To date, we have covered a myriad of topics designed to help you get your firm off the ground, focusing primarily on issues like registration, licensing, advertising, disclosure, and communicating and contracting with clients.  These critical issues have one thing in common – they all involve working with folks outside your firm. Today, we kick off a new chapter of our blog, inviting you to turn your gaze inward and examine the key pieces of your compliance program.

So, let’s start at the very beginning. Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that all advisers registered with the SEC:

  • adopt and implement written policies and procedures reasonably designed to prevent the adviser and its personnel from violating the Advisers Act and rules adopted under the act;
  • review, at least annually, the adequacy of those policies and procedures and the effectiveness of their implementation; and
  • designate a chief compliance officer to administer its compliance program.

Interestingly, the Compliance Rule doesn’t indicate what operational issues those policies and procedures should cover.  To find out, we need to look at the Compliance Rule’s adopting release.  In that release, the SEC stated its expectation that an adviser’s policies and procedures, at a minimum, address the following areas to the extent they are relevant to the adviser:

  • Portfolio management processes
  • Trading practices
  • Proprietary trading of the adviser and personal trading activities of supervised persons
  • The accuracy of disclosures made to investors, clients and regulators
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel
  • Recordkeeping
  • Marketing of advisory services
  • Valuation and fee assessment
  • Privacy and information security
  • Business continuity

Granted, depending on the particularities of an adviser’s business, a firm is likely to need policies and procedures that cover additional compliance areas.  Nevertheless, the list above serves as a good baseline to start from when building or initially assessing your program.  As such, our next series of blog posts will walk you through these key compliance areas so that you can meet your regulatory obligations effectively and efficiently.   We hope you’ll return for our next post, when Josh will discuss critical aspects of your portfolio management processes, including policies and procedures for maintaining the algorithm driving your investment decisions.

Business Continuity PlanTo our readers, we hope this entry to our blog finds you and your family safe and healthy. As we all begin to envision a path forward following the unprecedented events caused by the COVID-19 pandemic, a focus on compliance for your firm should not be an overlooked task.

For robo-advisers, this is an opportunity to analyze your compliance program with specific attention on policies that may have been trigged as a result of the pandemic. Given the need for social distancing and the stay-at-home restrictions imposed by many states, it is likely that your firm operated at some point, and perhaps for the entirety, of the past few months pursuant to its business continuity plan (“BCP”).

Barring some unexpected previous need, this is likely the first time that your firm had to rely on its BCP. Like all compliance polices, periodic review and testing for effectiveness is always a best practice. In essence, the last few months have served as a live test of your BCP. What makes a review of your BCP so important at this juncture is that it presents an obvious target for potential regulatory review. During your next examination, your firm should anticipate scrutiny by the SEC staff of any compliance policy likely to have been relied upon during the pandemic. In preparation for such an exam, it would be prudent to evaluate your BCP as presently drafted and compare it against the practicalities of how your business operated for the past few months while the plan was in effect. Identify and reconcile any divergences from the plan. That is, analyze how your business operated during this period and ensure that the policy and procedures laid out in your compliance program accurately and appropriately match those business operations. Additionally, your firm should also work to identify any potential gaps in your BCP. Even if your firm operated in line with its current policy, consider if there were any lessons or best practices that could be adopted to improve your compliance procedures.

Staying ahead of regulatory scrutiny involves anticipating issues before they become problems. Regular review and testing of a compliance program are critical to the success of all robo-advisory firms. If we can be of assistance in reviewing your BCP or any aspect of your compliance program, please don’t hesitate to reach out. We thank you, as always, for your continued support of the blog and hope you’ll check back soon for our next entry.

If you can believe it, May 1, 2020 is almost upon us.  And if you don’t remember from our February post, that is the day when advisory firms serving retail investors may start filing client relationship summaries on Form CRS.  As a reminder, Form CRS gives clients a quick summary of the key things they need to know about working with your firm, as it discusses types of services offered, fees charged, conflicts of interest, and disciplinary history.  While it cannot exceed two pages, Form CRS still manages to cover many of the same topics that are discussed in detail in Form ADV Parts 1 and 2.

On April 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert announcing that regulatory exams occurring after the compliance date for Form CRS (June 30, 2020) will assess how well firms have implemented policies and procedures to ensure compliance with the new requirements. In that alert, OCIE confirmed that examinations of advisers occurring after the compliance date will:

  • assess whether firms have filed, delivered and posted Form CRS as required;
  • determine whether the content and format requirements of Form CRS have been met; and
  • evaluate whether Form CRS recordkeeping processes have been implemented.

