Solicitation ComplianceThe saying goes, referrals are the lifeblood of any business. Indeed, all business owners, robo-advisory firms included, strive to provide a level of value and service to their customers such that those customers in turn become advocates and solicitors of the business. Unfortunately, word of mouth referrals alone are not usually enough. Your firm may choose to engage third parties to solicit new clients. Traditionally, these third parties include the likes of broker-dealers, banks, accountants, and attorneys. While these third-party arrangements are important for any investment adviser, for robo-advisory firms, these arrangements may carry added significance. For example, your firm may engage in a cash referral program whereby existing clients are encouraged to refer new potential clients in exchange for waiving advisory fees, or simply depositing cash into the client’s account. Another example might involve an arrangement to have a link to your firm’s website appear on a third-party website. While these arrangements may be sound from a business standpoint, from a compliance perspective they can be problematic.

Unlike a traditional brick and mortar advisory firm, your firm likely doesn’t have direct client engagement. Moreover, your firm’s business model may rely on a higher volume of clients with lower individual account sizes.  Therefore, having a dedicated third-party solicitation network may be key to a healthy client pipeline.  However, before you rush to set up a referral program, you should consider what compliance steps are necessary.

If any of these third-party arrangements involve your firm paying for client solicitation, your firm must comply with both state and federal requirements. Individual state requirements related to solicitation agreements focus on licensing requirements. We previously covered this topic in our Individual Licensing Requirements Post, and highly encourage you to review it.

Federally, Rule 206(4)-3 (the “Solicitation Rule”) under the Investment Advisers Act of 1940 outlines specific disclosure and delivery requirements with respect to solicitation. Under the Solicitation Rule, an advisory firm can only pay a referral fee to a third party pursuant to a written agreement with that party. The agreement must describe the specific activities to be undertaken by the third party and the compensation to be received for those activities. The Solicitation Rule also requires that the third party, at the time of solicitation, provide to the potential client a copy of the adviser’s brochure along with a separate document that discloses the details of the solicitation arrangement. This separate disclosure document must be signed by the potential client and returned to the third party, and ultimately delivered to the adviser before the prospect can become a client. Your firm also has a duty under the Solicitation Rule to make a bona fide effort to ensure that the third-party solicitor has complied with these requirements.

While this process may seem onerous, you may find that the potential benefits of third-party solicitation far outweigh the compliance burdens.  As always, our recommendation is to involve a compliance professional early in the process.

Thank you for your continued interest in the blog! So far, we have received very positive feedback and hope that you continue to find our posts useful. We welcome any comments or questions you might have. Check back soon, as Craig’s next piece will cover advertising.

If you’re a robo-adviser, chances are you want to create a fully “digital” experience for clients that doesn’t involve sending paper documents. For example, you may want to email clients or communicate with them directly through your firm’s online platform. If you’re going to ditch the paper, the SEC expects you to follow its guidance on the use of electronic media before doing so.

That guidance is found in a series of SEC releases published in 1995, 1996 and 2000. The 1996 release, in particular, discusses how advisers may use electronic means to meet their legal obligations to deliver information to clients, such as Form ADV Part 2A (the firm brochure). In short, the SEC expects advisers to meet three requirements: notice, access, and informed client consent. Here’s what they mean by that.

Notice. Firms should consider the extent to which the proposed means of electronic communication provides timely and adequate notice to clients that information is available. The SEC reasoned that because delivery of paper documents puts the recipient on notice that new information is available, the chosen means of electronic communication should do the same. So, for example, posting a document on a website would not, by itself, be sufficient to meet the notice requirement. By contrast, it would be sufficient to (i) email the document directly to clients or (ii) post the document and send clients an email notifying them that the document is available and providing a URL for accessing the document.

Access. The use of a particular medium should not be so burdensome that intended recipients cannot effectively access the information provided. For example, a URL provided in an email notice of information availability should directly link users to the intended document. It should not link users to a generic webpage where users must continue to search to find the document. In addition, a client’s access to information delivered electronically should be similar to their experience with documents delivered in paper form. This means that they should be able to retain the information delivered (like the ability to print or download) or otherwise have ongoing access to the information.

Informed Consent. Before you send your first e-communication, be sure to get your client’s “informed” consent to electronic delivery. Generally, consent is informed when it is obtained after a client is told that:

  • the document to be provided will be available through a specific electronic medium and that medium is described;
  • there may be costs associated with the delivery;
  • the duration and scope of the consent (i.e. whether the scope is indefinite and whether the consent applies to more than one document); and
  • the client has the right to revoke consent at any time and receive all covered documents in paper format.

For robo-adviser firms who want to communicate electronically with clients, we recommend, as a best practice, obtaining the client’s informed consent as part of the onboarding process. For example, you may choose to have clients provide their consent in a pop-up window that appears before or after clients execute your advisory contract. And as you’ll recall from a previous post, obtaining the consent separately is preferable to burying the consent in a contract.

