SEC Issues Guidance Regarding Increasingly Popular Robo-Advisers

New SEC Guidance Legitimizes Robo-Advisers

Investors increasingly seek to obtain investment advice online. Some even rely on computers to determine where to invest their money.

The new online services allow individual investors to create and manage their investment accounts through a web portal or mobile application, sometimes with little or no interaction with a human being. The online services are growing in popularity in large part because they cost less than traditional investment advisory programs. While this new business model offers opportunities for both businesses and investors, automated investment platforms also pose regulatory challenges.

In response, the Securities and Exchange Commission (SEC) recently issued guidance on automated investment advisers, more commonly referred to as “robo-advisers.” The new guidance outlined how robo-advisers must satisfy their disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940.

“As technology continues to improve and make profound changes to the financial services industry, it’s important for regulators to assess its impact on U.S. markets and give thoughtful guidance to market participants,” acting Chairman Michael Piwowar said in a statement. “This information is designed to help investors tap into the opportunities that fintech innovation can provide while ensuring fairness and investor protection.”

Guidance for Investment Firms

The SEC guidance highlights that the unique business models used by robo-advisers, namely the use of computer algorithms and limited human interaction with clients, may raise questions in terms of Advisers Act compliance. The SEC robo-adviser guidance focuses on three distinct areas identified by SEC staff and offers suggestions on how robo-advisers may address them. Below is a brief summary:

Disclosures

Firms must be mindful of the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers. The SEC highlights that because many clients may not fully understand how robo-advisers provide investment advice, firms should disclose information regarding their particular business practices and related risks. According to the SEC, the information robo-advisers provide to clients should include the following:

• A statement that an algorithm is used to manage individual client accounts, along with a description of the algorithmic functions used to manage client accounts;
• A description of the particular risks inherent in the use of an algorithm to manage client accounts;
• An explanation of the degree of human involvement in the oversight and management of individual client accounts; and
• A description of any circumstances that might cause the robo-adviser to override the algorithm used to manage client accounts.

The SEC guidance also cautions that “[r]obo-advisers…should consider the clarity of the descriptions of the investment advisory services they offer and use reasonable care to avoid creating a false implication or sense about the scope of those services which may materially mislead clients.” For instance, robo-advisers must take care not to mislead clients by implying they are providing a comprehensive financial plan when they are not, in fact, doing so. Because most of the disclosures are provided online, the SEC reminds robo-advisers to carefully consider whether their written disclosures are designed to be effective, i.e. not buried in text or incomprehensible.

Suitability

Although most interactions occur online, robo-advisers still have an obligation to obtain information from clients to support the duty to provide suitable advice. Given the limited human interaction and heavy reliance on customer questionnaires, the SEC advises that robo-advisers must carefully consider whether their questionnaires are designed to 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.” Other factors to consider include:

• Whether the questions in the questionnaire are sufficiently clear;
• 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.

Compliance

The SEC highlights that robo-advisers must adopt and implement effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice, such as the reliance on algorithms, the limited, if any, human interaction with clients, and the provision of advisory services over the internet. According to the agency, robo-advisers should consider whether to adopt and implement written policies and procedures that address areas such as:

• The development, testing, and backtesting of the algorithmic code and the post- implementation monitoring of its performance (e.g., to ensure that the code is adequately tested before, and periodically after, it is integrated into the robo-advisers’ platform; the code performs as represented; and any modifications to the code would not adversely affect client accounts);
• 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; and
• The appropriate oversight of any third party that develops, owns, or manages the algorithmic code or software modules utilized by the robo-adviser.

Investor Bulletin on Robo-Advisers

For consumers, the SEC’s Office of Investor Education and Advocacy also released an Investor Bulletin. “Before making a decision about whether to invest through a robo-adviser, or in deciding which robo-adviser might be best for you, you should do your own research,” the agency advises. “Make sure the robo-adviser and the investment portfolio it puts together for you are a good match for your investment needs and goals, and that you understand the potential costs, risks, and benefits of using that particular robo-adviser.”

We advise consumers to carefully consider and review the information that they provide to investment firms about themselves and their investment objectives. We also advise that consumers maintain, in a separate file, copies of all such information, and update or correct the information on a timely basis. One reason to do so is that if they suffer losses in their portfolio and there is a subsequent claim made to recover those losses, the investment firm will focus on the information provided, produce copies of documents containing the information and contend that the investment advice given was suitable for the consumer.

Do you have any questions regarding these robo-advisers? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.