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Compliance in the Age of Robo Investment Advice

In late August, four registered financial service firms settled SEC charges of misleading retail investors about the efficacy of their quantitative models. The SEC alleged that the firms promoted, offered, sold and managed mutual funds, variable life insurance products and annuity investment portfolios that used a faulty “proprietary quant model.” Without admitting or denying the charges, the firms agreed to refund $97 million to retail investors.

Questions about the proper use and regulation of algorithmic models in advisory services are raised with more urgency these days, most recently at the SIFMA New York Regional conference held in early November. In this article, Bates Research takes a closer look at this case and existing SEC compliance guidance on robo-advisory services as well as some of the enforcement concerns in this rapidly expanding marketplace.


In the case referred to above, the SEC found a host of disclosure issues. These included failures to disclose: (i) that the model was developed by an inexperienced junior analyst; (ii) that the day-to-day manager of the products was not (as communicated) an experienced asset manager; (iii) certain errors when they were discovered, (iv) the decision to discontinue use of the model; (v) errors in model methodology and accuracy; and (vi) known risks or to verify that the models worked as intended. In separate proceedings, the SEC found that the Global Chief Investment Officer and the former Director of New Initiatives were personally responsible for the compliance failings related to the development and use of models.

Notably, according to the Order, the “[r]espondents cooperated with the Commission’s investigation throughout its entirety, and their efforts assisted the Commission staff in its collection of evidence…” That cooperation took the form of voluntarily retaining a compliance consultant “to conduct a comprehensive, independent review related to their respective compliance policies and procedures, internal controls and related practices, with an emphasis on product development, use of investment models and algorithms, due diligence, disclosures in prospectuses and marketing materials, and enterprise compliance functions and the operation of those controls within and among the Respondents.” In addition, the SEC recognized that “[r]espondents began revising and improving their compliance and due diligence policies and procedures related to the use of models and the creation and use of marketing communications, product development, and investment management.”


The case raises many of the concerns the SEC expressed in an Investor Bulletin and a Guidance Update on robo-advisers in February 2017. In the Bulletin, the SEC Office of Investor Education and Advocacy (“OIEA”) acknowledged that “automated digital investment advisory programs” allow individual investors to create and manage their investment accounts for potentially less money in fees and account minimums, than through a traditional investment adviser. OIEA described a simple process, whereby an investor would complete a questionnaire on financial goals, investment horizon, income, assets, and risk tolerance. Based on such information, a robo-adviser would create and manage an investment portfolio. All of it would be accessible to the investor from a web-portal or mobile device. OIEA’s general advice to investors was to do research, understand the products contained in a robo-advised portfolio, consider how much human interaction is preferred, ask good questions and identify personal investment goals.

OIEA also advised investors to remember that firms providing robo-advisory services have to be registered as investment advisers with either the SEC or one or more state securities authorities. It is this point that underscores the compliance obligations for such firms contained in the industry-issued guidance.

The SEC industry guidance focused on (i) the substance and presentation of disclosures to clients about the investment services offered; (ii) a firm’s obligation to gather client information to support a robo-adviser’s duty to provide “suitable advice;” and (iii) “the adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.” This last area includes the adoption, implementation, and annual review of written policies and procedures “that take into consideration the nature of the firm’s operations and the risk exposures created by such operations;” the designation of a competent and knowledgeable chief compliance officer to be responsible; and additional written policies and procedures that address testing of the algorithmic code, monitoring, oversight of third parties, cybersecurity and the protection of client accounts.

Panelists at the 2018 SIFMA New York Regional Conference deliberated on the compliance challenges presented by the current guidance. One panelist expects regulators to further test the industry on ensuring that the algorithms used are working the way they are supposed to. Others raised practical questions about how compliance officers should best supervise robo-products. Responses ranged from reliance on greater use of IT testing teams, to ensuring that a firm’s legal, compliance and business teams are in sync with each other, particularly before the launch of any new algorithmic trading products. All the while, these panelists were concerned with the kinds of disclosures that adequately communicate—in plain English—the risks and the benefits to the investor.


Though it has been only a short while since the SEC issued its guidance, investments in robo-offerings have grown and the application and use of algorithmic programming expanded. A new report by Charles Schwab cites data that predicts “digital advice users will increase from roughly 2 million to 17 million by 2021.” The report asserts that the use of robo-advisers will have a bigger impact on financial services in the future (say 45 percent of Americans surveyed) than cryptocurrency (29 percent), artificial intelligence (28 percent), or big data (21 percent). Those are the kinds of findings that make regulators take notice.

Perhaps the most striking finding from the survey is that seventy-one percent of people say they want a robo-adviser but also access to human advice, and almost half of those surveyed who are not using a robo-adviser today said they would be more likely to use one if it has quick and easy access to human support. This finding cuts across generational investors. According to the survey results, baby boomers would be more likely to use a robo-adviser if they feel like their information in the service is secure, if the fees are lower than a traditional financial adviser, if the mobile app is easy to use, and if the service has a low investment minimum.

Bates Director of Institutional and Complex Litigation Alex Russell, a specialist in algorithmic trading and testing validation, observed, “If these findings pan out, regulators will ramp up their scrutiny of algorithmic trading platforms.”


The rapid growth and investment in robo-products and advisory services is garnering increasing attention. The recent SEC case puts compliance officers on notice that enforcement regulators are watching.

Bates will continue to follow these market developments. For more information on how Bates Group might help, contact Alex Russell, Director of Institutional and Complex Litigation at 971-250-4353. Mr. Russell provides consulting services related to quantitative financial modeling, trading systems, and derivative strategies and products within both the retail and institutional securities litigation practice areas.

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