SEC Staff Issues Guidance Update and Investor Bulletin on “Robo-Advisers”
March 14, 2017
The staff of the Division of Investment Management (Staff) of the U.S. Securities and Exchange Commission (SEC) published a Guidance Update (Guidance) on February 23, 2017, on the subject of automated investment advisers (often referred to as “robo-advisers”) and their obligations under the Investment Advisers Act of 1940 (Advisers Act).1 The Guidance provides the Staff’s most recent views on the growing number of SEC-registered investment advisers (RIAs) that utilize automated and digital processes to provide investment advisory services. The SEC Guidance provides suggested practices for robo-advisers to consider in: (i) meeting their disclosure obligations; (ii) assessing the suitability of their investment advice; and (iii) adopting and implementing effective compliance programs. Concurrently with the issuance of the Guidance, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin to help educate investors regarding robo-adviser services.2 The Guidance follows in the wake of guidance and reports published by other legal and regulatory bodies on this topic.3
Automated Investment Advisory Programs Industry Trend
The Staff observed that robo-advisers have become increasingly popular across a range of age groups and types of investors, and that the use of automated advice is growing among industry participants.4 The Staff stated that, typically, robo-advisers are RIAs that use technology to provide discretionary asset management services to clients online and often using algorithmic-based programing. According to the Staff, a potential client typically begins its relationship with a robo-adviser by responding to an RIA’s questionnaire on a website or mobile application, after which the robo-adviser, utilizing algorithms and other technology, generates and manages an investment portfolio for the client based on the client’s responses. The Staff observed that, unlike traditional RIAs, robo-advisers offer “varying levels of human interaction to their clients” and sometimes none at all. Although the Staff recognized that robo-advisers have “the potential to give retail investors more affordable access to investment advisory services,” the Staff indicated that the trend toward automated advice presents unique challenges for RIAs in meeting their obligations under the Advisers Act.
The Staff’s Guidance
The Staff stated that it prepared the Guidance based on coordinated monitoring and evaluation efforts with the staff of the Office of Compliance Inspections and Examinations (OCIE). The Staff also stated that it relied on input from the panel participants at the Fintech Forum held at the SEC on November 14, 2016.5 As described more fully below, the Guidance offers suggestions as to how RIAs may address their obligations in three areas: (i) the substance and presentation of disclosures; (ii) the provision of suitable advice; and (iii) effective compliance programs.6
Scope of RIAs Covered
For purposes of the Guidance, the Staff stated that the term “robo-adviser” includes an RIA “and any automated investment advisory program it offers.” The Staff made clear that the suggestions laid out in the Guidance are not limited to the narrow set of firms that market themselves as robo-advisers. Rather, the Staff stated that for purposes of the Guidance, a “robo-adviser” includes programs “offered as digital portfolio management tools by traditional advisers that view these programs as components of their existing advisory practices.” Although the Staff focused on firms that offer robo-advisory programs over the internet, the Guidance “may be helpful for other types of robo-advisers as well as other registered investment advisers.”
Exemption from the Definition of “Investment Company”
As an initial matter, although the Guidance focuses on the obligations of robo-advisers under the Advisers Act, the Staff recognized that robo-advisers should consider whether their programs raise other issues, including whether their operations and organization present unique facts or circumstances not currently addressed by Rule 3a-4 under the Investment Company Act of 1940 (1940 Act). Rule 3a-4 provides a non-exclusive safe harbor from the definition of “investment company” under the 1940 Act and the registration requirements under Section 5 of the Securities Act of 1933. Among other provisions, to remain within the safe harbor: (i) each client’s account must be managed on the basis of the client’s financial situation and investment objectives; (ii) the client must receive “individualized investment advice;” (iii) clients must have the ability to impose reasonable restrictions on their accounts; (iv) clients must be provided with a quarterly account statement; and (v) clients must retain certain “indicia of ownership” of all securities and funds in their respective accounts. The Staff stated that robo-advisers raising such unique circumstances under Rule 3a-4 should consider contacting the Staff for further guidance. As Rule 3a-4 was adopted in 1995 in the context of wrap accounts provided by sponsoring institutions, the Staff may be suggesting that it may be appropriate for the SEC to revisit, or the Staff to provide additional clarification on, Rule 3a-4 given the changing marketplace.
