SEC Issues Guidance Update on Robo-Advisers

April 12, 2017

The staff (the “Staff”) of the SEC’s Division of Investment Management recently issued a Guidance Update regarding automated advisers, which are often colloquially referred to as “robo-advisers.”1 Robo-advisers typically are registered investment advisers that use innovative technologies to provide discretionary asset management services to their clients through online algorithmic-based programs. The Staff has been monitoring and engaging with robo-advisers in order to determine how robo-advisers meet their obligations under the Investment Advisers Act of 1940 (the “Advisers Act”).

The Staff listed three distinct areas for robo-advisers to consider: (i) the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers; (ii) the obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and (iii) the adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

1.  Substance and Presentation of Disclosures

The Staff stated that, as part of its fiduciary duty to clients, a robo-adviser should disclose information regarding its particular business practices and related risks, including the fact that an algorithm is used to manage individual client accounts; the algorithmic functions used to manage client accounts; the assumptions and limitations of the algorithm; the particular risks inherent in the use of an algorithm; any circumstances that might cause the robo-adviser to override the algorithm, any involvement by a third party in the development, management or ownership of the algorithm; any fees that the client will be charged and costs that the client will bear; the degree of human involvement in the oversight and management of individual client accounts; and how the robo-adviser uses the information gathered from a client to generate a recommended portfolio and how and when a client should update information he or she has provided to the robo-adviser.

The Staff encouraged robo-advisers to consider the clarity of the descriptions of their advisory services to avoid creating a false implication about the scope of those services. For example, a robo-adviser should not imply that it is providing a comprehensive financial plan if it is not in fact doing so.

Given that robo-advisers may not make investment advisory personnel available to clients to explain important concepts, the Staff reminded robo-advisers to carefully consider whether their written disclosures are designed to be effective. The Staff suggested that, in presenting their disclosures, robo-advisers consider whether key disclosures are presented prior to the client’s sign-up process; whether key disclosures are specially emphasized (e.g., through design features such as pop-up boxes); whether some disclosures should be accompanied by interactive text or other means to provide additional details to clients who are seeking more information; and whether the presentation and formatting of disclosure made available on a mobile platform have been appropriately adapted for that platform.

2.  Provision of Suitable Advice

The Staff expressed their view that Robo-advisers have a fiduciary duty to act in the best interests of their clients and to provide only suitable investment advice. The Staff observed that robo-advisers often determine what investment advice is suitable based primarily on client responses to online questionnaires. The Staff provided a number of factors for robo-advisers to consider when determining whether a questionnaire is designed to elicit sufficient information to support its suitability obligation. Specifically, the robo-adviser should consider whether the questions elicit 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 sufficiently clear and whether steps have been taken to address inconsistent client responses, such as alerting the client when his or her responses appear internally inconsistent or flagging apparently inconsistent information for follow up by the robo-adviser.

The Staff observed that some robo-advisers give clients the opportunity to select portfolios other than the ones recommended by the robo-adviser without an opportunity to consult the robo-adviser. In order to prevent clients from mistakenly selecting unsuitable portfolio options, robo-advisers should consider providing commentary as to why they believe particular portfolios may be more appropriate for a given investment objective and risk profile.

3.  Effective Compliance Program

Rule 206(4)-7 under the Advisers Act requires an investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder; review, no less than annually, the adequacy of the policies and procedures and the effectiveness of their implementation and designate a chief compliance officer to be responsible for administering the policies and procedures.2 In developing its compliance program, the Staff encouraged robo-advisers to be mindful of the unique aspects of their business models. Specifically, robo-advisers should consider whether to adopt and implement written policies and procedures that address the development, testing and back-testing of the algorithmic code and the post implementation monitoring of performance;3 the client questionnaire and the information it elicits; disclosure to clients of changes to the algorithmic code that may materially affect their portfolios; appropriate oversight of any third party that develops, owns or manages the algorithmic code; the prevention and detection of, and responses to, cybersecurity threats; the use of social and other electronic media in connection with the marketing of advisory services and the protection of client accounts and key advisory systems.

S&K Observations

Registered investment advisers that provide automated investment advice should carefully consider the Staff’s guidance. Certain of the points raised by the Staff, particularly with respect to client disclosures and effective compliance programs, may be relevant not only to robo-advisers but other investment advisers that employ quantitative or algorithmic-based investment strategies.

 


 

1 The Staff noted that while the Guidance Update focuses on robo-advisers that provide services directly to clients over the internet, the Guidance Update may be helpful for other types of robo-advisers and registered investment advisers.

2 The Staff noted that robo-advisers should also monitor their compliance programs for issues under other federal securities laws, including Rule 3a-4 under the Investment Company Act of 1940.

3 Specifically, the Staff noted that robo-advisers should consider adopting and implementing written policies and procedures to ensure that the code is adequately tested before, and periodically after, it is integrated into the robo-adviser’s platform; the code performs as represented (see e.g., In the Matter of AXA Rosenberg Group, L.L.C., et. al., Advisers Act Release No. 3149 (February 3, 2010)) and any modifications to the code would not adversely affect client accounts.


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