So, do advisers have to get informed consent before sending electronic communications? Technically, no. The SEC did provide an alternative – advisers need not get a client’s consent if they can obtain evidence that a client actually received the information, for example, by electronic mail return-receipt or confirmation of accessing, downloading, or printing. But this alternative has a downside that usually makes informed consent the better option. If advisers seek to rely on this method, they must revert to paper delivery for any client for which they cannot document receipt.

Thanks for reading! We hope you’ll come back for our next post by Josh Hinderliter, who will offer guidance for using paid solicitors to help you attract clients.

Early Stage DevelopmentSo, you’ve decided to launch a robo-advisory firm? Understandably, your first considerations are likely tied to the functionality of your product. Perhaps the final testing of your algorithm is complete, and your attention has turned to how clients will use your product. What will your client interface look like? How will client information be collected? And most important, how will the product be marketed and sold to potential clients? All these considerations, and many more, speak to the entrepreneurial nature of the business. And while obviously essential to the viability of your enterprise, these questions leave out a critical analysis; namely what is possible under the law? Given the highly regulated nature of the investment advisory industry, it is critical that business decisions be made with legal compliance in mind. We recommended, as a best practice, to involve a legal professional in your initial build-out process as soon as possible. Let’s explore a few examples of how the early involvement of a legal professional could save your firm time and resources.

Rule 204-2 under the Investment Advisers Act (the “Act”) sets out a multitude of books and records retention requirements for advisory firms. The Rule’s requirements cover financial records, client communications, and compliance policies, among many others. It is easy to imagine a firm just starting its business life-cycle not being aware of all of its record retention obligations, not having built procedures to capture and maintain the required records, or simply having something fall through the cracks as other concerns take priority.

It’s not just information coming into firms that poses early legal compliance concerns, but also the client facing information that a firm itself is producing. In particular, a firm should be conscious of its sales and marketing materials. Rule 206(4)-1 under the Act, commonly referred to as the “Advertising Rule”, defines client communications broadly, and implements strict prohibitions against communications that could be perceived to be false or misleading. As with the retention of records, a firm too eager to enter the marketplace without the proper compliance policies and procedures in place to control the content of marketing materials runs the risk of early and/or repeated violations, or even worse, the implementation of a compliance program with notable gaps. In either case, it’s clear that a firm’s investment in its compliance infrastructure early will pay dividends in the long run.

While we chose to highlight just two examples of potential early compliance concerns facing firms in this post, there are clearly many more than we have space to cover. Whether your firm is in its early stage of operations, or already up and running, we strongly recommend that you involve a compliance or legal professional in your business decision making process. Don’t let a regulator be the one to let you know about deficiencies in your compliance program.

We hope that you continue to find our blog helpful, and we appreciate all the feedback that we have received so far! If you have questions about this topic or any of the others we’ve touched on, please feel free to reach out. Craig will be back soon to discuss guidelines for communicating electronically with clients.

Even though your firm may be registered with the SEC, a state can impose licensing requirements on individuals associated with your firm who (i) have a “place of business” within the state and (ii) fall within the state’s definition of “investment adviser representative” (or “IA Rep”). These requirements should be met before any individuals begin to engage in activities that require licensing. We’ll talk about those activities shortly.

First, let’s tackle what a “place of business” is. It’s actually pretty easy. States normally interpret the term to mean a physical location (like an office) where the IA Rep regularly provides advisory services or otherwise solicits or communicates with clients.

By contrast, determining who falls within a state’s definition of IA Rep is more complicated, and states generally take one of two approaches to do this.

Many states simply adopt the definition of “investment adviser representative” found in Advisers Act Rule 203A-3(a), which provides that an individual associated with an investment adviser will be an IA Rep if:

  • he or she is a “supervised person,” meaning a partner, officer, director, employee, or other individual who provides advice and is subject to the adviser’s supervision and control;
  • at least six of his or her clients are natural persons (excluding certain wealthy clients);
  • at least 10 percent of his or her clients are natural persons (again, excluding certain wealthy clients); and
  • he or she regularly solicits, meets with, or otherwise communicates with clients.

However, a number of states do not use the federal definition, choosing instead to use their own. In these states, even though the definition will vary from state to state, an individual typically will be an IA Rep if he or she is a partner, officer, director, employee or other individual associated with an investment adviser who:

  • renders investment advice or manages portfolios;
  • solicits, offers or negotiates for the sale of investment advisory services; or
  • supervises employees who do the above activities.

If you’re dealing with a state that uses the federal definition, then it’s unlikely that, as a robo-adviser, you’ll have any personnel who will qualify as an IA Rep. That’s because as a robo-adviser providing automated investment advice, you probably don’t have any individuals who regularly meet with or communicate with clients (unless you employ solicitors).