Importantly, in the risk alert, OCIE discussed with some particularity how the staff anticipated assessing compliance with Form CRS.  OCIE noted specific questions the staff may ask, what documents may be requested, and what disclosures the staff might expect to see.  For example, the staff may review records of the dates that Form CRS was delivered, advisory contracts to confirm consistency with disclosed fees, or copies of the adviser’s recordkeeping policies and procedures.  Firms tasked with compliance with Form CRS should review the guidance provided in the risk alert and evaluate whether any updates to their compliance program should be made.

We will continue to follow guidance released by the staff on Form CRS and keep you informed.  And please be sure to check back next time, when Josh will discuss a challenge you’re probably facing right now – ensuring that your business continuity plan is effective or gets the upgrades it needs so that you can continue to operate in this time of adversity.  Until then, we hope you are staying safe and healthy.

As Josh discussed earlier this week, the annual update to Form ADV is generally due at the end of March for most robo-advisers.  However, we are interrupting our current discussion thread to make sure you were aware that on March 13, 2020, the SEC extended Form ADV filing and delivery deadlines for investment advisers whose operations may be affected by the coronavirus.  The agency acknowledged that the impacts of the pandemic may delay or prevent advisers operating in affected areas from meeting certain regulatory obligations due to restrictions on travel, access to facilities, the potential limited availability of personnel and similar disruptions.

To enable advisers to meet those obligations and to continue their operations, while recognizing that there may be temporary disruptions outside of their control, the SEC issued an order (“Order”), effective through April 30, 2020, exempting advisers from the requirements to (i) file an amendment to Form ADV and (ii) deliver amended brochures, brochure supplements or summaries of material changes to clients.

The exemptions are available provided that the firm:

  • is not able to meet a filing deadline or delivery requirement due to circumstances related to the coronavirus;
  • promptly notifies the SEC via email and the public via its website that it’s relying on the Order, why it’s relying on the Order and when it expects to be able to meet the filing or delivery deadline; and
  • meets the filing or delivery deadline by no later than 45 days after the original due date.

Please don’t hesitate to reach out to us with questions on how the Order may affect your firm.  We will continue to monitor regulatory events related to coronavirus and keep you updated.   And be sure to check back soon, as we plan to return to our regularly scheduled discussion topic – how to ensure that your algorithm continues to work for clients the way that you intend.

equationWith the deadline for the annual update to Form ADV closing in at the end of March, let’s examine one aspect of Form ADV disclosure which impacts a majority, if not all, robo-advisory firms – algorithm related disclosure.

Your firm likely utilizes a proprietary algorithm to automatically determine client asset allocation among a limited set of investment products. Typically, this is done after a client has provided certain personal information (e.g., personal income, risk tolerance) through an intake questionnaire. While this process is an effective and efficient business model for both your firm and the client, it is critical that you fulfill your fiduciary and regulatory obligations.

One of your primary fiduciary and regulatory obligations is disclosure. As we previously discussed, your firm must register, either federally or with any applicable state, by completing and submitting Form ADV. General Instruction 3 of Part 2 of Form ADV requires you to disclose your obligations as a fiduciary, including all material facts relating to your advisory relationship with your clients and any potential conflicts. For a robo‑adviser this consists of disclosure regarding your algorithm, including, at a minimum:

  • A general statement that an algorithm is used to manage client accounts;
  • A description of how the algorithm is used (e.g., that client accounts are initially invested and periodically rebalanced, if applicable, by algorithm);
  • An explanation of the underlying methodology of the algorithm; and
  • Any involvement by a third-party in the design, maintenance, or ownership of the algorithm (e.g., if the algorithm directs client assets to third-party investment products for which the third party earns a fee).

While much of this disclosure is straightforward, publicly disseminating the underlying methodology of your algorithm presents a potential issue – you don’t want to give away proprietary trade secrets. However, you can meet your fiduciary duty and protect the proprietary nature of your algorithm design at the same time. In describing the methodology of your algorithm, focus on its assumptions and limitations. For example, if the algorithm is based on modern portfolio theory, a description of the assumptions and limitations of that theory would adequately fulfill your fiduciary obligations without disclosing the particulars of investment selection.

Moreover, focus your algorithm disclosure on potential risks, such as any instances when the algorithm may rebalance a client’s account without regard to market conditions. Also consider disclosing any level of human involvement in the management of the algorithm, for instance if there are dedicated personnel overseeing the algorithm but not monitoring individual client accounts.

