costs necessary to comply with the
specific proposed requirements. Also, to the extent that they are not
already doing so in a manner that would meet the proposed rule's
standards, advisers would incur costs to mitigate and manage any
additional conflicts of interest created by outsourcing covered
functions. The above costs would include demands on personnel time to
verify that the depth and complexity of the analysis is consistent with
the adviser's assessment of risks associated with the function being
outsourced. There are a variety of paths that advisers could take to
complete these requirements and meet these demands, and the costs would
depend on the adviser's chosen route. For example, an adviser also
could establish a redundancy in the outsourced service or function,
such as by arranging a secondary pricing provider to provide pricing
services in the event a primary pricing service provider fails, and
could be used to validate accuracy and identify potential anomalies in
the data provided by the primary pricing provider.\198\ Such redundancy
would increase costs to clients and investors, or could deter some
advisers from engaging such third parties (even when it might be
beneficial to offer clients and investors access to those services).
---------------------------------------------------------------------------

    \198\ See supra section III.B.2.
---------------------------------------------------------------------------

    Fourth, to the extent advisers' processes for lessening the risks
associated with service providers' competence, capacity, and resources
differ from the proposal, there would be direct costs necessary to
comply with the proposed requirements. The cost of complying with this
new requirement would be limited to the additional costs necessary to
bring current practice into compliance with the proposed rule. Because
this analysis should be based on the facts and circumstances of the
functions being outsourced, costs will likely vary across functions
that are being outsourced, but there will also be specific costs
required to analyze the facts and circumstances of each function being
outsourced. For example, if outsourcing a function is determined to be
high risk due to the complexity of the function, the adviser may want
to focus on the experience and expertise of the service provider's
personnel. If the function is labor intensive, the adviser may consider
whether the service provider has the necessary staffing to provide the
function. The costs associated with these two circumstances are likely
to be different. These requirements may also result in additional costs
to service providers, to the extent they revise their practices in
order to satisfy an adviser's requests to ensure that the service
provider has the competence, capacity, and resources necessary to
perform the covered function in a timely and effective manner.
    Fifth, for large service providers, there may be many
subcontractors that materially contribute to the service provider's
covered function. In such cases, it may be more burdensome for advisers
to assess the potential risks each of these subcontracting arrangements
may pose to the service provider's provision of the covered function.
Similar to the costs associated with evaluating the nature and scope of
covered functions, there may be extra costs to advisers in the case
where it is ambiguous which subcontractors are material to the service
provider's ability to perform the covered function. Further, advisers
may face difficulty in getting providers or subcontractors to cooperate
with risk assessment efforts. Lastly, depending on the amount of non-
advisory business a service provider has, there may be a risk that a
service provider would discontinue business with advisers rather than
cooperate with the adviser's risk-assessment efforts to conduct due
diligence on sub-contractors.
    As a closely related matter, and in addition, cooperating with
advisers' assessment of subcontracting arrangements may impose
additional time and effort costs on service providers. In particular,
service providers may face costs associated with determining which of
their own subcontractors' services are material, meaning that
nonperformance or negligent performance would be reasonably likely to
cause a significant negative impact on the service provider's ability
to perform the covered function.\199\ These would include similar costs
that advisers would face in determining which outsourced operations are
covered functions, including extra costs to service providers where it
is ambiguous which subcontractors' services would be material to their
ability to perform the covered function.
---------------------------------------------------------------------------

    \199\ See supra section II.B.4.
---------------------------------------------------------------------------

    Sixth, in the case of the compliance coordination requirement,
direct involvement by business or operational personnel may be required
to ensure that reasonable assurance of coordination for purposes of the
adviser's compliance with the Federal securities laws has been obtained
from service providers. Similarly, service providers may face costs in
providing this reasonable assurance to advisers, requiring time of
senior business, legal, and compliance personnel, as well as external
costs for counsel. We expect such costs to be potentially high
initially, but decrease over time as advisers adopt more streamlined
systems to obtain this reasonable compliance. However, there may be
instances in which advisers encounter reluctance from service providers
to commit to cooperating. For instance, large service providers with
many non-adviser customers, such as general cloud computing service
providers, may be unwilling to accommodate as-needed unscheduled due
diligence or

monitoring requests by individual customers. In such cases, these
service providers may either not do business with advisers or assess
additional fees (which may be passed on to clients) to help advisers
comply with the Federal securities laws. Finally, it is possible that
some service providers, who are not themselves regulated by the
Commission, may provide certain assurances to the adviser of compliance
with the Federal securities laws and then simply fail to deliver on
those assurances, resulting in an adviser needing to implement an
unexpected and sudden termination of the service provider or transfer
of operations to a different service provider, which we expect would be
costly to the adviser and its clients.\200\
---------------------------------------------------------------------------

    \200\ However, these costs would potentially be mitigated by the
proposed rule's requirement that advisers obtain reasonable
assurance from the Service Provider is able to, and will, provide a
process for orderly termination of its performance of the covered
function. See supra section II.B.6.
---------------------------------------------------------------------------

    Lastly, if service providers perceive the requirement to provide
reasonable assurance that they can terminate their services in an
orderly fashion to be too burdensome, or if they believe such assurance
would not be reasonable, they may choose not to enter into agreements
with registered advisers. In this case, advisers may be left with a
limited selection of service providers, which may increase the costs or
lower the overall quality of services. To the extent that additional
costs outside of their normal course of business are required to
provide such reasonable assurance to advisers, service providers would
likely charge additional fees, some or all of which may be passed on to
adviser's clients. Finally, the costs imposed by the orderly
termination requirement may provide an incentive for certain advisers
to avoid discontinuing business relationships with inefficient or low-
quality service providers.\201\ However, this outcome may be unlikely,
as the continued monitoring requirements described above would require
advisers to reasonably determine that it remains appropriate to
outsource to the service provider.\202\
---------------------------------------------------------------------------

