Before your robo-adviser can accept its first client, it must be registered. Like other investment advisers, robo-advisers have two possible initial registration pathways. They either register with the SEC or they register with the state(s) where they maintain a place of business. Due to the additional complexity associated with state registration, most robo-advisers seek to qualify for SEC registration from the start. Here’s how you can do the same.

First, let’s talk about how the two processes work.

Whether a firm registers with the SEC or at the state level, it must complete and file the principal registration document, Form ADV. Form ADV is divided into 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).

But that’s where the similarities end.

If the firm is seeking SEC registration, once the agency reviews and approves the firm’s Form ADV, it will declare the firm’s registration effective within approximately 45 days.

By contrast, many states use the initial ADV filing as only the first step in the registration process. After a state reviews and comments on an adviser’s initial Form ADV filing, it will often ask for and review other operational documents, such as a compliance manual or client agreement (as discussed in May). A state may even ask an adviser to submit financial statements and require an individual license (we’ll talk more about individual licenses later). Only after all requested documents have been reviewed and approved will a state declare a registration effective. And this process usually takes significantly more than 45 days.

These differences in registration routes tend to make advisers want to register with the SEC. But you have to qualify first. So let’s discuss that now.

To be eligible to register with the SEC, a robo-adviser must gather at least $100 million in assets under management (“AUM”) within 120 days of registration or commit to operate as an “internet investment adviser” under Advisers Act Rule 203A-2(e). Because the former is a big hurdle, firms often choose the latter.

To qualify as an “internet investment adviser,” a company must provide its investment advice exclusively through an online algorithmic-based program that clients interact with directly. Otherwise stated, you can’t any provide advice like traditional advisers do, using human interaction, except for a de minimis number of clients.  Because this is the typical way robo-advisers deliver their services, qualifying as an internet investment adviser doesn’t present a problem for many firms. If you decide to register with the SEC based on your status as an internet investment adviser, be sure to keep written records that demonstrate that you have operated in a way consistent with that status, as required by the rule. In addition, you should adopt policies and procedures designed to ensure your firm continues to operate as an internet investment adviser.

If, however, you won’t have the required AUM in time or decide not to operate as an internet investment adviser (because, for example, you also use human interaction to deliver investment advice), then you’ll likely be required to initially register with the state(s) where you maintain a place of business. On this front, there’s good news and bad news. The bad news is that once registered and taking clients, you’ll have to register in additional states where you either add places of business or take on clients. The good news is that, as stated above, you can transition to SEC registration once you hit $100 million in AUM. Moreover, the SEC recognizes that being registered in too many states can be a compliance nightmare – you’re allowed to move to the SEC’s jurisdiction once you have to register with at least 15 states.

Thanks for reading! We hope you’ll come back for our next post from Josh Hinderliter, who will dive a little deeper on a specific part of Form ADV. In particular, Josh will discuss how robo-advisers should approach their obligation to prepare and deliver “brochure supplements,” which describe the backgrounds of certain advisory personnel.

All investment advisers must provide advice suitable for a particular client based on the client’s financial situation and investment objectives. Traditional investment advisers usually do this after getting to know their clients through conversations and other forms of direct communication.  Robo-advisers, by contrast, must accomplish this through other means.  Given this universal duty, it’s important for robo-adviser firms to not simply be aware of their fiduciary duty, but to contemplate how their client interaction differs from interactions a client may have with a traditional investment adviser, and determine how those differences effect the suitability of advice provided.

Unlike the traditional investment adviser/client relationship, the relationship that a robo-adviser develops with a client may be, and likely is, completely devoid of human interaction. The robo-adviser’s sole understanding of a client’s investment needs depends on the client providing enough information regarding personal history and investment preferences directly to the robo-advisory program. Regardless of what form a robo-adviser utilizes to capture client information, whether it be mobile application, online questionnaire, or some variation, a robo-adviser must be concerned from the outset that such information gathering is sufficient in its design and scope to accurately capture a client’s needs and investment preferences.

When designing its client information intake process, a robo-adviser should consider several best practices to ensure that the information it receives from a client is sufficient to meet its obligation as a fiduciary, such as:

  • Complete Information – Robo-adviser questionnaires should contain ample opportunities for a client to express his or her needs and wants. One of the primary selling points of a robo-adviser is convenience. However, such convenience cannot be delivered to a client at the cost of the robo-adviser’s fiduciary duty. For example, if it is possible for two clients with different investment goals to answer a simple intake form in a similar or identical fashion, then it is likely that the intake form is not sufficient for the robo-adviser to provide suitable advice.
  • Clarity – Another potential deficiency in a robo-adviser client intake form is a lack of clarity. In a traditional adviser/client relationship, a client has the ability to ask clarifying questions of his or her adviser when discussing investment needs. Robo-advisers should consider adding clarifying tools to their intake forms, such as examples discussing certain investment strategies, or pop-up-boxes, which a client could click on if he or she wanted additional information.
  • Inconsistencies – Client intake questionnaires should also be reviewed to ensure that all inconsistencies are removed. A client may not be able to readily determine if two answers that he or she provided are inconsistent. A robo-adviser could alleviate such a concern by incorporating design tools to alert a client when a provided answer is inconsistent with a pervious response.
  • Adequate Disclosure – In conjunction with its intake process, a robo-adviser should adequately disclose to a client the scope of its service. For example, if a particular robo-adviser only offers ESG investments that may affect how a client responds to the intake questionnaire.