Substance and Presentation of Disclosures
The Guidance states that disclosures should describe any unique aspects of a robo-adviser’s business model.7 In addition to including a statement (if applicable) that an algorithm is used to manage individual client accounts, the Staff stated that robo-advisers should consider providing particular disclosures regarding those algorithms, including disclosures concerning: (i) algorithmic functions, including whether the algorithm generates a recommended portfolio or implements or rebalances investments; (ii) the assumptions and limitations of an algorithm;8 (iii) the risks presented by an algorithm;9 (iv) the circumstances that might cause the RIA to override an algorithm;10 (v) involvement of, and any conflicts surrounding, a third party in the development, management or ownership of an algorithm;11 and (vi) the degree of human involvement in overseeing and managing client accounts. Further, if a questionnaire is used, the Staff stated that robo-advisers should consider providing disclosure addressing: whether the responses to the questionnaire are the sole basis for the adviser’s management of the account; whether there are other sources of client information; and how such information is used in managing the client’s account.
In addition, the Staff warned that a robo-adviser should take care not to imply that it is providing a comprehensive financial plan unless it intends to provide such a plan,12 or that tax-loss harvesting constitutes comprehensive tax advice. As noted above, these warnings also could apply to traditional advisers. The Staff also warned that, if a robo-adviser relies on an online questionnaire given to clients, the RIA should not imply that it considers information outside such questionnaire unless the RIA in fact does so.
The Staff stated that if a robo-adviser relies primarily on online disclosures or if its personnel are not generally available to explain concepts or disclosures, then the robo-adviser should even more carefully consider the effectiveness and clarity of the written disclosures made online to clients and prospects. The Staff reminded advisers that written disclosures should be clear and effective and “not buried or incomprehensible.” The Staff suggested that robo-advisers consider whether: (i) sufficient disclosures are made prior to the sign-up process; (ii) important disclosures should be emphasized through features such as online pop-up boxes or interactive text; and (iii) mobile applications have been properly formatted to provide adequate disclosures.
Suitable Advice
The Staff observed that many robo-advisers manage client accounts based primarily, if not solely, on client responses to an online questionnaire. The Staff cautioned that some questionnaires were “not designed to provide a client with the opportunity to give additional information or context.” The Staff also indicated that some robo-advisers may not: (i) follow-up with clients about their responses; (ii) address inconsistencies in their responses; or (iii) provide assistance to a client filling out a questionnaire. Although the Guidance does not take the position that any of these particular practices would be required in order for a robo-adviser to comply with the Advisers Act and adequately discharge its fiduciary duties, the Staff suggested that advisers “may wish to consider” whether their questionnaires and practices provide sufficient support for the adviser’s suitability determination. Separately, the Staff suggested that if a client has the opportunity to select portfolios other than those recommended by the RIA (referred to as “client-directed changes in investment strategy”), “a robo-adviser should consider providing commentary as to why it believes particular portfolios may be more appropriate for a given investment objective and risk profile,” as well as whether design features such as online pop-up boxes would be useful to alert a client of potential inconsistencies. Many of these observations apply to traditional investment advisers as well.
Compliance Policies and Procedures
The Guidance states that in developing a compliance program that is “reasonably designed to prevent violations” under Rule 206(4)-7 of the Advisers Act, a robo-adviser should consider its “reliance on algorithms, the limited if any, human interaction with clients, and the provision of advisory services over the internet” as sources of risks that should be addressed in the RIA’s compliance policies and procedures. The Staff suggested that these procedures should be “in addition to” procedures that address issues relevant to traditional RIAs, and that such policies and procedures could address such areas as: (i) “the development, testing, and backtesting of the algorithmic code and the post-implementation monitoring of its performance;”13 (ii) whether the questionnaire is eliciting sufficient information to allow the robo-adviser to conclude that its advice is and remains suitable; (iii) disclosure of changes to the algorithmic code that may materially affect portfolios; (iv) oversight of third parties that may develop, own or manage algorithmic code or software utilized by the robo-adviser; (v) cybersecurity threats; (vi) marketing and advertising by means of social and electronic media; and (vii) custody and other client protection issues unique to online RIAs.
