On February 23, 2017, the U.S. Securities and Exchange Commission (“SEC”) Division of Investment Management issued a Guidance Update for Digital Advisers (aka Automated Advisers or Robo-Advisers). In the Guidance Update, the Staff addresses Digital Advisers’ unique business models and certain compliance concerns with respect to the Investment Advisers Act of 1940 (“Advisers Act”). Specifically, Digital Advisers rely on algorithms, provide advisory services over the Internet, and offer limited direct human interaction to their clients. Therefore, Digital Advisers should consider certain risk areas, including:
Substance and Presentation of Disclosures
As a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts so that clients are able to make informed decisions about engaging and managing the relationship with the adviser. Given their unique business model, Digital Advisers should consider the most effective way to disclose the limitations, risks, and operational aspects of their advisory services. Specifically, a Digital Adviser should:
Explain its business model by including:
- A statement that an algorithm is used to manage individual client accounts;
- A description of the algorithmic functions;
- A description of the assumptions and limitations of the algorithm;
- A description of the particular risks inherent in the use of an algorithm;
- A description of any circumstances that might cause the Digital Adviser to override the algorithm;
- A description of any involvement by a third party in the development, management, or ownership of the algorithm, including an explanation of any conflicts of interest;
- An explanation of any fees the client will be charged directly by the Digital Adviser, and of any other costs that the client may bear either directly or indirectly;
- An explanation of the degree of human involvement in the oversight and management of individual client accounts;
- A description of how the Digital Adviser uses the information gathered from a client to generate a recommended portfolio and any limitations; and
- An explanation of how and when a client should update information provided to the Digital Adviser.
Describe the scope of advisory services and avoid misleading clients by implying:
- The Digital Adviser is providing a comprehensive financial plan if it is not;
- A tax-loss harvesting service also provides comprehensive tax advice; or
- Information other than that collected by the questionnaire is considered when generating investment recommendations if is not.
Consider presentation of disclosures such as whether:
- Key disclosures are presented prior to the sign-up process;
- Key disclosures are specifically emphasized;
- Some disclosures should be accompanied by additional details; and
- The presentation and formatting of disclosure made available on a mobile platform have been appropriately adapted.
- Explain its business model by including:
Provision of Suitable Advice
Investment advisers, including Digital Advisers, have an obligation to make a reasonable determination that the investment advice provided is suitable for a particular client based on the client’s financial situation and objectives. Digital Advisers provide investment advice based primarily, if not solely, on client responses to online questionnaires. Therefore, it is important to determine whether questionnaires provided to clients are appropriately designed to elicit sufficient information to support the adviser’s suitability obligation. Digital Advisers may wish to consider factors such as whether:
- The questions elicit sufficient information to allow the Digital Adviser to conclude that its recommendations and investment advice are suitable and;
- The questions in the questionnaire are sufficiently clear and/or whether the questionnaire is designed to provide additional clarification or examples to clients when necessary; and
- Steps have been taken to address inconsistent client responses.
Effective Compliance Program
Rule 206(4)-7 under the 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 that Advisers Act. In developing a compliance program, Digital Advisers' written policies and procedures should address unique risks that Digital Advisers face such as:
- The development, testing, and backtesting of the algorithmic code and the post-implementation monitoring of its performance;
- The questionnaire eliciting sufficient information to allow the Digital Adviser to conclude that its recommendations and investment advice are suitable and appropriate;
- 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 Digital-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; and
- The protection of client accounts and key advisory systems.
Furthermore, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin, which provides investors with the information they may need to make informed decisions when considering using a Digital Adviser platform. The Investor Bulletin describes a number of issues to consider including:
- The level of human interaction important to the investor;
- The information the Digital Adviser uses in formulating recommendations;
- The Digital Adviser’s approach to investing; and
- The fees and charges involved.
Prior to its Guidance Update and Investor Bulletin, the SEC previously addressed compliance risks with respect to Digital Advisers in its joint investor alert with FINRA on Digital Investment Tools in May 2015, at its public forum on financial technology (“Fintech”) in November 2016, and in its 2017 Examination Priorities issued in January 2017. The SEC has made it clear that it will focus on Digital Advisers and that such advisers should be prepared.
How Can ACA Help?
ACA is a leading global provider of regulatory compliance products, performance services, cybersecurity and technology risk assessments, and technology solutions to the financial services industry. Founded in 2002 by former SEC examiners and state regulators, ACA’s products are developed and provided by a team comprised of former SEC, FINRA, FSA, NYSE, NFA, and state regulators, as well as former senior managers and technologists from prominent financial institutions and consulting firms. ACA serves a diversified base of leading investment advisers, private fund managers, commodity trading advisors, investment companies, and broker-dealers.
For More Information
If you have any questions about compliance for Digital Advisers or ACA's consulting services, please contact Giselle Casella, Senior Principal Consultant, Luis Garcia, Principal Consultant, or your ACA consultant.