Compliance Consult | PLANADVISER May/June 2017

SEC Weighs In On ‘Robo-Advisers’

The commission sees several quagmires

By David Kaleda | May/June 2017

PAJF16_Article-Image-Comp-Con-_David-Kaleda-Portrait_Tim-Bower.jpgArt by Tim BowerIn February, the Division of Investment Management of the Securities and Exchange Commission (SEC) issued guidance on how registered investment advisers (RIAs) who act as “robo-advisers” may comply with the Investment Advisers Act of 1940. In the guidance, the SEC provided some insights as to what it may view as shortcomings in current robo-adviser program offerings.

The guidance also reminds us that robo-advisers should integrate their Advisers Act compliance efforts with the prohibited transaction compliance and fiduciary requirements that apply to robo-advisers who serve retirement plans, retirement plan participants and individual retirement accounts (IRAs) under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC).

The SEC guidance primarily focuses on robo-advisers who give clients investment advice through the Internet or another electronic platform but include little or no human interaction. The SEC pays particular attention to the algorithm upon which the advisory services are based, the questionnaire used to gather investors’ information, any limitations on the algorithm and the questionnaire, and the disclosures about the robo-adviser that are provided to investors.

The SEC views the lack of human involvement in the delivery of robo-advisory services as presenting some unique compliance challenges. For example, the SEC points to robo-advisers that let investors select from portfolios the adviser has generated even though its questionnaire has determined those investments are unsuitable. The SEC also notes that the information these questionnaires gather may be inconsistent or incomplete.

The agency emphasizes that the robo-adviser must provide advisory services that conform to the “fiduciary and other substantive requirements of the Advisers Act” including the “duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients.”

In the above-described instances, the SEC suggests that human involvement in an advisory program may aid in Advisers Act compliance because a representative of the firm would be available to explain the more complicated aspects of required disclosure and to answer related questions, to describe the risks of selecting portfolios not recommended by the robo-adviser, and to follow up with investors to ensure questionnaires are appropriately completed so that sufficient information can be gathered to generate a recommendation. In the absence of human involvement, the SEC states, the robo-adviser must use technology to meet the requirements of the Advisers Act.

In essence, the SEC challenges robo-advisers to review how they provide advice and whether the technology employed appropriately replaces services a human adviser representative might otherwise lend. It also suggests that robo-advisers, in how they provide services, may be noncompliant with the Advisers Act, particularly when no human representative is involved. The SEC points to a number of techniques whereby technology can fill the gap including, but not limited to: presenting important disclosures prior to the sign-up process; using design features such as pop-up boxes to emphasize key disclosures; using frequently asked questions (FAQ) or interactive text to provide more detail to investors seeking further information; using design features incorporated into questionnaires to alert investors as to when information supplied is internally inconsistent and to automatically flag information for follow-up by the adviser; and providing required information and otherwise complying with the act in a way appropriate for the platform through which the advisory services are delivered, e.g., a website vs. an app on a smartphone.

In light of the SEC guidance, robo-advisers should review whether they comply with the Advisers Act. As discussed in “Is This the Age of the Robot?” (Compliance Consult, PLANADVISER, November–December 2015), robo-advisers must comply with the prohibited transaction provisions under ERISA, the IRC or other Department of Labor (DOL) guidance when advisory services are provided to ERISA plans and their participants or to IRAs. The prohibited transactions are designed to mitigate conflicts under ERISA and the IRC. There are a number of avenues to compliance that are dependent upon: whether the advisory services involve advice or discretion; the exemption or guidance the robo-adviser chooses to follow; and any changes to the DOL’s final regulation redefining the term “investment advice” and related exemptions. Robo-advisers would do well to evaluate their current compliance strategies under the Advisers Act, ERISA and the IRC and make any required changes.

David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers. He served on the Department of Labor’s ERISA Advisory Council from 2012 through 2014.