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NASD Narrows Guidance on Outsourcing: Demands Due Diligence, Written Policies for Third-Party Vendors


With advisory firms and brokerage houses that sell mutual funds increasingly looking to outsource activities to third-party service providers, NASD is now calling for more detailed oversight of vendors and explicit written policies and procedures.

In a five-page notice to member firms dated July 22, NASD outlined "accountability and supervisory" responsibilities for outsourced functions, along with a clarification of which activities are prohibited from being farmed out to outside contractors. The guidance comes in response to growing interest among registered investment advisors and brokerages in outsourcing activities such as transfer agent and data services, as well as activities other than those traditionally performed under clearing agreements.

"Increased competition, new and proposed regulation, and the velocity of technological change have made it more difficult for intermediaries to focus on their core business," said Karen Keene, a senior analyst at research and consulting firm Cerulli Associates in Boston and co-author of a report on outsourcing trends.

Keene notes in her report that lowering expenses continues to be one of the most common factors driving broker/dealers to consider outsourcing. Indeed, her research shows that one-third of firms indicated that the need to reduce costs is the primary reason influencing the decision to outsource.

On top of that, a broker/dealer firm's realization that establishing a relationship with a third-party product and services provider can derive multiple benefits is further fueling the trend toward outsourcing.

Many firms recognize that as technology improves within the marketplace, it is more cost-effective to purchase a product or service from a provider with comparative advantages than it is to develop an in-house product or service and provide for its upkeep.

In light of the outsourcing trend that has emerged over the last 18 months, the NASD issued the notice to remind its membership base of 5,180 brokerage firms, 102,650 branch offices and more than 661,780 registered representatives that any third-party firms conducting activities that require registration under NASD rules "will be considered associated persons of the member, absent the service provider being registered as a broker/dealer."

Further, the NASD reiterated that outsourcing an activity does not relieve members of their compliance obligation under federal securities laws as well as NASD and MSRB rules.

Given that reality, NASD is urging members to reevaluate and perhaps adjust their supervisory structure to ensure that a qualified person monitors the arrangement.

Under NASD Rule 3010, which deals with so-called "covered" activities, NASD members must draft a "supervisory system" and a written compliance manual tailored to each member's business structure. Critical to the monitoring process is a top-to-bottom "due diligence analysis" of all current and prospective third-party service providers to determine whether they are capable of performing their assigned duties. Beyond the due diligence analysis, members are required to monitor service providers' performance and provide NASD and other regulators with access to their work product, as if it were performed by the member firm itself.

Hired Gun

Characteristics that should be taken under advisement when selecting an outsourcing partner, according to the notice, include the financial, reputational and operational impact on the member if the hired gun doesn't get the job done.

Another factor is the potential impact of outsourcing on the quality of services provided to customers. Additionally, member firms should consider the impact on the firm's ability to abide by regulatory requirements and any subsequent changes to those requirements, the NASD said.

"Reputation plays a critical role in broker/dealers' opinions of vendors," Keene said. "A firm's reputation is directly related to the quality of work, the products and client services delivered by the vendor. In the current market environment, a spotless reputation is of greater value as the financial industry attempts to repair its image after a period of scandals."

Also highlighted in the NASD's guidance are functions that are prohibited from being outsourced. "The performance of covered activities, which require qualification and registration, cannot be deemed to have been outsourced because the person performing the activity is an associated person of the member irrespective of whether such person is registered with the member," NASD said in the notice.

An exception to the rule would be an instance where a third-party service provider is separately registered as a broker/dealer and the arrangement is permitted under NASD rules and federal securities laws.

In other words, a third-party vendor is not an associated person if it only provides trade execution or back-office functions that are utilized by registered or other associated persons of the member firm.

Under no circumstances can an NASD member contract its supervision and compliance obligations. But this prohibition does not preclude firms from outsourcing certain activities that support the performance of its supervisory and compliance responsibilities.

For example, a brokerage house could implement a supervisory system designed by another party, which could include software to detect abusive market timing in customer accounts. However, it must make its own determination that the system is reasonably designed and meets the compliance standards outlined in Rule 3010.

Coping with the overall heightened focus on regulation and compliance in the financial services industry and getting up to speed on the minutia of the new requirements is likely to force more and more players to consider outsourcing. But chief compliance officers must be sure that they're not leaving their firms at risk in an effort to pare costs.

Recent history has proved that not having adequate internal controls and the necessary vigilance to oversee third-party service providers can be perilous.

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