When preparing your ADV updates this year, take an extra moment to review your algorithm disclosure. And don’t hesitate to reach out if you have any questions.

As always, we thank you for your continued readership. Please check back next time when Craig will discuss tips for making sure, on an ongoing basis, that your algorithm continues to serve your clients the way you intend it to.

OK, so remember last June when we discussed registering your firm? If you do, you may recall that the principal adviser registration document, Form ADV, is divided into two parts: Part 1 (a check-the-box form that is mostly for use by the regulator) and Part 2 (a narrative brochure that is the principal client disclosure document).

Well, for advisers registered with the SEC, as many robo-advisers are, there will soon be a new disclosure document to contend with. New Form CRS (client relationship summary) is designed to give investors easily digestible information about their relationship with their investment adviser. The form, which may not exceed two pages, provides information such as types of services offered, fees charged, conflicts of interest, and disciplinary history, covering many of the same topics that are discussed in detail in Form ADV Parts 1 and 2. Form CRS also includes sample questions or “conversation starters,” which clients can use to get additional information directly from their financial representatives.

Importantly, Form CRS is required only for advisers whose clients are “retail investors,” meaning natural persons seeking services primarily for personal or family purposes. This means that investment advisers that don’t serve retail investors need not worry about Form CRS. That said, because most robo-advisers have retail investor clients, most robo-advisers will need to complete, file and deliver the form.

When does this all start, you ask? Advisers currently registered with the SEC will need to file their initial Form CRS through IARD between May 1 and June 30 of this year. Importantly, you may not file the form prior to May 1, 2020. This means that for an adviser with a calendar fiscal-year end, the initial Form CRS must be filed as an other-than-annual amendment; it cannot be filed as part of the adviser’s annual Form ADV update due March 30, 2020.

Once you’ve filed Form CRS, you’ll need to start delivering the initial Form CRS no later than June 30, 2020 for new clients and July 30, 2020 for current clients. In addition, if any information in your Form CRS becomes materially inaccurate, you’ll need to file an amendment within 30 days and notify clients within 90 days.   Unlike Form ADV Parts 1 and 2, Form CRS does not have an annual filing requirement. Instead, once you’ve filed the form, you just need to make sure it stays accurate and notify clients if anything changes.

Speaking of notifying clients, let’s talk about how to actually deliver Form CRS. As a robo-adviser, chances are you will send Form CRS electronically. When you do, be sure to follow the form’s instructions, which require that the relationship summary be (i) presented prominently in the electronic medium, like a direct link or in the body of an email or message, and (ii) easily accessible. And of course, don’t forget to implement the tips we shared in our previous post on electronic communications.

Finally, just a brief word on recordkeeping. When they adopted Form CRS, the SEC also adopted corresponding amendments to Advisers Act Rule 204-2 (the recordkeeping rule). Those amendments, broadly speaking, require advisers to keep current and historical copies of Form CRS (including amendments) and records of the dates that the form is filed and delivered to clients.

Even though Form CRS need not be filed until June, we still recommend that advisers with retail investor clients take the time now to:

  • draft and finalize the initial Form CRS, consulting with counsel as necessary;
  • develop and update policies and procedures to ensure that on an ongoing basis, Form CRS is filed, delivered and updated appropriately; and
  • update recordkeeping portions of their compliance manual as needed to account for Form CRS.

That’s all for this time! Be sure to come back for our next post, where Josh will kick off a new chapter of our blog focused on compliance concerns related to the heart of your business – portfolio management and trading.

PerformanceIn our last post, Craig laid out the process of advertising a performance track record. That’s great, if you have a track record. What about a newly operational robo-adviser with no performance history? Your firm likely has spent considerable resources building and developing an investment strategy and corresponding algorithm. But without a client base, you can’t build a performance track record, and without a performance track record, it’s difficult to build a client base. Luckily, an option is available to advertise the hypothetical or “back-tested” performance of your strategy.

As a reminder, Rule 206(4)-1 (the “Advertising Rule”) generally prohibits misleading disclosure in advertising materials. The scope of this rule is broad and includes any disclosures made on your firm’s website. While the use of back-tested performance is not an automatic violation of the general prohibition, it certainly raises significant complications and the potential for scrutiny from regulators.

The SEC strongly disfavors the use of hypothetical performance. In fact, the SEC has sanctioned numerous advisers over the years for advertising misleading back-tested performance.   In those cases, the agency primarily focused on the lack of disclosure provided alongside the hypothetical performance. Before including any hypothetical performance in an advertisement, your firm must address a number of issues, including the fact that:

  • Hypothetical performance does not involve actual market conditions, especially real-world market risk;
  • Hypothetical performance inherently has the benefit of hindsight, thus making it difficult to determine what factors would have affected a manager’s decision-making process; and
  • The data shown in a particular set of hypothetical performance results may involve assumptions not indicative of the investment strategy displayed.