    \201\ Advisers may particularly avoid discontinuing business
relationships with inefficient or low-quality service providers to
the extent that the proposed rule would reduce the population of
viable service providers, either by preventing service provider
entry, causing certain service providers to exit because of their
increased costs, or causing service provider fees to increase. See
infra section III.E.2.
    \202\ See supra section II.B.6.
---------------------------------------------------------------------------

    We estimate the direct costs to advisers associated with the
proposed due diligence requirements, including legal expenses for an
adviser to identify its covered functions and service providers, legal
expenses for review of contracts to determine the nature and scope of
the services provided for those covered functions, time and personnel
costs to obtain a sufficient understanding of the covered function to
be outsourced, securing of various reasonable assurances from service
providers (which could be provided through written agreements,
correspondence, or other written documentation, or through oral
negotiations), and additional legal costs to review subcontracting
arrangements, among others.
    Because the nature and magnitude of these expenses are likely to
vary across advisers and across covered functions, in particular
because many advisers likely already satisfy many of the proposed
requirements for due diligence processes as a result of competitive
market forces and resulting reputational effects on individual advisers
and in accordance with their fiduciary duty or other applicable
law,\203\ we anticipate a range of possible costs of the rule. At
minimum, we estimate that the proposed due diligence requirements would
be completed by compliance managers ($339/hour), a chief compliance
officer ($580/hour), attorneys ($455/hour), assistant general counsel
($510/hour), junior business analysts ($191/hour), senior business
analysts ($300/hour), paralegals ($199/hour), senior operations
managers ($400/hour), operations specialists ($150/hour), compliance
clerks ($77/hour), and general clerks ($68/hour).\204\ Certain advisers
may need to hire additional personnel to meet these requirements.
---------------------------------------------------------------------------

    \203\ See supra section III.B.3.
    \204\ The Commission's estimates of the relevant wage rates are
based on salary information for the securities industry compiled by
the Securities Industry and Financial Markets Association's Office
Salaries in the Securities Industry 2013. The estimated figures are
modified by firm size, employee benefits, overhead, and adjusted to
account for the effects of inflation. See infra section IV.
---------------------------------------------------------------------------

    Advisers would face initial, one-time direct costs associated with
coming into compliance with the proposed due diligence requirements, as
well as ongoing annual direct costs associated with the due diligence
requirements. As discussed throughout this section, the initial, one-
time direct costs associated with coming into compliance with the
proposed due diligence requirements are likely to be higher than the
ongoing annual costs. For example, to the extent that advisers analyze
the facts and circumstances analysis of each outsourced function,
advisers may face substantial initial costs in determining their full
set of covered functions.\205\
---------------------------------------------------------------------------

    \205\ See supra section II.A.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. We estimate that on
average, advisers would require at a minimum 40 hours of time from each
of the personnel identified above as an initial burden in coming into
compliance with the proposed rule, assuming an average of 8 hours per
covered function and five covered functions per adviser.\206\ As noted
above, we believe it is likely that these minimum costs would be
required even for an adviser who conducts little outsourcing or who
already conducts substantial due diligence in accordance with their
fiduciary duty, because such an adviser would likely still undertake a
careful review in order to confirm that they are in compliance with the
rule.\207\ For example, we believe the substantial majority of, if not
all, advisers would elect to prepare some form of written agreement
with their service providers as part of their means of complying with
the proposed due diligence requirements.
---------------------------------------------------------------------------

    \206\ For certain of these categories of professionals, these
hours may be imposed on two professionals of each, who would face
one-time costs of 20 hours each. Other categories may require four
professionals who would face one-time costs of ten hours each. For
some, such as the Chief Compliance Officer, these hours would come/
originate from one staff member. While there are no publicly
available granular data on adviser outsourcing of operations that
would be covered functions, this assumption is consistent with
frequent outsourcing of custodial, administrative, prime brokerage,
auditing, and recordkeeping services among RIAs. See supra section
III.B.1; see also infra section IV. Service providers may also face
direct costs, such as personnel costs for providing reasonable
assurances to advisers, but for the purposes of estimating minimum
costs to advisers, we assume that service provider costs are not
passed on to advisers. Individual estimates correspond to the
aggregated average cost per adviser, where the average is taken
across all advisers. Some advisers, particularly the smallest
advisers or those who do no outsourcing, are likely to face costs
that are below this lower bound for the average cost across all
advisers.
    \207\ Also as noted above, an adviser who conducts substantial
due diligence would still need to review its due diligence processes
to confirm its processes constitute appropriate risk analysis,
mitigation, and management. See supra section II.B.2.
---------------------------------------------------------------------------

    These minimum-cost assumptions indicate a one-time initial burden
of 440 total labor hours and $132,320 per adviser, or a total one-time
initial burden of 6,492,640 labor hours and $1.953 billion across all
advisers.
    As noted above, certain due diligence costs would be ongoing,
separate from monitoring costs. These include costs associated with the
adviser changing service providers, renegotiating contractual
relationship with service providers, changing which of their

functions they outsource, implementing other such changes that require
new due diligence, or evaluating a need to implement any of these
changes. We estimate that the ongoing annual burden of the due
diligence requirement would be one-third the initial burden,\208\
resulting in minimum-cost ongoing annual burden of 146.67 labor hours
and $44,106.67 per adviser and 2,164,213 labor hours and $650,837,973
across all advisers.
---------------------------------------------------------------------------

    \208\ See infra section IV.
---------------------------------------------------------------------------

    However, many due diligence costs would be likely to be higher for
certain advisers. Larger advisers, with more outsourcing of covered
functions, may have greater costs. An adviser needing to revise its
existing practices, needing to hire new personnel, choosing to switch
service providers in response to the rule, and multiple other factors
may cause costs to increase as well. The factors that may increase due
diligence costs are difficult to quantify. For example, an adviser may
implement a policy that prevents the adviser from retaining a service
provider that primarily relies on subcontractors to perform the covered
function, or implement a procedure to audit the service provider's
oversight of its subcontractors. These internal adviser policy
limitations or audits may represent additional costs, such as increased
prices for using service providers. Similarly, any audit procedure
would entail audit fees or costs for new personnel. As another example,
as noted above, certain advisers may elect to retain a secondary
pricing provider to provide pricing services in the event a primary
pricing service provider fails, and could be used to validate accuracy
and identify potential anomalies in the data provided by the primary
pricing provider, even though no such secondary pricing provider would
be required by the proposed rules.\209\
---------------------------------------------------------------------------

