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Robo-Advisors: Regulators May Be Closer Than You Think

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Electronic investment advice, automated investment tools, digital advice services — whatever you call them, robo-advisors have experienced explosive growth in the investment advisory space in recent years. And regulators are struggling to keep up.

How long will this period of loose regulatory oversight continue? Will this current period of market volatility reveal fault lines that spur regulators to take a closer look? There are signs that increased regulatory scrutiny of robo-advisory platforms may be on the horizon.

The term “robo-advisor” means different things to different people. For our purposes here, think of robo-advisors as automated investment platforms — available online or through an app — that rely on computer algorithms to determine asset allocation models that align with investors’ investing experience, investment objectives, risk tolerance and investment time horizon, among other things (i.e., suitability information).

The asset allocation models selected through these automated investment tools usually consist of appropriately weighted, diversified baskets of ETFs.

Because robo-advisors charge low (or no) fees, typically require low minimum balances and include helpful features like automatic investing/rebalancing, they have become increasingly popular investment tools for retail investors.

Indeed, by any measure, the robo-advisory market segment has exploded in recent years, and the pace of growth appears to be accelerating. According to Statista, in 2019 U.S. robo-advisors had $283 billion in assets under management (up 10% over 2018 and up roughly 16% since 2017).

LearnBonds estimates that AUM of U.S. robo-advisors could jump as high as $1 trillion in 2020. And we should expect corresponding rises in the number of users/investors — from 13.1 million users in 2017 to an anticipated 70.5 million users in 2020, and as many as 147 million users by 2023. (It is worth noting, of course, that recent market events could meaningfully depress the actual figures for 2020.)

The staggering growth of the industry has given rise to new services (like interest-bearing savings accounts or debit cards issued by robo-advisors), new fee structures and new market entrants — indeed, nearly every major U.S. bank now has a digital advice service.

A Closer Regulatory Look?

But regulators haven’t kept up with innovation in the robo-advisory space. There has been precious little scrutiny of robo-advisory firms or platforms, and the few examples of enforcement actions involving robo-advisors largely reflect instances of regulators applying elements of the existing regulatory framework to these innovative investment platforms.

Indeed, there have been only six noteworthy enforcement actions against robo-advisors (four by the Financial Industry Regulatory Authority and two by the Securities and Exchange Commission), and all involve fairly routine charges: failure to create or provide customer records, failure to report trade data, failure to preserve electronic communications, reliance on misleading marketing materials or advertisements that overstate performance and, reliably, failure to develop or implement adequate written supervisory procedures.

There have been no enforcement actions that really drive at the heart of the robo-advisory model.

The relative lack of scrutiny may result from a lack of expertise at the SEC and other regulators. Indeed, Reuters reports that, before leaving his post, former SEC Commissioner Robert Jackson lamented the scarcity of SEC regulatory and enforcement resources in the robo-advisory space.

“I know what it looks like when a human being commits fraud,” he said. “It’s a lot harder to detect when an algorithm defrauds the investor. But investors deserve no less protection simply because money is being moved around by an algorithm. … In 20 years we may need to be an agency of 2,000 lawyers and 2,000 programmers.”

Still, there are signs that increased regulatory scrutiny of robo-advisory platforms may be on the horizon, and current market conditions may cause regulators to take a closer look sooner than later.

The SEC continues to tout the programmatic significance of protecting so-called “retail investors” — in its examination and enforcement programs, as well as recent regulatory actions relating to the COVID-19 pandemic. The SEC Enforcement Division believes investor harm occurs most frequently “in the interactions between investment professionals and retail investors.”

Because robo-advisors are often viewed through the prism of democratizing access to investment advice (though some debate whether that is the reality), they create a natural intersection with “main street investors” that the SEC can police for low-hanging regulatory violations.

The possibility of investor harm where robo-advisors and retail investors intersect is not lost on the SEC’s Office of Compliance Inspections and Examinations (OCIE), which counted “electronic investment advice” among its 2020 Examination Priorities.

According to its exam priorities letter, OCIE’s exam staff will focus on robo-advisors’ marketing practices, adherence to the duty of care, disclosures and compliance programs. (It is worth noting that OCIE’s focus on robo-advisors’ adherence to the applicable duty of care almost certainly implicates the SEC’s Regulation Best Interest.)

More Regulators

Furthermore, several recent regulatory initiatives may intersect with the robo-advisory segment. For example, FINRA’s Market Regulation Department has asked firms to provide information concerning their “decision not to charge commissions for customer transactions, the impact that not charging commissions has or will have on the firm’s order routing practices and decisions, and other aspects of the Firm’s business.” And the SEC’s Division of Enforcement is conducting an investigation relating to firms’ cash sweep programs.

In addition to these open lines of inquiry, recent market volatility may reveal new areas for regulatory scrutiny. For example, OCIE or FINRA exam teams may be interested in how robo-advisors manage downside risk and adjust/rebalance portfolios.

Firms that offer electronic investment advice should note that regulatory priorities and programs are coalescing around — or are at least adjacent to — the robo-advisory model.

Given the growth of the industry and the number of new market entrants, firms that offer robo-advisory services could be increasingly likely targets for regulatory scrutiny when the SEC and FINRA resume normal service. From compliance with Reg BI, to the new advertising rule, to nuts-and-bolts record-keeping requirements, regulatory scrutiny of robo-advisory platforms is closer than you think.

Kurt Wolfe is an attorney with Troutman Sanders LLP. He can be reached at [email protected].


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