As more investors turn to the convenience of robo-advisers, the greater the burden on a robo-adviser to provide suitable advice to each client. Unlike a traditional adviser, a robo-adviser is not able to easily assess the intricacies of a particular client through human interaction. It is therefore incumbent upon a robo-adviser to appropriately design its client intake to obtain all necessary information to fulfill its fiduciary duty while still maintain the convenience of its platform.

We’ll be back soon with our next post covering the firm registration process.

Thanks for taking the time to check out our first of many blog posts designed to help robo-advisers operate more efficiently, reduce business risk, and comply with applicable law.

To start, when we say “robo-advisers” or “you,” we mean registered investment advisers that use technology to provide discretionary asset management services to their clients through online algorithmic-based programs. Robo-adviser clients enter personal information and other data into an interactive, digital platform like a website or mobile app. And based on that information, the robo-adviser generates a portfolio for the client and subsequently manages the client’s account.

Here’s why we started this blog. The way that robo-advisers deliver their services is both relatively new and unique, but the laws and rules that govern these firms are old and slow to adapt to changing technology. That means robo-advisers face many compliance challenges that traditional advisers, for whom the laws and regulations were designed, do not.

We think we can help you overcome those challenges. Our goal for this blog is to offer solutions and guidance to you as you navigate all aspects of your operations. To begin, our first set of posts will discuss those tasks you need to tackle before you can take on a single client.

Which brings us to the topic at hand – the client agreement.

This document sets all the rules for how you will interact with your client and your client’s money. You want to be sure it has provisions that are tailored to your business, meet all legal requirements, set client expectations, and protect your interests. And all that should be done before you hang out your virtual shingle.

Just like any traditional adviser, when you and your counsel are designing your client agreement, you will want to be sure the contract has accurate fee provisions, gives you the necessary authority to manage the account and select brokers, requires the use of a custodian, has clients acknowledge receipt of necessary disclosures, limits your liability appropriately, and prohibits assignments without client consent.

However, consider again how you will deliver your services. Clients won’t be coming into your office and meeting with an adviser representative, and humans won’t be making the investment decisions. These crucial operational differences need to be built into your client agreement through provisions addressing issues such as:

  • Methods of communication – Many robo-advisers seek to provide a completely “digital” experience where clients receive all communications and regulatory disclosures electronically. Be sure your agreement clearly explains how you will communicate with clients (i.e., through email or an online platform), so they know how to get in touch with you. Note that before you may communicate electronically with clients, the SEC requires that clients provide their “informed consent” so that clients know the risks of electronic transmissions. And it’s a good practice to get that consent separately, rather than bury it in the advisory contract.
  • Changes to the agreement – You will want to retain flexibility to modify certain provisions of the agreement unilaterally when you need to. Ensure your advisory contract gives you that flexibility and that clients understand how changes to the agreement will be communicated.
  • Incorporate the client questionnaire responses – You will undoubtedly ask your client a number of questions about risk tolerance and investment objectives so that you can build a suitable portfolio. Consider incorporating those responses into the client agreement and ensure the client attests that the responses are accurate.
  • Funding accounts – Be sure your agreement details the process by which advisory accounts may be funded and places appropriate limitations on that process (such as restricting the types of funding accounts that may be used or allowing for processing delays).
  • Foreign jurisdictions –You don’t want to inadvertently trip up foreign law by taking on a client living outside the U.S. Ensure your contract and client onboarding process appropriately restrict service to persons living in the U.S.
  • Antimoney laundering representations – You likely won’t have a chance to vet your prospective client in person – consider adding client representations that will help you meet your obligation to know the source of client money.
  • Access interruptions – Because your services will be provided through the internet, your clients should be made aware that there will be times when your services might not be available due to maintenance, hardware or software malfunction, or internet service failure.
  • Electronic signatures – You will want clients to be able to sign your agreement electronically – be sure your agreement and platform accounts for that functionality.

Needless to say, the above list is not meant to be complete. Each firm is different, and your client contract needs to account for the relationship you want to build with your client. The essential point is that when you substitute algorithms and websites for human advisers and offices, a contract designed for traditional advisers is unlikely to suffice.

That’s all for today. We hope you’ll come back for our next post from Josh Hinderliter, who will discuss how robo-advisers address their duty to provide suitable advice to clients.