SEC’s Proposed Rules Should Also Address Phantom Indemnity

The SEC has solicited public comments on proposed rule 206(4)-11 under the Investment Advisers Act of 1940, which would require investment advisers to exercise additional diligence and oversight when outsourcing functions to third-party service providers. The rules address risks faced by an adviser’s clients, including investment companies, when “an adviser outsources to a service provider a function that is necessary for the provision of advisory services without appropriate adviser oversight.” The oversight obligation applies not only to a provider’s daily operations but also potential conflicts of interest that may arise between the provider and the investment company.


We agree with the SEC’s rationale in proposing these new rules: namely, that “as a fiduciary, an investment adviser cannot just ‘set it and forget it’ when outsourcing,” and an “adviser remains liable for its obligations, including under the Advisers Act, the other Federal securities laws and any contract entered into with the client, even if the adviser outsources functions.”

As set forth in a comment letter provided to the SEC, we also believe that the new rules should provide additional clarity around when a provider is entitled to indemnity (and when it is not). Specifically, any contract with a fund service provider should state plainly that:

(1)  the service provider will be liable, with no limitation of liability and no right to indemnification, for losses caused by its own conduct;

(2)  the service provider will have no right to expense advancements if a fund’s trustees find, after reasonable investigation, that the provider was at fault in any way for the losses or liabilities; and

(3)  the service provider will never have a right to indemnification or expense advancements in connection with claims asserted under the federal securities laws.

Plain contract language regarding a provider’s entitlement to indemnification and expense advancements will be crucial when an inevitable dispute arises. Funds should never find themselves facing liability or the prospect of paying out-of-pocket legal expenses to parties that have culpability for the fund’s litigation or regulatory problem. In many cases, fund boards should be advancing the fund’s own indemnification and expense advancement rights against third parties rather than considering those the fund may owe.

The comment letter proposes a structure that would place the onus on the fund’s trustees to consider carefully, consistent with their fiduciary duties, any third-party claims for indemnification or expense advancement before compromising the fund’s assets.

For additional information, contact Aaron Morris.