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News March 6, 2017 Issue

Robo-Adviser Guidance Focuses on Disclosure, Suitable Advice, Compliance

Given the growth in the use of automated advisory systems – known as "robo-advisers" – by investment advisory firms in recent years, it was only a matter of time before the SEC stepped in with at least some guidance. That day has arrived.

The SEC on February 23 issued both a Guidance Update and an Investor Bulletin on robo-advisers. The Guidance, issued by the Division of Investment Management, focuses on the "unique issues" raised by robo-advisers and offers suggestions on how they should meet disclosure, suitability and compliance requirements under the Advisers Act.

Robo-advisers use technologies to provide discretionary asset management services to clients through online algorithmic-based programs. "Robo-advisers represent a fast-growing trend within the investment advisory industry, and have the potential to give retail investors more affordable access to investment  advisory services," the Guidance states, using the term "robo-adviser" to include both the registered investment adviser and any automated investment advisory program it offers.

"It puts firms on notice" that use of robo-advisers will be an area of scrutiny, said K&L Gates partner Michael Dyson, adding that the SEC’s Office of Compliance Inspections and Examinations listed electronic investment advice as one of its 2017 examination priorities. Specifically, OCIE said it would "examine registered investment advisers and broker-dealers that offer such services, including ‘robo-advisers’ that primarily interact with clients online and firms that utilize automation as a component of their services while also offering clients access to financial professionals."

Dyson also noted the Guidance’s repeated emphasis on robo-advisers’ use of algorithms, and suggested that advisers using robo-advisers make certain that their compliance practices stay up to date with the algorithm itself. "If the algorithm changes, how does that affect a client’s portfolio whose investments were made under the previous algorithm?"

"When you consider the nuances involved in the use of technology related to the automation of the programs and the algorithms used to generate the investment advice, coupled with the fact that these programs are designed primarily to target retail investors and provide them with greater access to investment advice," said Mayer Brown partner Amy Ward Pershkow, "it’s not surprising to see the staff highlighting areas of focus for robo-advisers to pay close attention to."

Eversheds Sutherland partner Michael Koffler noted that traditional advisory firms that use algorithms would be wise to review the Guidance, since much of it would be applicable to any firm that uses algorithms to make investments. "If I’m at an algorithm shop, I’m going to go over this forward and backward."

Areas of focus

The Guidance focuses on three areas where the SEC staff found concerns in regard to use of robo-advisers:

  • Disclosures. The staff wants advisers to pay particular attention to the "substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;"
  • Suitable advice. Robo-advisers must meet their obligation to obtain information from clients "to support the robo-adviser’s duty to provide suitable advice;" and
  • Compliance program rule. Like all registered advisers, robo-advisers, under Rule 206(4)-7, must adopt and implement effective compliance programs that "address particular concerns relevant to providing automated advice."

The Guidance makes clear that the SEC staff is aware that there are multiple kinds of robo-advisers, and that, in terms of addressing the challenges such systems may bring, one size does not fit all. "There may be a variety of means for a robo-adviser to meet its obligations to its clients under the Advisers Act, and . . . not all of the issues addressed in this Guidance will be applicable to every robo-adviser," the staff says. For instance, "some robo-advisers provide investment advice directly to the client with limited, if any, direct human interaction between the client and investment advisory personnel. For other robo-advisers, advice is provided by investment advisory personnel using the interactive platform to generate an investment plan that is discussed and refined with the client."

Following is a breakdown of just what the agency wants from robo-advisers in each of these three areas.


"It may be useful for a robo-adviser to consider how it explains its business model and the scope of the investment advisory services it provides, as well as how it presents material information to clients," the Guidance says. It added that robo-advisers should keep in mind that a client, in making an informed decision about 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."