    \209\ See supra section II.B.2.
---------------------------------------------------------------------------

    While the potential sources of increased costs are difficult to
quantify, we anticipate that very few advisers would face a burden that
exceeds three times the above-described minimum burden. To the extent
that the average adviser faces this upper bound of three times the
minimum burden, this would indicate that a potential upper bound for
due diligence costs would be initial costs of 1,320 hours and $396,960
per adviser and 19,477,920 hours and $5.858 billion across all
advisers, and ongoing annual costs of 440 hours and $132,320 per
adviser and 6,492,640 hours and $1.953 billion across all
advisers.\210\ We request comment on all aspects of this
quantification, including the minimum estimated burden represented here
and any range of costs that could hold for different advisers.\211\
---------------------------------------------------------------------------

    \210\ Individual estimates correspond to the aggregated average
cost per adviser, where the average is taken across all advisers.
Some advisers, particularly the largest advisers, are likely to face
costs that substantially exceed this upper bound for the average
cost across all advisers.
    \211\ See infra section III.G.
---------------------------------------------------------------------------

    Additional direct costs would be generated by the impact of the
proposed rules on service providers, distinct from those costs directly
faced by advisers as a result of the proposed due diligence
requirements. Some of these costs would result from responding to
adviser requests for information, as noted in this section. These costs
may include the time of service provider personnel required in
communicating directly with the adviser, understanding the nature of
the requests, and compiling the information to be provided. Larger
service providers serving many advisers may benefit from economies of
scale in responding to these informational requests, as similar
information may be requested by multiple advisers. Additionally, there
would be costs to service providers who elect to update or reform their
operations due to increased adviser due diligence resulting from this
rule.\212\ Similar to costs for information requests, larger service
providers may be able to update or reform their operations with greater
economies of scale than smaller service providers.
---------------------------------------------------------------------------

    \212\ See supra section III.D.1.a.
---------------------------------------------------------------------------

    We are unable to quantify these direct costs that would be incurred
by service providers as a result of this rule, as the cost range would
be too wide to be informative. In particular, the direct costs that
would be incurred by service providers are subject to substantially
greater uncertainty than the direct costs that would be incurred by
advisers. This uncertainty is due to a number of factors, including
variation in complexity of covered functions outsourced to service
providers, the degree of market concentration across service provider
markets (and hence the number of advisers a service provider may need
to work with to comply with the rule), and variation in current service
provider practices. The costs to any single service provider of meeting
the burden for any single covered function for any single adviser may
therefore have substantial variance. For example, if few service
providers perform a particular covered function, those service
providers may perform the same covered function for many advisers and
hence benefit from economies of scale. By contrast, for service
providers in less concentrated industries, the rule would potentially
impose higher costs per service provider. The costs to service
providers would also depend on the degree to which service providers
are able to increase their prices and pass those costs on to advisers.
We request comment on any data that could enable us to calculate the
effect of the proposed rule on service providers.\213\
---------------------------------------------------------------------------

    \213\ See infra section III.G.
---------------------------------------------------------------------------

2. Monitoring
    The proposed rule would require the adviser, once a service
provider has been engaged, to periodically monitor the service
provider's performance of the covered function and reassess the
retention of the service provider in accordance with the due diligence
requirements of the proposed rule with such a frequency that the
adviser can reasonably determine that it is appropriate to continue to
outsource the covered function and that it remains appropriate to
outsource the covered function to the service provider.\214\ The manner
and frequency of an adviser's monitoring would depend on the facts and
circumstances applicable to the covered function, such as the
materiality and criticality of the outsourced function to the ongoing
business of the adviser and its clients. We discuss the benefits and
costs of the proposed monitoring requirement of the rule below.
---------------------------------------------------------------------------

    \214\ See supra section II.C. The benefits and costs of the
required recordkeeping provisions associated with monitoring are
discussed in section III.D.3.
---------------------------------------------------------------------------

a. Benefits
    Advisers' clients rely on adviser monitoring of service providers
for prevention and timely detection of potential harms resulting from
operational risk and conflicts of interest, including ensuring their
clients are continuing to receive advisory services. The enhanced
client and investor protections resulting from the proposed periodic
monitoring requirement would benefit clients to the extent that
requiring such periodic monitoring mitigates operational risks and
risks posed by conflicts of interest, or reduces the effect of negative
outcomes, should they occur. For example, periodic monitoring of
service providers' performance would allow advisers to evaluate service
providers' performance over time, comparing current to past performance
and more easily identifying any changes or trends in that performance,
and taking remedial action where appropriate. As with the other

components of the proposed rules, the proposed monitoring rule would
thereby benefit clients and investors through reduced risks of
operational failures including broad or systemic operational failures,
reduced risk of fraud associated with outsourced functions, reduced
risks from potential or actual conflicts of interest, and greater
regulatory transparency and resulting effectiveness of the Commission's
client and investor protection efforts. Clients and investors may
additionally benefit from a reduction in operational risk as a result
of service providers electing to update or reform their operations in
response to adviser oversight. These benefits may vary across advisers
and across covered functions. For example, benefits may be minimal for
advisers who outsource very few covered functions. By contrast, and as
mentioned above, benefits may be substantial for advisers who outsource
functions that are of significance to investment performance but are
new or experimental functions for which the adviser has limited
expertise or experience.
    The magnitude of the benefit would depend on the extent to which
advisers currently periodically monitor the service provider's
performance and reassess their due diligence in response to the
competitive market forces they face, their reputational considerations,
or their fiduciary duties.\215\ While advisers are not required to have
specific processes in place today, as fiduciaries, and as a matter of
business practice, advisers that engage service providers today should
be monitoring those providers.\216\ To the extent advisers currently
have such, or similar, processes in place, and to the extent those
processes include all of the elements required by the rule, the client
and investor protection benefit of the requirement would be lessened.
However, this factor would not mitigate the broader benefits of clients
and investors being able to consistently rely on the existence of a
minimum and consistent framework for identifying, mitigating, and
managing risks associated with outsourced functions.
---------------------------------------------------------------------------

