SEC IM Guidance Update 2017-02 Robo-Adviser: The New Model on the Block

By March 3, 2017New in Compliance, SEC

March 3, 2017:  The evolution of investment adviser business models to reflect “robo-adviser” services represents a fast-growing trend within the advisory industry.  Initially perceived as a service offering directed to the millennial target market, in an era of rising competition in the asset management industry, this business model is now perceived as having the real potential to be a “win-win” for both advisers and retail investors across the board. The robo-model is rapidly gaining traction with the adviser industry as it provides the means to arrest and possibly reverse compressed fee schedules while introducing significant efficiencies in the business of marketing, developing, and executing invest advice.

As always, there is a catch to the happy-ending, in this case, the SEC and its oversight of all registered investment advisers.  The SEC has been monitoring and engaging with robo-advisers to evaluate how robo-advisers meet their compliance obligations under the Investment Advisers Act.  Additionally, the Commission held a “Fintech Forum” in 2016 that included an informative panel on the robo-adviser evolution. Collectively, these efforts have informed the SEC to the point where the Commission was comfortable issuing IM Guidance Update 2017-02 “Robo-Advisers” in late February 2017, focusing upon the robo-adviser business model and the unique compliance challenges it places upon registered advisers.


Risk-based compliance

In short, the Commission believes that, depending upon the degree that advisory firms evolve to a robo-model, advisers must remain self-aware of the unique risks presented to their compliance risk management programs, ever vigilant in pursuit of a “risk-based” compliance program.  The concept of risk-based compliance is not new, as the SEC has for years expected advisers to adapt their risk management efforts to match their business model and the regulatory regime.


Robo models are varied

Robo-advisers operate under a wide variety of business models and provide a range of advisory services. For example, robo-advisers offer varying levels of human interaction to their clients. 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, advisory personnel leverage the interactive platform to generate an investment plan that is discussed and refined with the client. Robo-advisers may also use a range of methods to collect information from their clients. For example, many robo-advisers rely solely on questionnaires of varying lengths to obtain information from their clients, while others obtain additional information through direct client contact or by allowing clients to incorporate information about other accounts.  These permutations present a panoply of challenges for the CCO.


The Robo model introduces risk to the compliance program 

The ascendancy of the robo-model has expanded the risk attendant to marketing and delivery of adviser services relative to maintaining a risk-based compliance program. Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Investment Advisers Act.  If robo-advisers rely on algorithms, provide advisory services over the Internet, and limit direct human interaction with clients, certain risks emerge when seeking to comply with regulations. The SEC recommends that advisers seeking to introduce elements of the robo-adviser business model carefully evaluate client disclosures, suitability protocol, and compliance policies. The Guidance Update addresses each of these elements, as outlined below.


Client Disclosures

As a fiduciary, advisers have a duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients. The information provided in disclosures must be sufficiently specific so that a client understands the adviser’s business practices and conflicts of interests. Such information must be presented in a manner wherein clients are likely to read it and understand it. Insofar as most client relationships with robo-advisers 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 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. When designing disclosures, the robo-adviser must 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.


Unique Disclosure Risks Attendant to Robo-Business Model

In the absence of the investment adviser representative to interview and cultivate client information pertaining to the suitability of forthcoming investment advice, the obligation of the robo-adviser to obtain relevant client information to support the duty to provide suitable advice is critical.  This entails the adviser identifying potential gaps in a client’s understanding of how the robo-adviser provides its investment advice.

Information a robo-adviser should consider providing includes:

  • A statement that an algorithm is used to manage individual client accounts;
  • A description of the algorithmic functions used to manage client accounts (e.g., that the algorithm generates recommended portfolios; that individual client accounts are invested and rebalanced by the algorithm);
  • A description of the assumptions and limitations of the algorithm used to manage client accounts;
  • A description of the particular risks inherent in the use of an algorithm to manage client accounts (e.g., 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);
  • A description of any circumstances that might cause the robo-adviser to override the algorithm used to manage client accounts (e.g., that the robo-adviser might halt trading or take other temporary defensive measures in stressed market conditions);
  • A description of any involvement by a third party in the development, management, or ownership of the algorithm used to manage client accounts, including an explanation of any conflicts of interest such an arrangement may create (e.g., if 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);
  • An explanation of any fees/costs/expenses that the client will be charged directly by the robo-adviser;
  • A clear explanation of the degree of human involvement in the oversight and management of individual client accounts (e.g., that investment advisory personnel oversee the algorithm but may not monitor each client’s account);
  • A description of how the robo-adviser uses the information gathered from a client to generate a recommended portfolio and any limitations therein; and
  • An explanation of how and when a client should update information he or she has provided to the robo-adviser.


Accurate Representations

Robo-advisers, like all registered investment advisers, must consider the clarity of the descriptions of the investment advisory services they offer and use reasonable care to avoid creating a false implication or expectation about the scope of those services which may materially mislead clients.

Robo-advisers should be careful not to mislead clients by implying, for example, that:

  • The robo-adviser is providing a comprehensive financial plan if it is not in fact doing so (e.g., 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);
  • A tax-loss harvesting service also provides comprehensive tax advice; or
  • Information other than that collected by the questionnaire (e.g., information concerning other client accounts held with the robo-adviser, its affiliates or third parties) is considered when generating investment recommendations if such information is not in fact considered.


