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Robo Firms May Violate Investment Laws, Asset Manager Argues

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After arguing that the Department of Labor's proposed fiduciary standard would deprive millions of Americans of financial advice, some industry opponents are pushing a more incendiary objection: that robo advisors may be unregistered investment companies, in violation of both the Investment Company Act of 1940 and SEC regulation.

The Labor Department, according to a report titled Robo-Advisors: A Closer Look,"has touted robo advisors as investment alternatives for retirement investors based on ill-founded assumptions that robo advisors are free or 'low-cost' and seek to minimize conflicts of interest."

The report, commissioned by asset management giant Federated Investors and authored by Washington-based banking and securities attorney Melanie Fein, challenges DoL Secretary Thomas Perez’s support of robo advisors with several claims.

"It's an inquiry into what they are and what they do, drawing on Perez's comments and the DoL's statements that robo advisors minimize conflict and are a low cost alternative," Fein says.

She adds that the report's purpose is to examine the robo phenomenon, which involved reviewing the user agreements of "three leading robo advisor platforms." (The robos are unnamed in the paper.)

The report makes several claims: that robos do not provide personal investment advice, do not minimize investment costs, are not free from conflicts of interest, do not meet a high standard of care, do not act in a client's best interest, exclude ERISA accounts and do not meet the DoL's proposed best interest contract. Additionally, there is the allegation that robos may be unregistered investment companies.

(Read Fein's explanation of her report here.)

The DoL said it had no comment on the report, and Federated also declined to comment on its decision to fund it.

Fein – who contributes occasionally to American Banker, which like Financial Planning is published by SourceMedia – describes the effort as an academic exercise: "Why is Perez talking about [robos] and mentioning them, what are their characteristics – that's all," she says. 


The report's argument that robos may be unregistered investment companies, in violation of SEC regulation, Fein says, comes out her reading of the agreements. "It leaped out at me as a legal issue," Fein says.

She argues that because the robos she examined rely on form questionnaires and do not gather a client's entire financial situation and also do not provide clients an actual advisor, they do not manage accounts on the basis of the client’s financial situation, and thereby do not meet the safe harbor requirements under SEC Rule 3a-4 of the 40 Act.

The safe harbor was originally created with wrap accounts in mind, to ensure that an investor being charged a wrap fee would be connected to an advisor who managed their account individually, rather than placing their money into common account, which regulators would define as an investment company requiring registration under the act.

Fein clarifies that her report is not saying the SEC should address whether robos are in violation of the act. "I saw that as a legal issue, that is something obviously for the SEC to consider," she says.

Securities law experts described the argument as a novel one, but one that could be remedied by robo advisors with little difficulty.

"Well-advised robo advisors will not have a problem fitting within the safe harbor so that they are not treated as mutual funds," says Mercer Bullard, professor at the University of Mississippi School of Law and president and founder of Fund Democracy, a mutual fund shareholder advocacy group.

Bullard says robos do face other potential regulatory risks, such as maintaining meaningful contact with clients, and acknowledges there are substantive agurments the report makes about conflicts of interests among robos.

"But if that is such a problem with robos why don't broker-dealers see it as a problem of their own?" 

Steven Wallman, former SEC commissioner and current CEO of online brokerage Foliofn Investing, says Fein's argument resembles a similar objection brought against Foliofn by the Investment Company Institute in the early 2000s, which the SEC ultimately dismissed.

"This [report] is saying robos are giving the same portfolio to every investor who comes in, without taking into account their financial situation, which is not true," Wallman says.

He adds that the application of the act to robos is misguided.

"You can look at the technical issues of the 40 Act to see whether robos fit or not, but they were not intended to be funds, they are not intended to be registered investment companies, and there is no benefit to regulating them as such," Wallman says. "They clearly have registered as advisors, which is what they purport to be and what they are."


The report united robo advisories and consumer advocates in refuting its claims.

"Characterizing all of the robo advisors into one bucket is a gross generalization," says Joe Ziemer, Betterment's director of communications, adding the report's "most inflammatory insinuation [is parsed] with enough qualification as to make it meaningless."

"Robos may be unregistered investment companies. It may be questioned whether robos meet the requirements of the safe harbor. These are hallmarks of a writer leaving enough wiggle room to completely back away from a question that is never quite turned into an argument, much less a persuasive one," he says. 

Rob Foregger, co-Founder of NextCapital, Personal Capital and EverBank, questions the reasons for Federated's report.

"Many detractors of the new proposed fiduciary rule suggest that retirement savers will have less access to retirement advice. What I believe Sec. Perez was accurately saying is that the industry should be paying more attention to technology-driven solutions to deliver scalable retirement advice to more people, at a lower price. 

"I find it interesting that anyone feels the need to attack the so-called robo advisors — especially since many of these companies are focused on providing high-quality investment advice to consumers that previously did not exist have an option."

Barbara Roper, director of consumer protection at the Consumer Federation of America, characterized the report as an industry lobbying effort with sweeping claims, not backed by hard data.

"Industry firms will try and discredit anyone with a different business model, whether fee-based advisors or robos," Roper says. "They don’t want to have to change their current practices and they see the DoL proposal very threatening, and potentially force them to fundamentally change the way they do business."

"We don't think they are the end-all and the be-all, but all robos can't be painted same brush," she adds. "We do think technology has the potential to change how advice is offered and will make it affordable for people who can't get advice under the traditional model, which is a good thing."

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