SEC's Division of Investment Management issues guidance for "robo-advisers" – key takeaways

by DLA Piper

DLA Piper

The Staff of the SEC's Division of Investment Management (IM), in conjunction with the Office of Compliance Inspections and Examinations (OCIE), has issued its second Guidance Update of 2017. [1]  This Guidance focuses on "automated advisers," which it refers to by their more colloquial name – "robo-advisers."

Guidance from IM staff is generally noteworthy. In this instance, moreover, the Guidance is reasonably specific and lays out a relatively clear set of directives (and factors) that the Staff believes robo-advisers should follow in managing their businesses.

Given the involvement of OCIE staff in the preparation of the Guidance, the Staff's detailed suggestions appear to present advisory firms with a blueprint for minimizing SEC staff criticism of their contracting, client interaction and disclosure practices.

What is a "robo-adviser"?

The term "robo-adviser" encompasses a wide variety of business models and a range of advisory services. While some robo-advisers operate as stand-alone companies, others are part of larger and/or more traditional investment advisers. Furthermore, some enable clients to access their services directly, while others are offered by advisers as portfolio management tools.

What robo-advisers have in common, according to the Guidance, is their use of "innovative technologies to provide discretionary asset management services to their clients through online algorithmic-based programs." In brief, such advisers utilize information provided by clients through a digital platform or otherwise, and generate and subsequently manage a portfolio for the client's account.

Guidance for robo-advisers

The Guidance is founded upon the Staff's belief that robo-advisers face "unique challenges" in meeting their obligations under the Investment Advisers Act of 1940. Drawing on its observations and experience (including input received during the SEC's November 2016 Fintech Forum), the Guidance emphasizes certain "unique considerations" that robo-advisers should keep in mind when structuring their operations and delivering advisory services to clients, with particular focus on three areas: (i) disclosure to clients; (ii) suitability issues; and (iii) compliance programs.

            1.         Disclosure practices and related operational issues

Investment advisers have a duty to disclose all material facts to and to take care to avoid misleading clients. Moreover, as emphasized in the Guidance, all required information must be presented in a manner that clients are likely to read and understand.

This is an important point, because clients of such firms typically interact with them through an electronic or even mobile platform. [2] The Guidance focuses on robo-advisers' reliance on algorithms and the internet as a means of providing advisory services, and advises robo-advisers to consider the most effective way to communicate to their clients the limitations, risks, and operational aspects of their advisory services. It also reminds advisers to consider whether their written disclosures are likely to be effective.

The Guidance identifies specific considerations that robo-advisers should keep in mind when creating their disclosure and makes a series of concrete suggestions regarding specific disclosures items. Advisers should view these suggestions as a starting point and perhaps a "punch list" of disclosure items:

  • The risks inherent in the use of an algorithm to manage client accounts, including the circumstances (if any) that might cause the adviser to override the algorithm used to manage client accounts
  • Any involvement by a third party in the development, management, or ownership of the algorithm, including an explanation of any conflicts of interest such an arrangement may create
  • Fees charged to and costs borne by clients, directly or indirectly
  • The degree of human involvement (if any) in the oversight and management of individual client accounts
  • A description of how the robo-adviser uses the information gathered from a client to generate a recommended portfolio and any associated limitations and
  • An explanation of how and when a client should update information he or she has provided to the adviser.

The Guidance also addresses some of the more operational types of issues that robo-advisers face in light of the fact that their client interactions occur primarily on-line and/or through a digital platform. These are the following:

  • Whether key disclosures are presented prior to the sign-up process
  • Whether key disclosures are specially emphasized through design features, such as pop-up boxes
  • Whether some disclosures should be accompanied by interactive text or addressed in a "Frequently Asked Questions" section and
  • Whether disclosure for a mobile platform has been appropriately formatted.

            2.         Suitability of Advice

An investment adviser must determine that the advice provided is suitable for the client based on the client's financial situation and investment objectives. As stated in the Guidance, given the somewhat limited interaction between a robo-adviser and its clients, such an adviser should consider whether its questionnaire is designed to elicit sufficient information to support its suitability obligation. According to the Staff, robo-advisers should consider including the following factors:

  • 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 and
  • Whether steps have been taken to address inconsistent client responses, such as incorporating into the questionnaire a mechanism to alert a client when his or her responses appear internally inconsistent or implementing a system to flag apparently inconsistent information provided by a client for review by the adviser's staff.

            3.         Compliance

The Guidance states clearly that a robo-adviser should be mindful of the unique aspects of its business model when developing its compliance program. For example, an 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 adviser that should be addressed through written policies and procedures. It suggests that robo-advisers should consider whether to adopt and implement written policies and procedures that address areas such as:

  • The development and testing of the algorithmic code and post-implementation monitoring of its performance
  • Assessing whether the questionnaire elicits sufficient information to allow the robo-adviser to conclude that its advice is suitable and appropriate for that client based on his or her financial situation and investment objectives
  • Ensuring disclosure to clients of changes to the algorithmic code that may materially affect client portfolios
  • Ensuring oversight of any third party that develops, owns, or manages the algorithmic code or software modules utilized by the robo-adviser
  • Constructing a plan to prevent, detect and respond to cybersecurity threats
  • Overseeing the use of social and other forms of electronic media in connection with the marketing of advisory services and
  • Protection of client accounts and key advisory systems.

[1] Guidance Update from the SEC's Division of Investment Management No. 17-02 (February 2017). 

[2] As stated in the Guidance, "… as 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."

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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