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SEC Issues Guidance for Robo-Advisors, Investors

ThinkAdvisor

By Danielle Andrus | February 24, 2017

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Robos are fiduciaries under the Advisers Act, SEC says.

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The Securities and Exchange Commission issued guidance on Thursday for advisory firms that offer automated advice platforms to help them meet disclosure, suitability and compliance obligations under the Investment Advisers Act of 1940.

The SEC’s Office of Investor Education and Advocacy also released an Investor Bulletin outlining for consumers typical services offered by robo-advisors. The bulletin stressed the importance of consumers doing their own research to supplement the robo-advisor’s recommendations to make sure it works for them. It also proposed questions consumers should ask themselves before investing with a robo, and throughout the planning process, such as:

  • How much human interaction is important to you? Would you like to be able to speak with a person during market events, such as periods of exceptional volatility or downturns?
  • What is your level of financial literacy, especially when it comes to investing? Are you comfortable using online resources?
  • How often does the robo-advisor follow up with clients to confirm any changes that would affect their investment choices? Would you have to contact the robo-advisor with any updates to your financial situation?

“As technology continues to improve and make profound changes to the financial services industry, it’s important for regulators to assess its impact on U.S. markets and give thoughtful guidance to market participants,” acting Chairman Michael Piwowar said in a statement. “This information is designed to help investors tap into the opportunities that fintech innovation can provide while ensuring fairness and investor protection.”

Robos Are Fiduciaries, SEC Says

Robo-advisors are subject to the same fiduciary obligations under the Advisers Act as any other RIA, the SEC wrote in the guidance issued by the Division of Investment Management.

The guidance focuses on robos’ obligations under the Advisers Act, but the SEC warned that robo-advisors’ services may also be subject to the Investment Company Act of 1940, particularly Rule 3a-4, which creates a safe harbor for advisors who manage multiple accounts in a similar way to avoid being categorized as a mutual fund.

“The SEC is definitely in touch with the problem,” Scott MacKillop, CEO of First Ascent Asset Management, told ThinkAdvisor on Thursday. “They recognize the difficulties that robos have in being fiduciaries, and they’re trying as best they can to lay out a roadmap for them.”

The guidance identified three areas robo platforms should focus on.

Disclosure

Automated advice providers should take care to explain their business model, including a description of the algorithm used to make recommendations and when a robo might override the algorithm.

Disclosure should clearly explain the scope of their services, taking care to “avoid creating a false implication or sense” of those services. For example, a robo-advisor that advertises comprehensive financial planning but doesn’t consider a client’s tax situation or focuses on one goal without considering the broader financial situation may not be in compliance.

The presentation of disclosure is just as important as the substance. The SEC noted that for many clients of robo-advisors, disclosure may be limited entirely to electronic communications. Without a human advisor to interact with the client, it may not be clear if they understand or even read the disclosure offered. The guidance recommended that in addition to initial disclosure material, robo-advisors should emphasize specific disclosure throughout the process and incorporate interactive tools to help explain some disclosures.

Robos should also make sure their disclosures are readable on mobile devices.

Suitability

Advisors have a fiduciary obligation to act in their clients’ best interest, which requires them to know something about their clients. However, the guidance suggested that the questionnaires used by many robos to gather information about users may not sufficiently allow them to meet that requirement. Questionnaires vary in length and in the types of information they collect. Some don’t allow users to provide additional information, or don’t allow advisors to ask follow-up questions.

This is the main issue MacKillop sees for robos trying to comply with fiduciary obligations.

“How much can they do to really know and understand the needs of their clients?” MacKillop asked. The technology robos use, “by its nature, is limited in terms of how you can interact with the client. […] You’re having to try to learn enough about the client through an online interaction to really be able to provide the right portfolio management advice.”

The SEC recommended that robo-advisors that use a questionnaire to form the basis of their recommendations make sure they have enough information to make a suitable recommendation, and that questions are clearly written so users can answer them accurately. They should also implement ways to address inconsistent responses from clients.

If robo-advisors allow users to select a portfolio other than the one the advisor recommended, they should implement ways to alert the user that the portfolio may not be entirely suitable.

Compliance Programs

Robo-advisors may have additional risks that traditional advisors don’t face that they need to address in their written policies and procedures in order to comply with Rule 206(4)-7 of the Advisers Act. For example, they may need to address development and testing of the algorithm used to develop client plans, oversight of any third parties that are associated with the platform, the use of social media and other electronic communications, and protection of client accounts and key advisory systems.

“It wouldn’t surprise me if there were an enforcement action a year from now, let’s say, after the SEC’s given them fair warning and laid the roadmap out for them,” MacKillop said. “I think [the SEC will] wait and see how the industry moves to try to respond to these guidelines, and if there’s a good example they can make of somebody along the way, I think they’ll do it.”

Consumer vs. Hybrid Robos

The guidance focuses on robos that deal directly with consumers, but noted that it “may be helpful for other types of robo-advisors.”

MacKillop agreed, and suggested that hybrid robos, which offer access to a human advisor in addition to automated account management, pay especially close attention to the guidelines.

“My fear for the hybrid model is that on the surface it looks much more like a fiduciary interaction, but really a lot of what you’re getting is 800-number type service, or in the worst case you may just be talking to a salesperson,” he said.

Hybrids might have an easier time complying with fiduciary guidelines, “just by the nature of the human interaction that they potentially can provide,” MacKillop said, “but they should watch out, too, to make sure they don’t drift into more of a sales or customer-service type of mode.”

“What a financial advisor does is pretty significantly different from what a salesperson does,” he said. “That’s where the difficulty is going to be for the hybrids.”