In this most recent guidance, SEC staff identified three robo adviser regulatory compliance focus areas:
- Substance and Presentation of Disclosures
- Explanation of Business Model
- Scope of Advisory Services
- Presentation of Disclosures
- Provision of Suitable Advice
- Reliance on Questionnaires to Gather Client Information
- Client-Directed Changes in Investment Strategy
- Effective Compliance Programs
- Unique Aspects of the Business Model
- Use of Algorithmic Code
In regards to disclosures, the SEC staff notes that "because client relationships with robo-advisers may occur with limited, if any, human interaction, robo-advisers should be mindful that the ability of a client to make an informed decision about whether to enter into, or continue, an investment advisory relationship may be dependent solely on a robo-adviser’s electronic disclosures made via email, websites, mobile applications, and/or other electronic media." As such, the staff makes it clear that the firm should be focused on how it "presents material information to clients." In particular, the staff wants to ensure that a robo adviser thoroughly discloses the use and limitations of any investment algorithms including:
- Stating that an algorithm is utilized
- Detail of the algorithm functions
- Assumptions and limitations relevant to the algorithm
- Particular risks inherent in the use of an algorithm
- Circumstances which might cause the robo adviser to intervene and override the algorithm
- Disclosure of third party involvement in the development, management, or ownership of the algorithm which could lead to potential conflicts of interest
In addition to stating that automated advisers should "use reasonable care to avoid creating a false implication or sense about the scope of those services which may materially mislead clients," the staff also makes specific recommendations regarding considerations as to how disclosures are presented:
- Whether key disclosures are presented prior to the sign-up process
- Whether key disclosures are specially emphasized
- Whether some disclosures should be accompanied by interactive text
- Whether the presentation and formatting of disclosure are optimized for mobile display
SEC staff writes that "we have observed that robo-advisers may provide investment advice based primarily, if not solely, on client responses to online questionnaires. The questionnaires we have reviewed have varied with respect to length and the types of information requested." When designing questionnaires in order to gather required suitability information, the staff notes that robo advisers may want to consider the following:
- 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 questions in the questionnaire are sufficiently clear and/or whether the questionnaire is designed to provide additional clarification or examples to clients when necessary
- Whether steps have been taken to address inconsistent client responses
Furthermore, the staff references that online advisers "may wish to consider whether pop-up boxes or other design features would be useful to alert a client of potential inconsistencies between the client’s stated objective and the selected portfolio."
Effective Compliance Program
Robo advisers need to focus on designing and implementing compliance programs which address the unique aspects of their business model. For example, "robo-adviser’s reliance on algorithms, the limited, if any, human interaction with clients, and the provision of advisory services over the internet may create or accentuate risk exposures for the robo-adviser that should be addressed through written policies and procedures." When crafting and adopting written polices and procedures, the staff states that robo advisers may want to consider the following:
- The development, testing, and backtesting of the algorithmic code and the post implementation monitoring of its performance
- The questionnaire eliciting 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
- The disclosure to clients of changes to the algorithmic code that may materially affect their portfolios
- The appropriate oversight of any third party that develops, owns, or manages the algorithmic code or software modules utilized by the robo-adviser
- The prevention and detection of, and response to, cybersecurity threats
- The use of social and other forms of electronic media in connection with the marketing of advisory services
- The protection of client accounts and key advisory systems
In regards to online marketing tactics, the firm needs to ensure that it does not violate Advisers Act Rule 206(4)-3 which makes cash payments to solicitors by RIA firms unlawful unless certain conditions are met. This often becomes relevant when online advisers consider implementing an online affiliate or client referral program.
The number of online advisory firms registered with the SEC continues to grow and it's therefore likely that the SEC will continue to focus on this area of the market for years to come. As of February 1, 2017, the SEC reports that 175 firms registered at the federal level are currently relying on the "Internet adviser exemption" specified by Rule 203A-2(e)s as the basis for SEC registration. However, this figure likely understates the number of firms currently operating as online advisers as a number of robo advisers have already exceeded $100 million in regulatory assets under management and are thus are not relying upon the "Internet adviser exemption" as the basis for federal registration.
The SEC staff also writes that, "while this guidance focuses on the obligations of robo advisers under the Advisers Act, 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 (the “Investment Company Act”), and in particular Rule 3a-4 under that Act." Rule 3a-4 provides, a "nonexclusive safe harbor from the definition of investment company for programs that provide discretionary investment advisory services to clients." As RIA compliance consultants, we strongly encourage all current and prospective robo advisers to review Rule 3a-4 to ensure that the firm will not be deemed an investment company subject to additional regulatory compliance requirements. Furthermore, we strongly recommend that the principals and Chief Compliance Officer of all current or prospective robo advisers review the full details of this latest SEC RIA regulatory compliance guidance.
Lexington Compliance and RIA in a Box LLC are not law firms, investment advisory firms, or CPA firms. Lexington Compliance and RIA in a Box LLC do not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.