Proposed SEC Rules Regarding Continuity and Succession Planning

On June 28, 2016, the SEC proposed new Rule 206(4)-4 and amendments to Rule 204-2 under the Advisers Act that would require SEC-registered investment advisers to establish business continuity and transition plans.   Existing Advisers Act Rule 206(4)-7 requires advisers to adopt formal written compliance policies, and the SEC has previously interpreted that Rule as requiring policies that address business continuity planning, such as in the event of a natural disaster or death of an owner or key personnel. There has been no formal detailed guidance on those policies, however, and advisers have adopted plans that vary widely in scope and level of detail.   The proposed Rules clarify what is required in a manner similar to business continuity rules already adopted by FINRA, the CFTC and the NFA.   In addition to listing specific topics that business continuity and transition plans must address, the proposed Rules require advisers to review the adequacy and effectiveness of their plans at least annually and maintain documentation of the reviews.

The proposed Rules focus on minimizing “material service disruptions.”   They reflect the SEC’s  concern with mitigating both short-term disruptions (due, for example, to data loss or facility destruction caused by a natural disaster, cyber-attack or other man-made crisis) and long-term disruptions (such as might be triggered by the death, incapacity or departure of key personnel). The proposed Rules leave advisers flexibility to craft their plans to address the particular risks associated with their operations—and indeed instruct them to do so–but state that the plans should at least cover:

  • maintenance of critical operations and systems, and the protection, backup and recovery of data;
  • pre-arranged alternate physical location of office and employees;
  • communications with clients, service providers and regulators; and
  • identification and assessment of third-party services critical to the adviser’s operations
    (such as custodians, prime brokers and fund administrators).

Many advisers have already adopted policies that cover these logistical issues, some of which may be addressed to a large degree through technological solutions.

The more challenging aspect of the proposed Rules for many advisers will be their requirement that the adviser also have a plan for winding down or transitioning the business to others if the adviser’s principals are unable to continue.  On this topic, the proposed Rules specify that the plan must include:

  • policies and procedures to safeguard, transfer and distribute client assets during a transition;
  • policies and procedures to facilitate the prompt generation of any client-specific information necessary to transition each client account;
  • information about the adviser’s corporate governance structure;
  • identification of material financial resources available to the adviser; and
  • assessment of applicable law and contractual obligations that apply to the adviser and its clients (including any investment funds it manages) and that may be implicated by a transition (such as “key man” provisions in fund documents that trigger redemption rights if key personnel depart or become incapacitated).

Again, some of these responsibilities, such as generating, preserving and transmitting client data, relate mainly to technological capabilities and can be readily discharged through competent data management systems and communications protocols.  But underlying the proposed Rules is also an expectation that the adviser consider “what next” in a more fundamental and personal sense.   Issues to consider include:

  • whether there are existing personnel competent to continue to manage the business on their own, and if not, whether it is desirable and possible to hire and train staff to take that role in the future;
  • how to prepare clients for a transition, perhaps including building awareness of management by a “team” rather than one or two individuals;
  • how and on what terms to transfer ownership to new owners, including whether it is desirable to force a buy-out of departing owners’ interests, how the purchase price will be calculated and over what period it will be paid;
  • how current co-owners will fund any purchases of departing owners’ interests (for example, through life insurance policies maintained by the firm on current owners); and
  • how to address contracts under which key individuals have provided personal guarantees for obligations of the firm.

Planning ahead to transfer ownership of the business, or to transfer clients to a new adviser, can be awkward and without any immediate reward.  But institutional  investors have long asked questions about transition planning as part of their due diligence reviews, and it’s not surprising that the SEC has decided to do the same.  Firms with only one key person need to have plans to transfer control of the business to others or at least liquidate client accounts (often through the appointment in advance of a knowledgeable “liquidating person”) and return capital in an orderly fashion.   Large firms with more complex ownership structures need to have clear agreements in place for transferring executive and investment management functions to the remaining – hopefully well-prepared – employees and owners.

Comments on the proposed Rules are due by September 6, 2016.   That deadline could be extended if there are significant comments, and in any case the SEC is likely to give SEC-registered advisers ample time to develop and implement whatever policies the final Rules require.  However, given the sensitivities and complexities of succession planning, advisers that have not yet made a continuity and transition plan should start thinking about it now.