The SEC is taking a hard look at how financial advisory firms are handling disclosures and investment recommendations as part of its policy framework for the fast-developing digital advice space.
In particular, the commission wants to assure advisors with a robo platform are ensuring that their onboard questionnaires produce suitable product recommendations, and, above all, that they are delivering in line with online disclosures and marketing materials, according to Robert Shapiro, branch chief in the chief counsel's office at the SEC's Division of Investment Management.
"If a client is expecting... a goals-driven advisor [who] is providing full-service financial planning — that includes paying off loans first or whatever else — and that's not what's being delivered, that's a problem," Shapiro said at a conference in early February hosted by the Practising Law Institute and broadcast online.
"It's really about that expectation setting and making sure that clients understand exactly what the service they're getting is," Shapiro said.
Shapiro's overarching message is that while digital advice can create some unique technical challenges and opportunities, the same compliance considerations that govern traditional advice codified in the 1940 Investment Advisers Act prevail on the online channel as well. That was a central element of the guidance the SEC released on robo advice last year, when the commission affirmed that digital services must hew to the same fiduciary requirements that govern traditional RIAs.
"I think what we came to realize is that one of the greatest assets of the Advisers Act is that it's fundamentally a principles-based act, and as a result, principles that were laid out 75 years ago before the first computer were even built could still apply to robo advisors," Shapiro said, citing "the basics of the fiduciary duty" and other compliance functions.
"The requirements of those rules really could apply to robo advisors, which was great, because we determined that there was not at that time... a need for new or different rules or new or different regulations," he added.
Despite that core commonality, however, there are some elements of the digital advice world that are undeniably different from the traditional model of delivering investment advice.
As a starting point, Shapiro and other experts note that the robo landscape remains highly unsettled, and that firms have been rolling out digital services that vary considerably. But to generalize, the SEC sees a heavy internet component across robo services, which means that they tend to have more limited human interaction than the traditional advisor-client relationship, and also rely more heavily on questionnaires and algorithms for managing a client's portfolio.
Onboarding questionnaires to determine a client's risk profile are a common industry practice and long predate robo advisors, Shapiro acknowledges. But in evaluating a predominantly digital platform, the SEC wants to see that the firm has devised its questionnaire to ensure that it produces suitable investment recommendations, and it expects firms to put in place red flags to alert advisors to instances where the client might have provided contradictory information.
"Plenty of traditional advisors rely on questionnaires, right? It's a myth to say only robo advisors use questionnaires to generate a client profile — that's silly," Shapiro says. "Instead, as with any advisor, the question is: is the questionnaire really eliciting the right information that you feel like you can make a suitability determination as an advisor? Are your questions clearly crafted, especially since there's no one there to clarify or explain them?"
Some industry officials caution against overstating the role that automated processes play in selecting investments at most firms, noting that advisors typically rely on algorithms to handle more routine functions such as portfolio rebalancing and risk profiling.
"There's a common misconception that algorithms are driving the trading strategies, the portfolio selection," says Todd Cook, who heads up legal affairs for JPMorgan Chase's Intelligent Digital Solutions business. "That's just generally not the case."
But those risk profiles can be operative in determining which investments are suitable for a client, and Cook urges firms to take a close look at how their systems work — because the regulators will certainly want to peer under the hood.
"You don't want to be figuring out how you decided which portfolios were suitable for clients when the SEC is knocking on your door," he says. "You want to do that when you're designing your risk-profile questionnaire and document it."
Advisors should also be aware that with an online questionnaire, they are creating a digital trail of breadcrumbs that will be easy for regulators to put together, cross-referencing how clients answered items on a questionnaire with the types of products the advisor selected for them, according to Andras Teleki, managing member of the Teleki AML and Cybersecurity Law Firm. Those decisions are a little murkier in a traditional onboarding process, where the advisor might jot down an incomplete set of notes in a face-to-face meeting with the new client.
"This is an area where it's really easy for the SEC staff to map back," Teleki says of online questionnaires. "In this particular case, there's going to be a super-clear map, because they'll pull all the data points of how a whole bunch of people answered those questions and then they'll look at what investments were they in and do the two match up? And that's where the second guessing comes.”
“So to the extent you can actually demonstrate your thought process of how you decided, you're already one step ahead in the game,” he adds.