    \215\ See supra sections III.B.2, III.C.
    \216\ See supra section III.B.3.
---------------------------------------------------------------------------

b. Costs
    Advisers' current processes for monitoring service providers may
differ from those specified by the proposed rule. The cost of complying
with this new requirement would be limited to the additional costs
necessary to comply with the more specific requirements of the proposed
rule.\217\ These costs would include demands on personnel time to
verify that an adviser's monitoring of service providers is in
compliance with the proposed rule. As with due diligence requirements,
periodic monitoring would also impose distinct costs on service
providers associated with service provider time and cooperation with
adviser requests for information, costs to update or reform their
operations in response to adviser oversight, and costs to negotiate or
re-negotiate service arrangements. Any portion of the resulting costs
that is not borne by service providers would ultimately be passed on to
advisers.\218\ Likewise, any portion of adviser costs that is not borne
by advisers would ultimately be passed on to clients and investors.
---------------------------------------------------------------------------

    \217\ The costs estimated in this section are associated with
actually conducting the proposed monitoring requirements, and are
thus in addition to the PRA costs discussed below, which are limited
to the collection of information costs of the proposed recordkeeping
requirements associated with the proposed monitoring requirements.
See infra section IV.
    \218\ The division of the service provider's direct costs
between the service provider and the adviser would depend primarily
on the relative bargaining power of the two parties. See supra
section III.D.1.b.
---------------------------------------------------------------------------

    Similar to the benefits, the costs associated with implementing
this requirement are likely to vary depending on advisers' and service
providers' current practices, as advisers may already engage in
monitoring in response to relevant competitive market forces and
resulting reputational effects on individual advisers. In addition,
some advisers may choose to update their systems and internal processes
and procedures for tracking their monitoring of service providers in
order to better respond to this requirement, and some service providers
may choose to update their systems and internal processes and
procedures for responding to advisers' monitoring requests. These
updates may require the time and attention of business and operational
personnel, which may detract from their regular functioning. However,
they are also likely to vary their monitoring based on the particular
service provided. For instance, for information technology services,
the implementation of automated scans or reviews of service provider
data feeds, could require more significant costs upfront to the adviser
with minimal maintenance costs. Additionally, business and operational
personnel may incur costs that arise from negotiating contractual
safeguards with service providers in order to comply with this due
diligence requirement. The costs of those improvements would be an
indirect cost of the rule, to the extent they would not occur
otherwise, and they may be higher initially than they would be on an
ongoing basis.
    Other costs such as those associated with periodic meetings and
ongoing monitoring are more likely to persist, instead of consisting of
upfront costs that decline over time. For instance, some functions may
require periodic onsite visits, and advisers may specify contractual
obligations to approve new systems prior to implementation.\219\
Similar to due diligence requirements, to the extent that an adviser
responds to the proposed monitoring rules by providing a covered
function in-house and does so less efficiently or at a lower quality
than a service provider would, this loss of efficiency or quality would
represent an additional cost of the proposed rule.\220\ Similarly,
there may be cases where advisers currently have multiple service
providers, but the monitoring costs would cause an adviser to reduce
its reliance to only a single provider, even if it would result in less
reliable or lower quality service to the adviser's clients, because of
the costs to properly monitor a provider. Advisers may also face
additional costs to the extent they spend money and staff time on
evaluating as well as enhancing their due diligence and monitoring for
a broader range of their outsourced functions than they ultimately
determine to be covered functions.\221\
---------------------------------------------------------------------------

    \219\ See supra section II.C.
    \220\ As noted above, smaller advisers may be less able than
larger advisers to provide a covered function in-house as
efficiently and with equal quality as a service provider. See supra
section III.C.
    \221\ The Commission requests comment on whether the proposed
rule should explicitly list certain service providers or covered
functions that the rule applied to. See supra section II.A.
---------------------------------------------------------------------------

    Because the direct costs associated with the proposed monitoring
requirements primarily constitute periodically monitoring the service
provider's performance of the covered function and reassessing the due
diligence requirements of the proposed rule, we anticipate that the
costs of the monitoring requirements would be closely related to the
costs of the due diligence requirements. In particular, we anticipate
that the proposed monitoring requirements would require the same staff
as the due diligence requirements: compliance managers ($339/hour), a
chief compliance officer ($580/hour), attorneys ($455/hour), assistant
general counsel ($510/hour), junior business analysts ($191/hour),
senior business analysts ($300/hour), paralegals ($199/hour), senior
operations managers ($400/hour),

operations specialists ($150/hour), compliance clerks ($77/hour), and
general clerks ($68/hour).\222\ As for the number of hours required for
these personnel, we estimate that a typical adviser would face one
third of its due diligence costs as additional monitoring costs. This
indicates a lower bound for initial costs of 146.67 hours and
$44,106.67 per adviser and 2,164,213 hours and $650,837,973 across all
advisers, and a lower bound for ongoing annual costs of 48.89 hours and
$14,702.22 per adviser and 721,404 hours and $216,945,991 across all
advisers. This also indicates an upper bound for initial costs of 440
hours and $132,320 per adviser and 6,492,640 hours and $1.953 billion
across all advisers, and an upper bound for ongoing annual costs of
146.67 hours and $44,106.67 per adviser and 2,164,213 hours and
$650,837,973 across all advisers. We request comment on all aspects of
this quantification, including the minimum estimated burden represented
here and any range of costs that could hold for different
advisers.\223\
---------------------------------------------------------------------------