The SEC has not provided any guidance that specifically endorses the use of hypothetical performance. However, the SEC staff has repeatedly emphasized that the inclusion of abundant disclosure is the key to adverting hypothetical performance without misleading potential clients. Some of the best practices for advertising hypothetical performance include:

  • Clearly labeling all applicable performance as hypothetical and indicating that such performance was not subject to actual market conditions (note that disclaimers in small type are not sufficient to dispel otherwise misleading advertising);
  • Do not mix hypothetical and actual results in the same display;
  • Disclose all assumptions relied upon in creating the hypothetical performance;
  • Do not refer to hypothetical results as “past performance” as doing so may imply to the reader that such performance is actual in nature;
  • Maintain all records related to the production of the hypothetical performance displayed in the advertising; and
  • Develop written procedures related to the production and review of any hypothetical performance.

While all of these best practices are important, perhaps the most important is the development of a strong set of policies and procedures related to advertising of hypothetical performance. Thorough review of advertising is fundamental, for whether a particular advertisement, performance based or not, is considered misleading is a factual determination. Moreover, the inclusion of hypothetical performance in an advertisement always carries the potential to attract regulator scrutiny. Developing a robust compliance program to review all hypothetical performance advertising can alleviate these concerns and allow your firm to focus on growing its client base.

We hope that you’ve found our series on advertising useful. Check back next time, when we’ll shift our focus and Craig will discuss the new Form ADV Part 3. Thanks for reading!

Let’s say that five years ago, you developed an investment strategy and built an algorithm to execute it. Since then, your robo-adviser has managed several client accounts using that algorithm. Much to your delight, the strategy weathered the ups and downs of the market and to date, has produced very favorable returns. Now, you want to share that track record with the world, or at least post it on your website, in order to attract new clients.

Before you do that, however, there are some things you need to know. First, remember how Josh discussed the “catch all” restriction of the advertising rule, which generally prohibits misleading disclosure? Well, one of the most common violations of that restriction can occur when an adviser advertises its track record without knowing how to do so properly. In fact, at one point, the SEC was so concerned that investors could draw inappropriate inferences from past performance information (like inferences about future results) that the agency prohibited the practice completely.

However, in 1986, the SEC backed away from that stance in a no-action letter issued to Clover Capital Management, Inc. In Clover, the SEC took the position that past performance could be included in advertising provided it disclosed all material facts necessary to avoid such inferences. For example, advertising including past performance must, among other things:

• Disclose the effect of material market or economic conditions on the results shown
• Show performance results net of advisory fees, commissions, and other expenses
• Disclose whether the results reflect reinvestment of dividends
• Include material facts relevant to any comparison of the results to an index

The SEC emphasized in Clover that whether an advertisement was misleading was a fact-based determination based on form and content, use, potential inferences arising from the advertisement’s total context, and the sophistication of the target audience. The SEC also highlighted that merely including the disclosure described in the letter would not guarantee that any particular advertisement would be acceptable.

So, if you’re thinking about touting your track record in an advertisement, here’s the good news – you can do it! But take the time to make sure the advertisement’s content and design, as well as the included disclosure, meet the SEC’s expectations. And, if you’re unsure, don’t be afraid to get a second opinion from counsel or other compliance professional.

Now, let’s say you don’t have a track record of managing money, but instead, you’ve created back-tested hypothetical performance that has indicated your algorithm would have fared well in the past. Can you include such hypothetical performance in advertising? For the answer to that question, we encourage you to return for our next post, in which Josh will discuss that very topic.

In the meantime, we also encourage you to check out the SEC’s exam priorities for 2020, where you’ll find that the SEC announced their continued focus on robo-advisers and in particular, marketing practices like the ones we’re discussing in this blog.

False TrueYou’re ready to advertise. You know the basics, you can handle the complexities of including past specific recommendations, and even understand how to appropriately include client testimonials. Let the advertising campaign commence! Well, not so fast. Even if you’ve successfully managed all of the potential pitfalls we’ve discussed so far, you must still contend with the “catch all” restriction, which prohibits any false or misleading disclosure in a robo-adviser’s advertising.