Plain English

A term that is often associated with SEC guidance pertaining to preparation of Form ADV, the plain English directive assumes significant importance in client disclosures emanating from a robo-adviser. The absence of investment adviser reps in the marketing and execution of robo-adviser services places critical importance on the client interpretation of and conversancy relative to robo-adviser disclosures that, by their nature are likely to be far more technical in nature than those attributable to a traditional adviser.

After reviewing the websites and disclosures of robo-advisers, the Commission observed that robo-advisers utilize a variety of practices in providing important information to their clients. Insofar as robo-advisers heavily rely upon online disclosures to provide disclosures and important information pertaining to how the client will be serviced by the adviser, there may be unique issues that arise when communicating key information, risks, and disclaimers.  The SEC therefore reminds robo-advisers to carefully consider whether their written disclosures are designed to be effective (e.g., are not buried or incomprehensible).

When presenting their disclosures, robo-advisers must consider the following:

  • Whether key disclosures are presented prior to client matriculation to the robo-adviser wherein information necessary to make an informed investment decision is available to clients before they engage, and make any investment with, the robo-adviser;
  • Whether key disclosures are specially emphasized (e.g., through design features such as pop-up boxes);
  • Whether some disclosures should be accompanied by interactive text or other means to provide additional details to clients who are seeking more information (e.g., through a “Frequently Asked Questions” section); and
  • Whether the presentation and formatting of disclosures made available on a mobile platform have been appropriately adapted for that platform.


Provision of Suitable Advice

An investment adviser’s fiduciary duty includes an obligation to act in the best interests of its clients and to provide only suitable investment advice.  Consistent with these obligations, an adviser must make a reasonable determination that the investment advice provided is suitable for the client based on the client’s financial situation and investment objectives.


Reliance on Questionnaires to Gather Client Information

The SEC has observed that robo-advisers often provide investment advice based primarily, if not solely, on client responses to online questionnaires. The questionnaires reviewed by the Commission have varied with respect to length and the types of information requested. For example, some robo-advisers generate a recommended portfolio based upon a client’s age, income and financial goals. Other robo-advisers may obtain different or additional information such as investment horizon, risk tolerance, and/or living and other expenses when generating a recommended portfolio. Some 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-adviser customer service attributes may not enable advisory personnel to 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.  All of these factors impact the provision of suitable investment advice.

Given this limited interaction, when considering whether its questionnaire is designed to elicit sufficient information to support its suitability obligation, a robo-adviser should consider factors such as:

  • 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;
  • Whether the questions 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 design features to alert a client when his or her responses appear inconsistent and suggest that the client may wish to reconsider such responses; or
    • Implementing systems to automatically flag apparently inconsistent information provided by a client for review or follow-up by the robo-adviser.


Client-Directed Changes in Investment Strategy

Many robo-advisers give clients the opportunity to select portfolios other than those they have otherwise recommended. Some robo-advisers do not, however, give a client the opportunity to consult with investment advisory personnel about how the client selected portfolio relates to the client’s stated investment objective and risk profile, and its suitability for that client. This may result in a client selecting a portfolio that the robo-adviser believes is not suitable for the investment objective and risk profile the robo-adviser has generated for the client based on his or her questionnaire responses. Thus, consistent with its obligation to act in its client’s best interests, 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. In this regard, a robo-adviser may wish to consider the incorporation of design features to alert a client of potential inconsistencies between the client’s stated objective and the selected portfolio.


Effective Compliance Programs

Rule 206(4)-7 under the Investment Advisers Act requires each registered investment adviser to establish an internal compliance program that addresses the adviser’s performance of its fiduciary and substantive obligations under the law and which facilitates employee compliance with securities statutes. To comply with the rule, a registered investment adviser must adopt, implement, and annually review written policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act, and that take into consideration the firm’s business model and the attendant risk exposures created by the model.  A registered investment adviser must also designate a chief compliance officer who is competent and knowledgeable about the Investment Advisers Act to be responsible for administering the compliance program.

In developing its compliance program, a robo-adviser should be mindful of the unique aspects of its business model. For example, a 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.

Robo-advisers should consider whether to adopt and implement written policies and procedures that address areas such as:

  • The development, testing, and back testing 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;
  • 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 (e.g., websites; Twitter; compensation of bloggers to publicize services; “refer-a-friend” programs, etc.);and
  • The protection of client accounts and key advisory systems.



In conclusion, the robo-adviser business model does indeed offer compelling opportunities for both advisers and investors.  However, in the case of the investor the maxim “caveat emptor” reigns supreme as the buyer’s experience with innovative and technologically based service offerings will differ substantially from old school investment advisory business models.

For advisers, the opportunity afforded through the introduction of elements of robo-adviser components to your business models may be intriguing on many levels however, the Commission has succinctly and clearly challenged robo-adviser firms to re-evaluate their risk-based compliance programs … a challenge not to be ignored.

Follow this link to read the full IM Guidance Update:

March 3, 2017

Prepared by Horrigan Resources, Ltd.

(724) 934-0129

Not customized advice. Not legal advice.


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