On February 23, 2017 the Staff of the SEC’s Division of Investment Management released “suggestions” on how robo-advisers meet their obligations under the Investment Advisers Act of 1940 (“Advisers Act”).   The Staff noted that their guidance was intended for robo-advisers that “provide services directly to clients over the internet” but noted that the guidance could be useful to other types of robo-advisers.

The Staff categorized its guidance into the following three areas:

  1. Disclosures to clients;
  2. Information required to provide suitable advice;
  3. Effective compliance program designed to address automated advice.

Disclosures to Clients

Given the nature of the delivery of investment advice in a robo-adviser model (e.g. with limited, if any, human interaction), the Staff suggested that in developing their disclosures to clients that robo advisers “consider how it explains its business model and the scope of the investment advisory services it provides, as well as how it presents material information to clients.”

Disclosures with respect to business model

The Staff provided a laundry list of information that robo-advisers should consider providing clients with respect to its business model and related risks.  Highlights of the laundry list include the following disclosure items:

  • Information regarding the algorithm used to manage client accounts such as the fact that the algorithm is used and the functions it provides in the management of the account, the assumptions and limitations of the algorithm, the risks inherent in using the algorithm, and the circumstances in which the algorithm may be overriden.
  • The degree of human involvement in the oversight and management of client accounts.
  • Whether third parties are involved in the “development, management or ownership of the algorithm” and, if so, disclosure regarding conflicts of interest such as if the third party receives a fee for use of its products in the program.
  • How the robo-adviser uses the information collected from the client to generate a portfolio and whether or not the information collected is the sole basis for the recommended portfolio.
  • Information on how the client should update the information provided and the fees charged directly or indirectly to the client.

Scope of Services

The Staff cautioned that robo-advisers should “avoid creating a false implication or sense about the scope of those services which may materially mislead clients.”  Examples of potentially misleading disclosures provided by the Staff include disclosures that imply:

  • that the robo-adviser is providing a comprehensive financial plan if it is not doing so;
  • that tax-loss harvesting provides comprehensive tax advice; and
  • that information, other than information collected in the questionnaire, is considered in generating the portfolio recommendation if such information is not in fact used.

Presentation of Disclosure:

The Staff suggested that since robo-advisers primarily use online disclosures with clients that “there may be unique issues that arise when communicating key information, risks and disclaimers.”  Accordingly, the Staff indicated that robo-advisers may want to consider:

  • When key disclosures are made (e.g. before or after the sign-up process);
  • The emphasis given key disclosures such as through pop-up boxes, interactive text or FAQs; and
  • Whether or not information provided on mobile devices have been “appropriately adapted for that platform.”

Information required to provide suitable advice

The Staff reminded robo-advisers that they have an obligation to “make a reasonable determination that the investment advice provided is suitable for the client based on the client’s financial situation and investment objectives.”  Given the unique aspects of robo-advisers the Staff suggested that robo-advisers consider the following when determining whether they have fulfilled their suitability obligations to the client:

  • Whether the online questionnaire captures sufficient information to “allow the robo-adviser to conclude that its initial recommendations and ongoing investment advice are suitable and appropriate for that client based on his or her financial situation and investment objectives.”
  • Whether the questionnaire is clear and whether there is additional clarifications or examples available; and
  • Whether inconsistent client responses are addressed (e.g. alerts or automatic flags).

In circumstances where a client selects a portfolio other than the one recommended by the robo-adviser the Staff suggests that the robo-adviser incorporate features to “alert a client of potential inconsistencies between the client’s stated objective and the selected portfolio.”

Effective compliance program designed to address automated advice

The Staff indicated that in developing their compliance program that robo-advisers should consider adopting policies and procedures that address the following areas:

  • The ‘development, testing and backtesting of the algorithmic code and the post-implementation monitoring of its performance;’
  • Ensuring the questionnaire solicits sufficient information to provide the advice;
  • Disclosure to clients of changes in the algorithmic code and effect on portfolio;
  • Oversight of the use of third parties, if any, used in the offering;
  • Cybersecurity threats;
  • Social media marketing policies; and
  • Protection of client accounts and “key advisory systems”.

Note on Investment Company Act of 1940 Compliance:  The Staff notes that robo-advisers “should consider whether the organization and operation of their programs raise any issues under the other federal securities laws,  including the Investment Company Act of 1940. . ., and in particular Rule 3a-4 under that Act.”  Rule 3a-4 provides a non-exclusive safe-harbor from the definition of an investment company, and therefore registration under the 1940 Act, for discretionary managed account programs that are managed by an adviser.  Generally these programs have a large amount of clients with relatively modest assets.  Therefore, robo-advisers should have a compliance policy that documents how they are complying with the conditions of Rule 3a-4.

The Staff’s guidance can be found here.

Good Day.  DR2