SEC Takes First Robo-Adviser Enforcement Actions

January 25, 2019

On December 20, 2018, the Securities and Exchange Commission's Office of Compliance Inspections and Examinations (OCIE) announced its 2019 examination priorities and reaffirmed that, for firms actively engaged in the digital asset market, OCIE will continue to conduct examinations focused on portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls. Therefore, it comes as no surprise, with the SEC focusing enforcement actions on cryptocurrencies and cybersecurity, that the examination of advisory firms’ use of robo-advisers (also, known as automated advisers or digital advisers) was not far behind. Late last month, the SEC brought its first two enforcement actions against robo-advisers.

The recent actions took the form of two SEC settlements, each charging the respective advisers with making false statements about investment products and publishing misleading advertising. One settlement involves an adviser that allegedly made false statements about a tax-loss harvesting strategy it offered clients. The other settlement was with a robo-adviser that the SEC said posted misleading comparisons of its clients’ investment performance with those of two robo-adviser competitors.

The SEC alleged that the first adviser falsely stated in its tax-loss harvesting program white paper (identified as “TLH” in the settlement order) that it monitored all client accounts to avoid any transactions that might trigger a wash sale. The SEC claimed the adviser did not monitor all client accounts to prevent wash sales. As a result, the SEC fined the adviser $250,000 for, among other things, violating the Advisers Act’s anti-fraud provision and advertising rules. The SEC alleged that the adviser selectively retweeted certain posts by other Twitter users that constituted testimonials about the adviser’s services. In some cases, the adviser allegedly knew or should have known that the Twitter users providing positive reviews had an economic interest in promoting it and failed to disclose the conflict of interest. The adviser was further cited for failing to adopt and implement adequate policies and procedures to address the need for review of disclosures in the whitepaper to ensure the wash sales description reflected actual practices. Additionally, the adviser allegedly failed to implement adequate policies and procedures for reviewing marketing materials and communications for testimonials and misleading advertisements.

The second enforcement action involves an adviser that allegedly posted a “robo index” on its website and social media platform that “purportedly allowed clients and prospective clients to compare the performance from 2014 and 2015 of two other robo-advisers.” The settlement alleges that the index incorrectly illustrated the adviser’s returns. The adviser allegedly failed to include actual performance data and various other risk factors when showing average returns for the comparison robo-advisers. By doing so, it allegedly provided incorrect return projections. The firm also allegedly posted misleading fact sheets on its website that overstated the returns of various exchange-traded funds compared to certain benchmarks of blended index returns in violation of Adviser Act Sections 206(2) and 206(4). Similarly, the SEC claimed that the adviser’s online fact sheets were misleading. The firm was charged with having willfully violated Advisers Act Section 206(4) and its Rule 206(4)-1(a)(5), as well as Section 204(a) and its Rule 204-2(a)(16). The firm was censured and ordered to pay a civil money penalty of $80,000. The adviser was also cited for failing to implement adequate policies and procedures for reviewing the marketing and promotion materials posted on its digital media platforms.

What You Should Know

Robo-advisers, similar to all other registered investment advisers, are required pursuant to Rule 206(4)-7 under the Advisers Act to establish an internal compliance program that addresses the adviser’s performance of fiduciary and substantive obligations under the act. Registered investment advisers must adopt, implement, and annually review written policies and procedures that are reasonably designed to prevent violations of the Advisers Act, taking into account the specific nature of their operations and areas of risk exposure. As conveyed in the February 2017 Guidance Update issued by the SEC’s Division of Investment Management on robo-advisers, robo-advisers must be mindful of the unique aspects of their business models when developing policies and procedures. In addition to the allegedly deficient policies and procedures identified in the enforcement cases, the Guidance Update suggests that advisers consider adopting, as applicable, the following written policies and procedures to address the unique risks faced by robo-advisers:

  • Measures to develop, test, and backtest the algorithmic code and the post-implementation monitoring of performance
  • Measures to ensure that the prospective client questionnaire elicits sufficient information to allow the digital adviser to conclude that its recommendations and investment advice are suitable and appropriate
  • Measures to ensure that disclosures are made to clients regarding changes to the algorithmic code that may materially affect their portfolios
  • Measures to ensure the appropriate oversight of any third party that develops, owns, or manages the algorithmic code or software modules used by the digital adviser
  • Measures to prevent, detect, and respond to cybersecurity threats
  • Measures to monitor social and other forms of electronic media used in connection with marketing advisory services
  • Measures to protect client accounts and key advisory systems

ACA Guidance

To address the concerns highlighted by the enforcement actions above, advisers should also review their policies and procedures to ensure they appropriately address the means through which they communicate with clients and prospective clients. Additionally, advisers to digital advisory programs that employ automated processes such as tax-loss harvesting programs to manage client accounts should ensure that such processes have been tested and work as intended, in line with disclosures made to clients. Finally, advisers should ensure they maintain internal processes to confirm all content provided for the benefit of clients and prospective clients is reviewed for accuracy and presented in a manner that is not misleading.

For More Information

For more information on these enforcement actions or for assistance in reviewing the technical aspects of your advisory platform, advertisements, and/or written policies and procedures to ensure they align with regulatory expectations based on your digital advisory platform’s unique aspects, please contact Michelina Cuccia, Director, Luis Garcia, Principal Consultant, or your ACA consultant.