As of May 1, 2018, there are presently 159 “robo adviser” registered investment adviser (“RIA”) firms registered with the Securities and Exchange Commission (“SEC”) utilizing the “Internet Investment Adviser” Rule 203A-2(f) exemption to qualify for federal registration. According to public records, in the 2017 calendar year, 50 new robo adviser RIA firms registered with the SEC. While the growth of this new advisory model spurred by a number of new financial technology entrepreneurs has the potential to democratize investment advice for a new group of potential consumers, robo advisers need to understand the responsibility and unique compliance requirements required when establishing a federally-registered RIA firm.
On February 23, 2017, the SEC Division of Investment Management staff issued a guidance update related to robo advisers. While we have previously written about this staff guidance, given the continued growth of the online advice model and the varied types of new entrants into the online advisory space, we wanted to take the time to once again highlight the the unique compliance requirements related to robo advisers.
All current and prospective robo adviser RIA firms are strongly encouraged to review the SEC staff guidance. In particular, financial technology entrepreneurs that have not previously operated a regulated investment advisory business need to ensure that the design and implementation of a proper compliance program is a top priority beginning with the firm’s initial registration.
The SEC staff guidance highlights a number of compliance issues relevant to internet only investment advisers including:
Substance and Presentation of Disclosures
- Explanation of Business Model
“To address potential gaps in a client’s understanding of how a robo-adviser provides its investment advice, the robo-adviser (like all registered investment advisers) should disclose, in addition to other required information, information regarding its particular business practices and related risks.”
- Scope of Advisory Services
“Robo-advisers, like all registered investment advisers, should consider the clarity of the descriptions of the investment advisory services they offer and use reasonable care to avoid creating a false implication or sense about the scope of those services which may materially mislead clients.”
- Presentation of Disclosures
“Because of robo-advisers’ reliance on online disclosures to provide such information, there may be unique issues that arise when communicating key information, risks, and disclaimers.We therefore remind robo-advisers to carefully consider whether their written disclosures are designed to be effective (e.g., are not buried or incomprehensible)”
Provision of Suitable Advice
- Reliance on Questionnaires to Gather Client Information
“We have observed that robo-advisers may provide investment advice based primarily, if not solely, on client responses to online questionnaires. The questionnaires we have reviewed have varied with respect to length and the types of information requested.”
- Client-Directed Changes in Investment Strategy
“Many robo-advisers give clients the opportunity to select portfolios other than those that they have 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.”
Effective Compliance Programs
“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.”
Compliance Best Practices for Robo Advisers
Given the above referenced SEC staff guidance and more recent regulatory focus, we strongly encourage all robo adviser RIA firms to consider taking the following steps:
- Carefully review the firm’s Form ADV Part 2A and other relevant disclosure documents to ensure full and accurate disclosure related to the scope and limitations of the investment advisory service provided, conflicts of interest, the use of algorithms, full fees and costs the client may pay directly or indirectly, and how an online questionnaire is utilized to create investment recommendations
- Ensure key disclosures are provided prominently on both web and mobile platforms to prospective clients before the client engages the online service
- Review online questionnaire design to ensure that the questionnaire is probably designed and has the proper flagging systems in place to ensure that sufficient and accurate information is provided by the client in order to provide suitable advice
- Make sure all Rule 206(4)-7 requirements have been properly implemented and documented and that the compliance program has been thoughtfully designed to address the unique risks of the robo adviser business model which may include the reliance on algorithms, the need for the questionnaire to provide sufficient information, the importance of cybersecurity, and the use of social media or other online forms of advertising
The above list of some robo adviser compliance best practices is far from an exhaustive list and all internet only RIA firm principals and Chief Compliance Officers are strongly advised to take the time necessary to review their compliance programs to identify and address any other potential compliance program deficiencies. Electronic investment advice remains a key SEC regulatory examination priority in 2018 so firms should expect continued regulatory focus in the coming years as the online advice business model continues to evolve.
RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.