Specifically the Guidance suggests that robo-advisers, in terms of disclosure to clients and potential clients, consider the following:

  • A statement that an algorithm is used to manage individual client accounts;
  • A description of the algorithmic functions used to manage client accounts, such as whether they are used to generate portfolio recommendations;
  • The assumptions and limitations of the algorithm, such as whether the algorithm is based on modern portfolio theory, and the assumptions and limitations inherent in that theory;
  • The risks inherent in the use of the algorithm, such as that it might rebalance client accounts without regard to market conditions;
  • The circumstances, if any, under which the robo-adviser might override the algorithm;
  • Any involvement by a third party in the development, management or ownership of the algorithm, including any conflicts of interest these might create;
  • Any fees the client will be charged directly by the robo-adviser, as well as any other costs the client may directly or indirectly bear;
  • The degree of human involvement in the oversight and management of individual client accounts, such as advisory firm personnel who oversee the algorithm but do not monitor client accounts;
  • How the robo-adviser uses the information gathered from clients to generate recommendations, as well as any limitations, such as questionnaire responses serving as the sole basis for those recommendations; and
  • How and when a client should update information provided to the robo-adviser.

In providing the above information to clients, robo-advisers "should consider the clarity of the descriptions" they use "to avoid creating a false implication or sense about the scope of those services which may materially mislead clients," the Guidance states. Specifically, the staff said that robo-advisers should avoid misleading clients by implying any of the following:

  • The adviser is providing a comprehensive financial plan if it is not doing so,
  • A tax-loss harvesting service also provides comprehensive tax advice, or
  • That information other than that collected by the questionnaire is considered when generating investment recommendations if such information is not, in fact, considered.

Presentation is also something that robo-advisers can expect the SEC to pay attention to. Disclosures should be in plain English, and should not be "buried or incomprehensible," the Guidance states. Specifically, the staff suggested that, in presenting disclosures, robo-advisers consider whether:

  • Key disclosures are presented prior to the sign-up process;
  • Key disclosures are emphasized, such as through the use of design features like pop-up boxes;
  • Some disclosures should be accompanied by interactive text or other means to provide additional details; and
  • The presentation and formatting is available on mobile platforms.

Suitable advice

The SEC also made clear in the Guidance that robo-advisers that gather information from clients primarily through the use of online questionnaires may not receive all the information needed to make suitable investments. "We have … observed that some of these questionnaires are not designed to provide a client with the opportunity to give additional information or context concerning the client’s selected responses. In addition, robo-advisers may not be designed so that advisory personnel may ask follow-up or clarifying questions about a client’s responses, address inconsistencies in client responses, or provide a client with help when filling out the questionnaire."

With this in mind, the Guidance suggests that robo-advisers consider the following factors when considering the design of its questionnaire:

  • Whether the questions "elicit sufficient information" for the robo-adviser to conclude that its initial recommendations and ongoing investment advice "are suitable and appropriate;"
  • Whether the questions are sufficiently clear and the questionnaire is designed to "provide additional clarification or examples to clients when necessary;" and
  • Whether steps were taken to address inconsistent client responses, such as design features that alert clients when their responses are inconsistent, or automatically flagging inconsistent information for review.

The SEC staff also suggests that, as applicable, each robo-adviser "provide commentary as to why it believes particular portfolios may be more appropriate for a given investment objective and risk profile." Doing so would be "consistent with its obligation to act in its client’s best interests," the Guidance states.

Compliance program

A robo-adviser, like other registered advisers, must comply with Rule 206(4)-7, the Compliance Program Rule, which requires advisers to adopt and implement written compliance policies and procedures, annually review them, and designate a chief compliance officer.

In creating their own compliance programs, robo-advisers need to keep in mind "the unique aspects of its business model," the Guidance states, among them their use of algorithms. In that regard, it suggests that robo-advisers consider adopting policies and procedures that address the following specific areas:

  • Development, testing and backtesting of the algorithmic code and the post-implementation monitoring of the code’s performance;
  • The questionnaire used to gather client information so that, when completed, the robo-adviser may conclude that its initial recommendations and ongoing investment advice "are suitable and appropriate;"
  • Disclosure to clients of changes to the algorithmic code that may materially affect portfolios;
  • Appropriate oversight of any third party that develops, owns or manages the algorithmic code or software modules;
  • Prevention and detection of, as well as response to, cybersecurity threats;
  • Use of social media and other electronic media in connection with advisory service marketing; and
  • Protection of client accounts and key advisory systems.

Robo-advisers staying on top of these suggestions will be able to point to them, when examiners visit, as evidence that they take their responsibilities seriously.?