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SEC Guidance on Advisers Act Compliance for Robo-Advisers

In recent years, advisory firms that offer automated advice platforms, colloquially termed “robo-advisers,” have been rapidly gaining steam.  These platforms utilize algorithms to generate portfolio recommendations, and typically do not come with the minimum account requirements or hefty fees of traditional investment advisers.*  These factors make robo-advisers an affordable and attractive account-management option for moderate-income investors.  As such, more and more investors are turning to this option.  It was estimated that robo-advisers had $53 billion dollars under management at the end of 2015, and this figure is forecasted to reach $7 trillion by 2020.[1]

 

Of course, along with increased popularity comes increased regulatory scrutiny.  On February 23, 2017, the Investment Management Division of the Securities and Exchange Commission (“SEC”) issued guidance (the “Guidance”) for robo-advisers regarding disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940 (the “Advisers Act”).  While robo-advisers are subject to the same fiduciary obligations under the Advisers Act as any other registered investment adviser, their e-platform and lack of human interaction present unique compliance challenges.  The Guidance provides standards and expectations for robo-advisers wondering how to match their internet-driven systems with pre-internet rules and regulations.

 

The Guidance provides that robo-advisers should provide a clear explanation to investors of its business model.  In particular, robo-advisers should disclose that algorithms manage individual client accounts and describe the algorithmic functions and assumptions used to manage those accounts.  The extent of human oversight over a robo-adviser’s program should also be made clear: for example, robo-advisers should disclose any circumstances that could override their algorithms and describe any involvement by third-party developers, managers or owners of the algorithms (including potential conflicts of interest and fee disclosures).

 

Discussing the importance of these disclosures, the Guidance states:

As a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients.  The information provided must be sufficiently specific so that a client is able to understand the investment advisor’s business practices and conflicts of interest.[2]

 

Noting the unique challenges of the internet-driven landscape that robo-advisers operate in, the Guidance also makes note of the importance of robo-advisers presenting their disclosures in ways that are sure to reach their clients. Disclosures should not just be found in the robo-adviser’s Form ADV, which it is doubtful very many clients will examine, but also on its website and on other documents delivered to clients and prospective clients.  In particular, key disclosures should be made prior to a client’s sign-up process so that the client has the information needed to make an informed investment decision.  The Guidance advises that key disclosures should also be specially emphasized (e.g. through design features) and in some cases accompanied by interactive text to provide additional details for clients seeking more information.  Additionally, robo-advisers offering a mobile app should ensure that their platforms are properly adapted for use on hand-held electronic devices.

 

The Guidance also stressed that robo-advisers must meet the Advisers Act’s suitability requirements. Under the Advisers Act, investment advisors must make a reasonable determination that investment advice is suitable for a client, taking into account such client’s financial situation and investment objectives.[3]  It is common practice for robo-advisers to attempt to fulfill this requirement, with varying degrees of success, by having clients complete investment questionnaires.  Client questionnaires vary from robo-adviser to robo-adviser, featuring differing lengths, content and ability for clients to give additional context to accompany their answers.  The Guidance sets some standards of conformity to this system, indicating that robo-advisers should ensure that they are obtaining enough client information to make a suitable recommendation, by drafting clear questions and implementing procedures to identify and address any inconsistencies in client responses.  In addition, the Guidance directs robo-advisers offering clients the option to invest against adviser recommendations to also offer commentary explaining why certain investments are deemed more suitable for client’s investment objectives and risk profile.

 

Lastly, the Guidance discusses the difficulties that may arise for robo-advisers in developing a compliance program that is in compliance with Rule 206(4)-7 of the Advisers Act.  Rule 206(4)-7 sets forth requirements for investment advisors to establish an internal compliance program, including the adoption, implementation, and annual review of written policies and procedures and the designation of a chief compliance officer.  The Guidance notes that the unique business model of a robo-adviser, and the algorithms, client questionnaires and electronic media it relies on, exposes the robo-adviser to certain risks that should be accounted for in its compliance program.  The Guidance suggests that robo-advisers consider adopting written policies and procedures addressing those risks, covering areas such as the development, testing and backtesting of algorithms and post-implementation monitoring, disclosure to clients of changes to algorithms that could materially affect their portfolios, and the prevention, detection of, and response to cybersecurity threats.[4]

 

While this Guidance falls short of issuing new rules applicable to robo-advisers, it serves as a reminder to robo-advisers that they are subject to the fiduciary and other substantive requirements of the Advisers Act and that regulators are keeping an eye on developments in the relatively new sphere.  As such, robo-advisers are advised to ensure that they are maintaining a robust compliance program designed to bridge the gap between the requirements of the Advisers Act and the remoteness of the digital world.

 

* As stated elsewhere on this site, although many people spell adviser with an “o,” we follow the lead of the SEC and FINRA and spell adviser with an “e,” since the U.S. laws that govern this type of investment professional invariably spell the job title this way.

[1] James Watkins III, The Unanswered Question About Robo-Advisors, The Motley Fool, February 21, 2017.

[2] Guidance Update No. 2017-02, Securities and Exchange Commission, at 3, February 2017.

[3] Status of Investment Advisory Programs under the Investment Company Act of 1940, Investment Company Act Release No. 22579, n.32 (Mar. 24, 1997)

[4]  Guidance Update No. 2017-02 at 7-8.