Observations for RIAs
As discussed above, by indicating that the Guidance applies to any RIA “and any automated investment advisory program it offers,” the scope of application of the Guidance extends beyond the small set of RIAs that market themselves solely or specifically as robo-advisers. RIAs should accordingly be aware that the Guidance may be an indication of expectations of the staffs of the Division of Investment Management and OCIE as to an RIA’s automated technology and other aspects of investment advice more generally.
In the Guidance, the Staff set forth a number of suggested disclosure and compliance practices for an RIA to consider regarding algorithms, their functions, risks and underlying assumptions and limitations. As a practical matter, however, it will likely be challenging for an RIA to provide more than general disclosure regarding algorithms, in particular for those developed by third parties that have an interest in protecting proprietary information about their algorithmic programming. The Guidance raises the perennial tension between clarity and simplicity in investor disclosures that online and mobile communications have made particularly acute, without providing a clear road-map to the trade-offs that sometimes must be made.
It is also notable that the Staff discussed “algorithms” at length in the substantive portions of the Guidance, while defining “robo-adviser” to include any “automated investment advisory program.” The Staff provided no clear definition of what it would consider an “algorithm” covered by the Guidance, nor a definition of an “automated” advisory program. More importantly, the Staff did not explain what features of automated investment advice present different compliance issues than traditional human-provided advice, or consider that investment advice often is generated using a spectrum of inputs and conclusions provided by both humans and computers. Certain statements in the Guidance raise the possibility that the automated aspects of investment advice will be subject to greater scrutiny, and potentially higher standards for liability, simply because they leave an audit trail where the inner workings of human judgment do not.
Nonetheless, the Guidance represents a serious and balanced attempt by the Staff to provide a framework and a degree of regulatory certainty in a fast-developing industry. It can be viewed as the first public statement by the Staff in a dialogue that they would like to have with robo-advisers about adapting the Advisers Act to online and mobile platforms.
To this point, the Guidance indicates that the Staff would be receptive to providing “further guidance” on the organization and operation of a robo-adviser that raises unique facts or circumstances not addressed by the nonexclusive safe harbor from the definition of an “investment company” pursuant to Rule 3a-4 under the 1940 Act. This may be an indication that, if requested, the Staff would be receptive to issuing separate guidance on Rule 3a-4, or providing no-action relief, in certain circumstances.
RIAs may want to carefully consider the Staff’s suggested practices and considerations, as well as their potential impact on the RIA's compliance programs, and may want to consider requesting further clarification from the Staff as to any aspects that appear problematic.
Footnotes
1) IM Guidance Update, Robo-Advisers.
2) Investor Bulletin: Robo-Advisers.
3) See Report on Digital Investment Advice, Financial Industry Regulatory Authority (March 2016); Update to the Report on the IOSCO Automated Advice Tools Survey: Final Report, International Organization of Securities Commissions (December 2016).
4) Some robo-adviser start-ups have been established as stand-alone companies, while others are units of larger, traditional advisers.
5) The Staff frequently cited to statements of industry participants at the Fintech Forum to support its suggestions in the Guidance. A video and transcript of the Fintech Forum is available here.
6) Although the Guidance provides suggestions, the Staff did not require that any particular suggestion be implemented.
7) IM Guidance Update, page 3.
8) The Staff suggested, as an example, that if “the algorithm is based on modern portfolio theory [an RIA could provide] a description of the assumptions behind and limitations of that theory.”
9) The Staff suggested, as an example, that such disclosure would provide “that the algorithm might rebalance client accounts without regard to market conditions or on a more frequent basis than the client might expect; that the algorithm may not address prolonged changes in market conditions.”
10) The Staff suggested, as an example, that an RIA disclose “that the robo-adviser might halt trading or take other temporary defensive measures in stressed market conditions.”
11) The Staff suggested, as an example, that such disclosure would state whether “the third party offers the algorithm to the robo-adviser at a discount, but the algorithm directs clients into products from which the third party earns a fee.”
12) The Staff suggested, as an example, that an RIA should not suggest it is providing a comprehensive financial plan “if the robo-adviser does not take into consideration a client’s tax situation or debt obligations, or if the investment advice is only targeted to meet a specific goal – such as paying for a large purchase or college tuition – without regard to the client’s broader financial situation.”
13) The Staff suggested, as an example, that such procedure would “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 Staff’s suggestion differs from the traditional treatment of the provision of investment advice not as a compliance function but rather a proper subject of management supervision.
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