    \222\ The Commission's estimates of the relevant wage rates are
based on salary information for the securities industry compiled by
the Securities Industry and Financial Markets Association's Office
Salaries in the Securities Industry 2013. The estimated figures are
modified by firm size, employee benefits, overhead, and adjusted to
account for the effects of inflation. See infra section IV. Certain
advisers may need to hire additional personnel to meet these
requirements.
    \223\ See infra section III.G.
---------------------------------------------------------------------------

    As with the proposed due diligence requirements, we are unable to
quantify the costs that would be incurred by service providers as a
result of this rule, as the cost range would be too wide to be
informative.\224\
---------------------------------------------------------------------------

    \224\ See supra section III.D.1.b.
---------------------------------------------------------------------------

3. Recordkeeping
    We are proposing to revise the Advisers Act books and records rule
in connection with the scope, due diligence, and monitoring provisions
of the proposed rule, as well as provide four more general new
requirements for outsourced recordkeeping.\225\
---------------------------------------------------------------------------

    \225\ See supra sections II.A.3, II.B.7, I.A.1, and II.E.
---------------------------------------------------------------------------

a. Benefits
    The proposed recordkeeping requirements would benefit clients and
investors by enabling an examiner to verify more easily that an adviser
is in compliance with the proposed rule and to facilitate the more
timely detection and remediation of non-compliance.\226\ More
generally, the recordkeeping requirements would enhance the
transparency of outsourced services and enhance the Commission's
oversight capabilities. Enhancing the Commission's oversight
capabilities could benefit clients and investors through reduced risks
of operational failures including broad or systemic operational
failures, reduced risk of fraud associated with outsourced functions,
reduced risks from potential or actual conflicts of interest, and
greater regulatory transparency and resulting effectiveness of the
Commission's client and investor protection efforts. For example, the
required recordkeeping would assist with outreach, examination, or
investigation into cases where a service provider who is providing
trade execution is not adhering to policies and procedures concerning
best execution.\227\
---------------------------------------------------------------------------

    \226\ Rule 206(4)-7 would already require advisers to adopt and
implement written policies and procedures reasonably designed to
prevent and detect violations of the proposed due diligence and
monitoring requirements if adopted. However, rule 206(4)-7 does not
enumerate specific elements that advisers would need to include in
their written policies and procedures, as the proposed recordkeeping
requirements would. See supra section I.A, III.B.3; see also infra
section V.D. The Commission staff have observed some advisers
currently unable to provide timely responses to examination and
enforcement requests because of outsourcing. See supra section I.A.
    \227\ See supra section II.E.
---------------------------------------------------------------------------

    The proposed requirements for outsourced recordkeeping would
further benefit clients and investors by mitigating the risk of loss,
alteration or destruction of all records maintained by a third-party
service provider, as well as ensuring access to these records for
investment advisers and their clients and investors. While many
investment advisers may already have service provider agreements or
other arrangements that contain these standards as part of their
policies and procedures or best practices to mitigate or manage risks
the investment advisers identified when performing due diligence, we
believe that clients and investors would benefit from a minimum and
consistent framework for third-party recordkeeping that applies to all
service providers to mitigate the risk of loss, alteration or
destruction of records.
b. Costs
    The proposed recordkeeping requirements would impose costs on
advisers related to creating and maintaining the required records. The
quantifiable costs include those that can be attributed to senior
business analysts, attorneys, and compliance professionals who would
review and familiarize themselves with requirements as specified in the
proposed rules. In particular, advisers would be required to make and
retain a list of covered functions and contributing factors, document
their due diligence efforts, retain any written agreements with service
providers, and document periodic monitoring of retained service
providers. Pursuant to the Paperwork Reduction Act analysis, we
anticipate across all 14,756 RIAs an initial cumulative burden of
206,584 hours with an initial cumulative cost of $60,477,466 associated
with this recordkeeping requirement.\228\ We anticipate on an ongoing
annual basis across all 14,756 RIAs a cumulative burden of 2,985,903
internal annual hours with a cumulative annual cost of
$237,527,702.\229\ These quantified estimates are solely for the time,
effort, and financial resources expended to generate, maintain, retain,
or disclose or provide information to or for the adviser or Commission.
These estimates are in addition to the direct costs, discussed above,
that would be imposed by the proposed requirements for actually
conducting additional due diligence and monitoring.\230\
---------------------------------------------------------------------------

    \228\ This burden corresponds to 88,536 hours with an initial
cumulative cost of $25,918,914 for collection of information costs
associated with making and retaining a list of outsourced covered
functions and factors, plus 118,048 hours with an initial cumulative
cost of $34,558,552 for collection of information costs associated
with making and retaining records documenting the monitoring
assessment. See infra section IV.B.
    \229\ See infra section IV.B.
    \230\ See supra section III.D.1.b, III.D.2.b.
---------------------------------------------------------------------------

    Additionally, the proposed rules include third-party recordkeeping
requirements, which would impose further costs on advisers. An adviser
that outsources either the storage, retention, or creation of records
to a third party would need to obtain reasonable assurances that the
third party would be able to meet the standards discussed above.\231\
These required standards would impose direct costs on advisers to the
extent that they choose to outsource some or all recordkeeping to
third-party providers. In particular, advisers may require time and
effort of operational personnel to negotiate arrangements with third-
party recordkeeping service providers to seek to ensure the standards
enacted by this rule are met. Additionally, third-party providers of
recordkeeping services would face costs associated with bringing their
systems into compliance to the extent that they differ from the
proposed third-party recordkeeping requirements.
---------------------------------------------------------------------------

    \231\ See supra section II.E.
---------------------------------------------------------------------------

