Robo-Advisors
I, for one, welcome our new robot investing overlords
Any FinTech that wants to offer products or services related to investment advice need to be aware of investment advisor regs. This group includes, for example, robo-advisors like Wealthfront, but also any wealth management software.
So what are the key investment advisor regs?
Glad you asked…
Investment Advisors
An “investment advisor” is anyone who: (1) engages in the business of (2) advising others about securities (3) for compensation.
Let’s break that down:
Engaged in the business of: advising doesn’t need to be the main thing you do. It depends on factors like how you advertise your services, how specific your advice is, and if you’re clearly paid for investment advice.
Advising others about securities: non-securities (e.g., commodities or commodity crypto) don’t count!
Compensation: includes any economic benefit, not just money.
Investment advisors are mainly regulated by the Investment Advisers Act (Advisers Act).
Advisor Registration / Exemption
Investment advisors generally must register with the SEC or states depending on how much money you manage and applicable state laws:
Registering with the SEC requires steps like filing Form ADV with the SEC, which discloses info about the advisor, the assets it manages, its employees, its conflicts, and other info.
Fun fact: you can research advisor filings (like Form ADV) on the SEC’s public database. You can look up Andreessen Horowitz’s filings, for example, and see how much $$ they manage ($35B in investment funds, as of 3/3/21).
States have similar filing requirements and often also require that key representatives of an advisor meet certification requirements (e.g., pass the Series 65), register with the state, file copies of their fingerprints with the state, and provide other info.
Fiduciary Duties
Investment advisors have “fiduciary duties,” which is legalese for “you need to act in the interests of the clients you advise, not yourself.”
Advisor fiduciary duties generally include:
Duty of care: you must...
Act and provide advice that’s in the best interest of clients.
Seek best execution of client trades (i.e., maximizing value the client receives).
Duty of loyalty: you must...
Not place your own interests before your clients’.
Disclose material facts about the advising relationship (including conflicts of interest).
Avoid conflicts of interest, or get consent where they can’t be avoided.
Duty to act with honesty and in good faith: don’t lie or mislead and do your job in earnest.
The duty of care to provide advice in a client’s best interest includes the “Suitability Requirement.” This is where Wealthfront’s sign-up questionnaire comes in: robo-advisors need to ask questions about a client’s financial situation, investment experience, and objectives.
Robo-advisors need to be thoughtful about these sign-up questionnaires to make sure they’re catching enough client variance while also having questions and product flows broad enough to apply to most applicants. Robo-advisors also need to make sure questions can be reasonably understood by everyone who applies.
Robo-Advisers
The SEC has issued guidelines for robo-advisors:
They must disclose how algorithms are used to manage accounts.
They should explain the risks of using algorithms.
They must disclose all info about how they’re compensated.
They must disclose transactional costs or commission fees that the client will be charged (i.e., so a client knows what they’ll be charged for automated trades).
They should disclose limits on any hypothetical projections used to market their services.
In the above guidelines, the SEC acknowledged that a robo-advisor may need to provide info beyond traditional disclosures. Specifically, a robo-advisor may consider including additional info related to its algorithms like:
Description of the algorithm.
The assumptions and limitations used in the algorithm.
The risks and how to minimize them.
Description of any third parties that were involved in developing the algorithm.
Description of human involvement in managing the algorithms.
Advertisements
Rule 206(4)-1 of the Advisers Act limits and regulates what investment advisers can advertise:
No false or misleading statements of fact
Limited use of testimonials and past performance
Limited use of graphics and other models
Limited use of free products and reports (unless there’s additional info so the advert is not misleading or incomplete).
Additionally, if investment advisors want to use client testimonials or paid bloggers, a few other regs apply:
You must provide certain disclosures (re: whether the promoter is a client and/or paid).
You need to comply with the Cash Solicitation Rule, which generally requires having a written agreement with promoters
Antifraud
Under Section 206 of the Advisers Act, investment advisors generally can’t (a) engage in fraud or (b) make materially misleading or false statements about the advisor’s business.
Investment Company Act
An “investment company” is an issuer that is, or holds itself out as being, engaged in the business of investing, reinvesting, or trading securities.
In English, it’s a business that takes investors’ funds and invests in securities. And any company that has or plans to have securities of >40% its value is presumed to be an investment company.
Under the Investment Company Act, investment companies must register with the SEC or fit under an exemption.
For robo-advisors, SEC Rule 3a-4 is a key exemption you can use if you meet conditions like:
You provide discretionary investment advisory services,
You do enough diligence (at the beginning and on on-going basis) to offer clients tailored advice,
You manage accounts based on each client’s financial situation, investment objectives, and any reasonable restrictions they want,
Clients have reasonable access to consult with the portfolio manager,
Clients have a right to trade and vote the securities in their portfolio.
A big risk here is if robo-advisors fail to do sufficient due diligence on clients. If that happens, they risk blowing their Investment Company Act exemption under the second bullet above.
Best Execution
Investment advisors must execute trades for their clients by seeking “best execution.” In practice, this includes considerations like:
The least expensive way to buy or sell.
The best way to deal with large orders.
The responsiveness and ability of the broker-dealer or exchange to complete the transaction.
Compliance Programs
Rule 206(4)-7 requires investment advisors to:
Implement written policies and procedures to prevent, detect, and fix violations of the Advisers Act,
Review these policies and procedures annually, and
Appoint a chief compliance officer.
Cybersecurity
Generally, investment advisors must take cybersecurity measures to protect any nonpublic personal info they have. Specifically, they must:
Disclose cyber risks and incidents in their periodic reporting, firm disclosures, and analyses of the firm’s financial conditions and operations.
Have written policies and procedures to protect customer records and information, which includes:
Back testing policies to ensure they’re effectiveness.
Periodically assessing vendors and third party service providers that have access to client info.
Setting up reporting mechanisms so that breaches are quickly found.
Disclosures
SEC-registered advisers that can control client assets must disclose any material info on compensation or conflicts of interest that could impair their ability to meet their contractual commitments to clients.
Broker-Dealers
Robo-advisors may offer broker-dealer services to execute investment strategies. These advisors are subject to regulation as broker dealers. More on what that means in another post coming soon…
AML & BSA
Robo-advisors will be subject to anti-money laws, which you can read about here.
Don’t want to miss more FinTech law summaries as they roll out in the coming weeks?
If you enjoyed the summaries, why not share?
About
Hi! I’m Reggie. I’m a FinTech lawyer at BlueVine, and any views expressed are my own (well, sort of? I mean, they’re laws and regulations, so they’re not really “mine”). These TL;DRs are not legal or financial advice, obv.