As a reminder, the primary rule governing robo-adviser advertising is Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advertising Rule”). The Advertising Rule broadly prohibits any adviser advertising that includes “any untrue statement of a material fact, or which is otherwise false or misleading”. On its face, this prohibition appears relatively straightforward. However, there is a bit to unpack here.

First, the Advertising Rule broadly defines an “advertisement” to include any communication addressed to more than one person that offers any of the following services:

  1. Any analysis, report, or publication regarding securities;
  2. Any graph, chart, formula or other device for making securities decisions; or
  3. Any other investment advisory services with regard to securities.

Second, the question of whether an advertisement is false or misleading will depend on the particular facts and circumstances surrounding its use, including:

  1. The form and the content of the advertisement;
  2. The implications or inferences arising out of the advertisement in its total context; and
  3. The sophistication of the prospective client.

As you can see, the prohibition against false or misleading advertising is extensive, and regulators often take a broad interpretation of the prohibition when reviewing an adviser’s advertising and accompanying disclosure. For your robo-adviser firm, this prohibition may be most relevant to the disclosure contained on your website or client facing portal such as your app or other intake medium.

We recommend that, as a matter of best practice, you conduct a regular review of any client facing advertising materials, including your website, to screen for claims that cannot be substantiated. Some common examples of these may be statements describing your investment strategy as “one-of-a-kind”,  or claims that your services will help clients grow assets. While these examples may seem obvious, it is important to again note that whether something is false or misleading is a determination that needs to be made on a case-by-case basis. A good metric for determining whether a statement is appropriate is to look at it from the point of view of a retail investor.  Statements on your website, particularly regarding strategy or performance, may seem fine to you but may be viewed very differently by a regulator. In our next post, Craig will continue our advertising discussion by providing some guidance on including information on your strategy’s track record in your marketing campaign. Thanks for reading!

For businesses of all types, posting positive reviews can be one of the most powerful means of attracting new customers.  Before individuals hire a company for a job, they want to know that others before them have had a good experience, and companies that have failed to get a sufficient number of good reviews are often screened out.

But before you set up a page to post good reviews or invite your current clients to do the same, recall from our previous post that unlike other businesses, robo-advisers are subject to Advisers Act Rule 206(4)-1 (the “Advertising Rule”), which generally prohibits the use of testimonials in advertising.

So what do we mean by “testimonials”?  Basically, we’re talking about statements by former or present clients that endorse the adviser or refer to a favorable investment experience with the adviser.  In addition to statements, “likes” and other means of endorsing a firm on social media can be considered testimonials. From the SEC’s point of view, testimonials are problematic because they may create an inference that all the adviser’s clients typically experience the same favorable results as the individual providing the testimonial.

While the letter of the Advertising Rule prohibits the use of testimonials, the SEC does not prohibit the adviser from using all communications that include favorable comments and allows the use of testimonials in some circumstances.  For example, the SEC has stated through no-action letters and formal guidance that it would permit:

  • An adviser’s publication of an article by an unbiased third party regarding the adviser’s investment performance, unless it includes a statement of a client’s experience with or endorsement of the adviser;
  • An adviser’s use of a rating by an independent third party, derived from client satisfaction surveys, provided certain conditions are met;
  • The publishing of partial client lists, as long as the adviser did not use performance data to determine the makeup of the list and certain other disclosure is provided;
  • Publication of all the testimonials about an adviser from an independent social media site on the adviser’s own website (a site is generally “independent” if the adviser cannot influence its content);
  • The placement of an advertisement for an adviser on a third-party site, as long as (i) the site is independent, (ii) the advertisement is separated from any public comment section and (iii) advertising revenue does not influence which public commentary is included or excluded;
  • An advertisement that includes a reference to a social media site (such as “see us on Facebook or LinkedIn”), without including specific testimonials from the site;
  • Listing of “friends” or “contacts”, as long as they’re not identified as clients and the adviser does not imply that they have received favorable results from the adviser; or
  • A third-party created “fan” or “community” site where the public may comment, but advisers should be careful when driving user traffic to such sites or publishing content from such sites, especially when the site is not independent of the adviser.

As you can see, determining whether a particular statement will be prohibited under the Advertising Rule can be complicated, so we encourage you to seek counsel if you’re considering the use of testimonials in your marketing strategy.  And on top of all that, as Josh mentioned last time, the SEC has proposed updates to the Advertising Rule, which, if adopted, would specifically allow testimonials under certain circumstances.  We are continuing to monitor these changes and will be sure to update you when they are final.  We thank you for reading and encourage you to return for our next post, in which Josh will discuss the Advertising Rule’s general prohibition against advertising that contains false or misleading statements.