    Because the direct costs associated with the proposed third-party
recordkeeping requirements primarily constitute activities with similar

principles as the proposed due diligence requirements, we anticipate
that the costs of the third party recordkeeping requirements would be
closely related to the costs of the due diligence requirements.\232\ In
particular, we anticipate that the proposed monitoring requirements
would require the same staff as the due diligence requirements:
compliance managers ($339/hour), a chief compliance officer ($580/
hour), attorneys ($455/hour), assistant general counsel ($510/hour),
junior business analysts ($191/hour), senior business analysts ($300/
hour), paralegals ($199/hour), senior operations managers ($400/hour),
operations specialists ($150/hour), compliance clerks ($77/hour), and
general clerks ($68/hour).\233\ As for the number of hours required for
these personnel, we estimate that a typical adviser would face one
fifth of its due diligence costs as additional third-party
recordkeeping costs, as the estimated due diligence costs rely on an
estimate of an adviser outsourcing five covered functions, and the
burden of the third party recordkeeping requirements are approximately
consistent with the due diligence burden on any other individual
covered function.\234\ This indicates a lower bound for initial costs
of 88 hours and $26,464 per adviser and 1,298,528 hours and
$390,502,784 across all advisers, and a lower bound for ongoing annual
costs of 29 hours and $8,821 per adviser and 432,843 hours and
$130,167,595 across all advisers. This also indicates an upper bound
for initial costs of 264 hours and $79,392 per adviser and 3,895,584
hours and $1.172 billion across all advisers, and an upper bound for
ongoing annual costs of 88 hours and $26,464 per adviser and 1,298,528
hours and $390,502,784 across all advisers. We request comment on all
aspects of this quantification, including the minimum estimated burden
represented here and any range of costs that could hold for different
advisers.\235\
---------------------------------------------------------------------------

    \232\ There may be differences in the costs of recordkeeping as
compared to due diligence, which would cause costs of recordkeeping
to be higher than those estimated here. For example, the costs of
implementing the proposed requirements as separate from the costs of
obtaining reasonable assurances from recordkeeping requirements
could require additional processes and personnel than those
discussed here, and would result in greater costs.
    \233\ The Commission's estimates of the relevant wage rates are
based on salary information for the securities industry compiled by
the Securities Industry and Financial Markets Association's Office
Salaries in the Securities Industry 2013. The estimated figures are
modified by firm size, employee benefits, overhead, and adjusted to
account for the effects of inflation. See infra section IV. Certain
advisers may need to hire additional personnel to meet these
requirements.
    \234\ See infra section IV.B.
    \235\ See infra section III.G.
---------------------------------------------------------------------------

    As with the proposed due diligence requirements, we are unable to
quantify the costs that would be incurred by service providers as a
result of this proposed rule, as the cost range would be too wide to be
informative.\236\ Any portion of the proposed required recordkeeping
costs that is not borne by advisers would ultimately be passed on to
clients and investors.
---------------------------------------------------------------------------

    \236\ See supra section III.D.1.b.
---------------------------------------------------------------------------

4. Form ADV
    We are proposing to amend Form ADV to require advisers to identify
their service providers that perform covered functions as defined in
proposed rule 206(4)-11, provide their location, the date they were
first engaged to provide covered functions, and state whether they are
related persons of the adviser. For each of these service providers, we
would also require specific information that would clarify the services
or functions they provide.\237\ Because Form ADV Part 1A is submitted
in a structured, XML-based data language specific to that Form, the
proposed information in proposed new Item 7.C would be structured
(i.e., machine-readable). We discuss the benefits and costs of the
proposed Form ADV requirements of the rule below.
---------------------------------------------------------------------------

    \237\ See proposed Form ADV, Part 1A, Item 7.C., and Section
7.C. of Schedule D.
---------------------------------------------------------------------------

a. Benefits
    The proposed Form ADV requirements would provide direct and
indirect benefits to clients. Form ADV disclosure would benefit clients
of advisers directly by making it less costly to gather information
necessary for investors and other clients to conduct more comprehensive
due diligence when deciding to hire or retain advisers, to the extent
that their choice of adviser is impacted by outsourcing of covered
functions to service providers as defined in proposed rule 206(4)-11.
Investors in fund clients (such as private funds) would similarly
benefit, to the extent they obtain Form ADV information.
    Form ADV Part 1A is submitted using a structured data language
(specifically, an XML-based data language specific to Form ADV), so the
information in the new Item 7.C of Part 1A would be structured (i.e.,
machine readable). Also, clients of advisers would be able to identify
quickly and consider any implications of an adviser's use of a service
provider or the outsourcing of any service or function. For example,
clients that use multiple advisers for purposes of total return risk
diversification could identify whether that diversification was
lessened by all or many of their advisers relying on a single service
provider, to the extent that their returns would be harmed by multiple
advisers facing operational failures.\238\ We also expect the use of
this information may help clients of advisers protect themselves
against losses resulting from a service provider failure or service
provider fraud. For example, if a client experienced a system failure
relating to a service provider, and the adviser has identified that
provider as a service provider defined in rule 206(4)-11 and reported
that provider in Form ADV, the client could determine more easily and
quickly whether its adviser uses that service provider for a covered
function and take remedial action such as contacting the adviser to
understand how the adviser is managing the issue or choosing to move to
a new adviser.
---------------------------------------------------------------------------

    \238\ As discussed in section III.C, when multiple regulated
entities use a common service provider, operational risk could
become concentrated. The proposed Form ADV requirements would make
it less costly for clients to gather information necessary to
mitigate concentrated operational risk.
---------------------------------------------------------------------------

    The proposed Form ADV requirements would also provide a benefit by
facilitating the Commission in its oversight role. The disclosures
would allow the Commission to understand better the investment advisory
industry as well as enhance the ability of the Commission to evaluate
and form regulatory policies and improve the efficiency and
effectiveness of the Commission's oversight of markets for client and
investor protection. For example, for service providers that advisers
identify as service providers defined in rule 206(4)-11 on Form ADV,
the information in the required Form ADV disclosures would provide the
Commission with a better understanding of the material services and
functions that advisers outsource to service providers, and would
enhance our assessment of advisers' reliance on service providers for
purposes of targeting our examinations. Also, the information would
help the Commission identify advisers' use of particular service
providers that advisers have identified that may pose a risk to clients
and investors. Additionally, the disclosures would improve our ability
to assess service provider conflicts and potential risks when
identifying firms for examination. Finally, the ability to identify
readily other advisers using such a service provider would allow the
Commission to assess quickly and react to the

potential harm to advisory clients.\239\ The proposed rules would
thereby benefit clients and investors through the Commission's
increased visibility into operational failures, greater regulatory
transparency, and resulting effectiveness of the Commission's client
and investor protection efforts.
---------------------------------------------------------------------------

