SEC Staff Issues Risk Alert on Robo-Advisers
On November 9, 2021, the SEC’s Division of Examinations (“EXAMS”) issued a risk alert (the “Alert”) based upon recent examinations of registered investment advisers providing automated digital advice services (“Robo-advisers”) to their clients. In the Alert, EXAMS notes that nearly all of the Robo-advisers examined received a deficiency letter. Findings included the following issues with respect to compliance programs:
Compliance Program Failures
Many advisers noted in the Alert lacked policies and procedures specific to robo-advice, including assessing whether algorithms were performing as attended, ensuring rebalancing services were occurring as disclosed and/or ensuring the protection of client passwords. Cited firms failed to conduct a review of policies and procedures at least annually to determine their adequacy and/or effectiveness of their implementation. In addition, other advisers did not comply with the Code of Ethics Rule because they failed to receive required holdings and transaction reports and/or obtain written acknowledgements from all access persons with respect to the Code of Ethics.
Portfolio Management Oversight Failures
Portfolio management related issues included advisers who failed to adopt and/or follow policies and procedures to develop a reasonable belief that investment advice was in the client’s best interest. Others lacked written policies and procedures related to the operation and supervision of the automated platforms, increasing the risk of algorithms producing unintended results, rebalancing error and trade errors. EXAMS also found that many advisers lacked written policies and procedures with respect to best execution.
Disclosure and marketing Issues
EXAMS cited firms for inaccurate or incomplete disclosures in Form ADV, including weaknesses with respect or conflicts of interest, advisory fees and investment practices. More than half of the firms reviewed had advisory agreements that included prohibited hedge clauses and/or other exculpatory language.
Other advisers posted misleading or prohibited statements on websites, while others distributed materially misleading performance advertisements, including hypothetical performance presentations. Another common disclosure weakness related to inadequate or insufficient disclosure about the level of human interaction in providing advisory services.
With respect to cybersecurity programs, EXAMS cited a lack of policies and procedures regarding the protection of firm systems and responding to cybersecurity events. In addition, many advisers failed to have policies and procedures to comply with Regulation S-ID and Regulation S-P regarding the protection of client information.
Customized Investment Advice
Investment advisory programs generally rely upon safe harbor provisions of Rule 3a-4 under the Investment Company Act of 1940. Under the safe harbor, a program will not be considered an investment company so long as each client’s account is managed on the basis of the client’s financial situation, gives the client the opportunity to impose reasonable restrictions on the account’s management, the client is advised at least quarterly to contact the adviser with changes in his or her financial situation and the sponsor is available to the client for consultation. EXAMS found situations in which Robo-advisers were offering clients a generic investment program that did not meet the requirements of the safe harbor, but instead offering the same investment program to all clients.
While many of these issues are also seen in traditional advisers, robo-advisers should pay particular attention to these findings and review their compliance programs to ensure that strong policies and procedures are implemented.
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