If you’re dealing with a state that does not use the federal definition, the analysis is a bit harder. As you’ll recall from our last post, determining who is rendering advice can be more difficult for a robo-adviser than for a traditional adviser because in the case of traditional advisers, advice is communicated directly from advisory personnel to the client. By contrast, robo-advisers utilize automated algorithms (not people) to formulate investment advice for clients and select investments for their portfolios. As a result, similar to picking individuals for inclusion in the brochure supplement, robo-adviser firms will generally have to license as IA Reps those individuals who (i) employ or contract with individuals who design, test, and maintain algorithms that create the advice provided to clients, (ii) solicit advisory business for the firm, or (iii) supervise individuals that do (i) or (ii).

Once you’ve determined who qualifies as an IA Rep, the licensing process tends to be similar among all states. For each person who must be licensed, a state will generally require that the firm submit electronically through IARD:

  • a completed Form U4, which provides information about the individual’s background;
  • evidence that the individual has passed the relevant securities exam (usually a Series 65 or a combination of the Series 7 and 66), unless the individual has received certain industry certifications, such as a certified financial planner (CFP) or chartered financial analyst (CFA); and
  • the filing fee (both initially and on an annual basis).

Once the forms and fee are submitted, the processing time tends to be relatively short, often just a few days. Once a license is effective, the individual can start to design and manage algorithms, solicit clients, or conduct any other activities that required licensing in the first place.

Thanks for taking the time to check out our blog today. In our next post, Josh will discuss how involving your compliance team in the initial build-out of your robo-advisory firm can save you time and headaches in the long run. We hope you’ll check it out!

brochure supplementsNo matter what form of investment advisory firm you have, completing Form ADV is a necessity. As a reminder, Form ADV is the form used by investment advisers to register with both the SEC and state securities regulators (see our June 12, 2019 post for more detail). Today’s post deals with the particularities of one component of Form ADV, Part 2B or the brochure supplement, and its unique application to robo-advisers.

First, we’ll briefly discuss the requirements of the brochure supplement and how it is handled in a traditional investment firm. Then, we’ll discuss how the brochure supplement applies to robo-adviser firms, given the unique nature by which a robo-adviser firm provides investment advice.

As we discussed in our previous post, Form ADV includes two parts, Parts 1 and 2. Part 2 of Form ADV is further sub-divided into two separate parts:  Part 2A, known as the brochure, and as noted, Part 2B, or the brochure supplement. Unlike Part 2A, which must be filed with the relevant regulator (e.g., the SEC) and is publicly available, the brochure supplement is not required to be filed by SEC registrants. A brochure supplement must be provided to each client of an investment adviser, except for (i) clients not required to receive a brochure (or wrap fee program brochure), like investment company clients; (ii) clients who only receive impersonal investment advice, even if they receive a brochure; and (iii) clients who are executive officers of the firm and employees who have been performing duties for the firm for at least 12 months.

In a brochure supplement, an investment adviser must provide information for each individual that it supervises who; (i) formulates investment advice for the client and has direct client contact; or (ii) makes discretionary investment decisions for the client’s assets, even if the supervised individual has no direct client contact. A brochure supplement requires that an individual disclose information related to educational and business background, any disciplinary history, other business activities, any basis for additional compensation, and information disclosing how the individual is supervised at the firm. In a traditional investment adviser/client relationship, where investment advice is being communicated directly from investment adviser personnel to the client, the decision as to who to include in a brochure supplement is typically straightforward. However, in the case of your robo-advisory firm, that decision is murkier.

Unfortunately the SEC has yet to provide guidance in this context. This places the onus on robo-advisory firms to determine which of its employees should be included on a brochure supplement. Given that robo-advisers utilize automated algorithms (not people) to formulate investment advice for clients and select investments their portfolios, neither prong of the brochure supplement requirement seems to apply. However, robo-adviser firms do employ or contract with individuals who design, test, and maintain algorithms that create the advice provided to clients. At present, industry best practice is for firms to create brochure supplements for such individuals.  For a small robo-advisory firm, this is likely a manageable task because the number of individuals is limited. For larger firms, with teams devoted to algorithm maintenance, the task of brochure supplement compliance becomes much larger. While the brochure supplement stipulates that if investment advice is provided by a team comprised of more than five supervised individuals, brochure supplements need only be provided for the five supervised individuals with the most significant responsibility for the day-to-day advice provided to the client, the tasks of making that determination may still be a challenge. If you find yourself with questions regarding the brochure supplement, the best course of action is to consult with a legal or compliance professional.

We hope you’re enjoying the blog so far! Please check back soon to read my colleague, Craig Foster’s next piece covering investment adviser representative licensing.

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.