    \239\ As discussed in section III.B.2, if a large number of
investment advisers used a common service provider, operational
risks could be correspondingly concentrated. Increased concentration
of operational risk could, lead to an increased risk of broader
market effects during times of market instability. The ability to
identify readily the advisers using such a service provider might
allow the Commission to respond more quickly to such broader market
effects.
---------------------------------------------------------------------------

b. Costs
    The Form ADV requirements would require the disclosure of certain
information that is not currently required in the Form. Costs would
likely vary across advisers, depending on the nature of an adviser's
business and its business model. For example, advisers that do not
outsource functions or that outsource fewer functions would have fewer
reporting requirements than advisers that outsource a large number of
functions, to the extent that these functions would qualify as covered
functions under the proposed rule. We believe, however, that much of
the information we propose requiring would be readily available because
we understand that it is information used by advisers in conducting
their business.\240\ Lastly, the requirement that information in Item
7.C of Part 1A of Form ADV be provided in a custom XML-based data
language is unlikely, by itself, to impose costs on advisers because
the XML-based data language is not new and applies to existing Form ADV
Part 1A disclosures.
---------------------------------------------------------------------------

    \240\ To the extent that the proposed rule would require
information not currently contained in adviser accounting or
financial reporting systems to be reported, advisers may bear one-
time costs to update systems to adhere to the new filing
requirements.
---------------------------------------------------------------------------

    The additional burden on advisers due to proposed modifications to
Form ADV would take the form of initial internal costs, annual internal
costs, and external costs. We estimate that the proposed modifications
would impose 1.5 additional hours of initial internal costs and 0.7
additional hours of annual internal costs per adviser. The total
internal burden is anticipated to be $9,706,497 across all RIAs.\241\
Additionally, initial external costs are anticipated for a subset of
RIAs. We anticipate this additional external cost would be $7,794,857
across all RIAs.\242\ In total, the proposed modifications are expected
to impose an additional burden of $17,517,585 across all RIAs. We
anticipate that these information collection costs are likely to be the
same initially as they are on an ongoing basis. Any portion of these
costs that is not borne by advisers would ultimately be passed on to
clients and investors.
---------------------------------------------------------------------------

    \241\ See infra section IV. Calculated as 2.2 internal hours per
adviser x 14,756 advisers at a blended hourly rate of $299.50. The
total revised internal cost per adviser of $13,094.14 incorporates
the increase in required hours and an inflation adjustment to the
blended hourly rate, and the calculation here captures only the
increase in required hours. Additionally, this aggregate cost
reflects only the current investment advisory industry size, and
does not incorporate the expected net addition of 552 RIAs per year.
    \242\ See infra section IV. Calculated as 1 hour of external
legal services x 0.25 x 14,756 advisers x $531 per hour + 1 hour of
external compliance consulting services x 0.5 x 14,756 advisers x
$791 per hour = $7,794,857. The additional burden resulting from
this rule is calculated using estimated additional hours and
inflation-adjusted hourly costs of corresponding personnel. See
supra footnote 241.
---------------------------------------------------------------------------

E. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency
    The proposed rules may affect the efficiency with which clients'
and investors' capital is allocated in two ways.
    First, the proposed rule would result in an increase in information
about advisers outsourcing that clients would be able to access on Form
ADV. To the extent that clients access this information and rely on it,
that increased information could permit clients to make better informed
decisions about allocating their capital. For example, clients may
choose to diversify investments across multiple advisers who engage
different service providers to perform certain covered functions, such
as advisers who rely on different index providers or model providers,
or advisers who rely on service providers offering different predictive
data analytics methods. Therefore, to the extent that clients and
investors access and make use of the additional Form ADV information
generated by advisers as a result of this proposed rule, we would
expect a more efficient allocation of client and investor capital among
advisers.
    Second, and alternatively, if some advisers were to elect to
perform certain covered functions in-house to avoid the compliance
costs associated with outsourcing the covered functions, or if the
service provider terminates the relationship as a result of its own
increased costs and the adviser cannot identify a suitable replacement,
the function may be performed less efficiently as compared to the
service provider. For example, such a loss of efficiency could occur
for any functions that experience economies of scale, and which may be
currently provided by a single service provider for a large number of
advisers, to the extent those advisers would perform the function in-
house in response to the proposed rules. As noted above, smaller
advisers may be less able than larger advisers to provide a covered
function in-house as efficiently and with equal quality as a service
provider.\243\
---------------------------------------------------------------------------

    \243\ See supra section III.C.
---------------------------------------------------------------------------

2. Competition
    The proposed rules may lead clients to make better-informed
decisions when selecting an adviser by increasing information about
advisers outsourcing that clients would be able to access on Form
ADV.\244\ As a result, competition among advisers could increase. An
increase in competition could, presumably, manifest itself in terms of
better service, better pricing, or some combination of the two, for
clients, to the extent that clients and investors access and use the
additional Form ADV information generated by advisers as a result of
this proposed rule.
---------------------------------------------------------------------------

    \244\ See supra section III.E.1.
---------------------------------------------------------------------------

    Alternatively, the proposed rule could have the opposite effect on
competition. As an initial matter, the proposed rule would create new
costs of providing advisory services, which could disproportionately
impact small or newly emerging advisers who may be less able to absorb
or pass on these new costs. New costs, especially fixed costs, could
also disproportionately impact small or newly emerging advisers. To the
extent these costs discourage entry of new advisers or cause certain
advisers to exit the market, competition would be harmed.
    It is also possible that the costs borne by advisers may be large
enough to cause some advisers to stop outsourcing some or all of their
covered functions.\245\ If advisers were to stop outsourcing some or
all of their covered functions, clients could experience a decrease in
the quality of advisers' services. Alternatively, if advisers were to
try to pass on the costs, or some component thereof, to clients, these

costs may cause some clients to seek other advisers or alternatives to
registered advisers. The decreased demand for advisory services could
result in a decline in the number of registered advisers and, a
decrease in competition among registered advisers, as a result. A
decrease in competition among registered advisers could manifest itself
in terms of poorer service, poorer pricing, or some combination of the
two, for clients.
---------------------------------------------------------------------------

    \245\ See supra section III.E.1. If there are fixed costs
associated with the proposed regulations, then smaller advisers
would generally tend to bear a greater cost, relative to adviser
size, than larger advisers. If there are material fixed costs
associated with the proposed rule, then we would expect the possible
negative effect on competition to be greater for smaller advisers
who engage service providers because the proposed regulations would
tend to increase their costs more (relative to adviser size) than
for larger advisers that engage service providers.
---------------------------------------------------------------------------

    Finally, the proposed rules may affect competition among service
providers or their subcontractors. The rules are designed to increase
transparency into an adviser's outsourced covered functions for clients
and investors, as well as for the Commission. One possible result of
this increased transparency may be increased competition among service
providers with respect to the quality of their services. Advisers may
be able to scrutinize service providers more closely, and thus better
select more effective service providers or service providers who better
align with their needs, to the extent these relationships are not
already appropriately aligned, and service providers overall may seek
to adjust the quality of their services accordingly. On the other hand,
the proposed rules may have the opposite effect, in the event that the
increased costs of the rule cause certain service providers to exit the
market, or choose not to contract with investment advisers, either to
avoid incurring new costs or to avoid the costs of improving the
quality of their services. The increased costs associated with the rule
could also dissuade new entry of service providers. In this case, the
number of service providers to investment advisers may shrink, which
may in turn result in higher service provider prices, although any
change in the average quality of remaining providers would depend on
whether higher or lower quality service providers would be more likely
to exit to avoid new costs.
3. Capital Formation
    Lastly, the enhancements to client and investor protection as well
as the additional information available to potential current clients
and potential investors could result in current investors being willing
to invest more and potential investors being more willing to invest for
the first time. For example, potential investors may be more willing to
invest for the first time knowing that outsourced covered functions
would be subject to enhanced due diligence and monitoring, as well as
knowing that any third-party service providers maintaining the records
of their investment would be subject to enhanced oversight.\246\ To the
extent that the proposed rule leads to greater investment, we could
expect greater demand for securities, which could, in turn, promote
capital formation.
---------------------------------------------------------------------------

    \246\ See supra sections II.B, II.C, II.E.
---------------------------------------------------------------------------

F. Reasonable Alternatives

1. Alternatives to the Proposed Scope
    Scope of Covered Functions. As noted above, the proposed rule would
generally apply to a registered adviser that outsources a covered
function to a service provider.\247\ A covered function is defined in
the proposed rule as a function or service that is necessary for the
adviser to provide its investment advisory services in compliance with
the Federal securities laws, and if not performed or performed
negligently, would be reasonably likely to cause a material negative
impact on the adviser's clients or on the adviser's ability to provide
investment advisory services.\248\ The Commission alternatively could
define covered functions to include broader or narrower sets of
outsourced functions. Changing the definition of covered functions
could provide a benefit in terms of either (i) increased client
protection and investor protection in the case of broadening the
definition or (ii) a reduction in the cost of the compliance with the
rule in the case of narrowing the definition.
---------------------------------------------------------------------------

    \247\ See proposed rule 206(4)-11(a).
    \248\ Proposed rule 206(4)-11(b).
---------------------------------------------------------------------------

    We believe the definitions that we have included in the proposed
rule will provide additional protections with respect to advisers
outsourcing that we think are important for the protection of clients
and investors. Additionally, the definition of covered functions, in
combination with other requirements of the proposed rule, would provide
efficiencies for our examination staff, as well as provide the public
with additional information about advisers to make more informed
decisions about the selection and retention of investment advisers.
Narrowing the scope of the definitions could reduce the cost of the
proposed rule's requirements, but could also result in a reduction in
client and investor protections as a result of being under-inclusive.
For instance, the rule could have alternatively limited the scope of
the definition of a covered function to a pre-identified list of
specific functions, but this could limit the rule's protections when
there are material changes in the manner in which advisers operate that
are outside the scope of the stated functions. This list could be
either the same as those provided by service provider types listed in
the proposed amendments to Form ADV, or more expansive, or more
restrictive. For example, it could define covered function as those
services pertaining to the selection, trading, valuation, management,
monitoring, indexing, use of predictive data analytics, and modeling of
investments.\249\ The rule could also provide detailed guidance on
variations of descriptions of functions that different service
providers may use. For example, the rule could separately define
``trading'' and ``execution,'' and provide explicit instruction as to
how they would be treated by the rule. As another example, the rule
could provide separate explicit instruction for ``management and
selection'' as separate from ``indexing and modeling.'' \250\ The rule
could also explicitly state that its application is limited to core
investment advisory services, and provide an explicit definition for
core investment advisory services. The rule could alternatively apply
based on a percentage of either regulatory assets under management or
clients directly affected by the service provider's performance. These
limitations may broadly have the effect of lowering compliance costs of
the proposed rule, but they may not reflect what is core to any
particular investment adviser.
---------------------------------------------------------------------------

    \249\ See supra section II.A.
    \250\ See supra section II.A.3.
---------------------------------------------------------------------------

    Alternatively, broadening the scope would have the opposite effect,
increasing the cost of the proposed rule's requirements but potentially
resulting in greater client and investor protections. For instance, the