The Rise of Robo-Advisers

Posted in: Business Law

The following is a short description of robo-advisers and the issues they raise. As automation spreads, it affects not only cost and reliability but also the rules, established years ago. As always, beneficial innovations are not costless. Human nature does not change as quickly.

What Are Robo-Advisers?

A robo-adviser is a machine that seems to offers investment advice with respect to an investor’s financial assets, and orders the performance of its advice by securities trades of sales and acquisitions. The client investor determines his or her risk level and perhaps other aspects of the investor’s choices. The design is then established and executed by a machine. Thus, all investors who have the same risk aversion level, or perhaps share other features, embedded in the robo-adviser, are likely to have the same investment management design. However, a number of other aspects of the investment design may remain or become more personalized.

Arguably an investor benefits from a robo-adviser by (i) lower expenses, as compared to a human adviser, (ii) greater accuracy of directives, (iii) less flexibility and (iv) less power that must be otherwise vested in the adviser After all, the machine does not have human incentives. It cannot design and break the law. And if it breaks, it can be fixed!

Today, most robo-advisers are established and offered by brokers. Even though the brokers may offer only investments that are suitable to the clients and their needs, the rest and most of their functions are securities trading. This is the brokers’ area of expertise, and traditionally their main source of income. However, as noted below, recently robo-advisers are being developed and refined, leading to the use of the robo-adviser device by professional advisers.

Regulation of Brokers With Respect to Investment Advice

Currently, brokers are not regulated as advisers. The Advisers Act of 1940 excludes brokers from the Act’s regulation of an adviser provided the brokers are not paid for their investment advice. Brokers have enjoyed this exclusion since the passage of the Act, even though many investors have been loyally and trustingly following their advice and paid for the execution of the brokers’ suggested transactions.

However, brokers are self-regulated by FINRA, an organization, subject to the Securities and Exchange Commission’s supervision. FINRA has a long-term rule, requiring brokers to provide clients with suitable advice. Suitability is not synonymous with fiduciary duties. In contrast to brokers, advisers are fiduciaries, subject to two duties: a duty of care, which means that their advice must be well prepared and thought-through. It cannot come by flipping a coin. The second duty is the duty of loyalty. That means avoiding conflicting interests, with one exception. If conflict exists, the adviser-fiduciary is required to disclose the conflict to the clients and receive the clients’ consent.

Neither the duty of care nor the duty of loyalty is fully covered by the brokers’ duty of “suitability.” Brokers need not provide considered and well researched advice, so long as it is “suitable,” to the advisee’s circumstances rather than to the broker’s research efforts. Brokers may act in conflict of interest. In fact, when they advise potential investors, they usually desire to serve the party that would pay them for the transaction. The “advisee” may or may not be that party.

Thus, investors in a 401(k) program filed a suit against Morningstar, Inc. (Morningstar) and two subsidiaries of Prudential Financial Inc (Prudential). The investors claim that Prudential worked with Morningstar to design robo-adviser software GoalMaker to recommend the more expensive funds the plan is eligible to invest in, including some that share revenue with Prudential. The suit claims that the parties violated the Racketeer Influenced and Corrupt Organizations. Act. The case is pending. However, it demonstrates possible claims against robo-adviser designers that reach an undefined area beyond direct advice.

Reactions to Robo-Advisers by the SEC and State Regulators

The Commission published guidelines for robo-advisers. An interesting detailed article described the guidelines by noting the required “suitability” of robo-advisers. This word demonstrated the subjects of the guidelines—the brokers. The guidelines are as follows:

The Securities and Exchange Commission noted the recent proliferation of robo-advisers: “These programs allow individual investors to create and manage their investment accounts through a web portal or mobile application, sometimes with little or no interaction with a human being with the potential benefit of lower costs than traditional investment advisory programs.”

The Commission defined a robo-adviser as: “An automated digital investment advisory program. In most cases, the robo-adviser collects information regarding [the investors’] financial goals, investment horizon, income and other assets, and risk tolerance by asking [the investor] to complete an online questionnaire. Based on that information, it creates and manages an investment portfolio for [the investor]. Robo-advisers often seek to offer investment advice for lower costs and fees than traditional advisory programs, and in some cases require lower account minimums than traditional investment advisers. The services provided, approaches to investing, and features of robo-advisers vary widely.”

In addition the Commission noted the difference between robo-advisers and traditional investment advisory programs, and suggests that investors should do their own research to ensure that the program and investments are “a good match” for the investors’ needs and that they “understand the potential costs, risks, and benefits of using that particular robo-adviser.”

The Commission offered the following guidelines. First, “What Level of Interaction with a Person is Important to You?” The range of the choices is very varied and broad and some examples are described, as well as the distinction and similarities with traditional investment advice. The Commission offers sample questions as well including self-evaluation of the investor’s expertise. Another area of inquiry is “What Information is the Robo-Adviser Using to Create a Recommendation?” Therefore, the less detailed or less relevant information the investor gives, the less appropriate the robo-adviser’s service will be.

Another point relates to the use of the robo-adviser. “[F]or a specific financial goal (for example, retirement, buying a home, or investing for [the investor’s] education), or to meet [the investor’s] overall financial needs more broadly?” Then come the questions:

  1. “Does the robo-adviser’s recommendation take into account your purpose in using the robo-adviser?”
  2. “Does the robo-adviser’s recommendation take into account relevant personal financial information given your goal?”
    For example: “Does the robo-adviser ask for information about high interest credit card debt or student loans you may have?”
    “Does it take into account your bank and savings accounts?”
    “Does it take into account your real estate holdings, such as your home, or other investments such as retirement accounts?”
    “Does it take into account other assets that you have?”
  3. “What is the Robo-Adviser’s Approach to Investing?” After all, there are many approaches.
  4. “Does this robo-adviser use ETFs?” (including a short explanation of ETFs).

Then the Commission added a list of questions for the investor:

 (i) “Does the robo-adviser offer a limited range of investment products, such as only ETFs? Are the investment products utilized by the robo-adviser appropriate for your goals?”

(ii) “Does the robo-adviser only offer certain limited portfolios within those investment products? How many different portfolios could your money possibly be invested in? What portfolio does the robo-adviser recommend for you and why?”

(iii) “What type of accounts does the robo-adviser manage? For example, does the robo-adviser manage individual retirement accounts (IRAs)? Taxable accounts? 401(k) accounts or college savings plans?”

(iv) “How does the robo-adviser handle volatility? For example, does the robo-adviser have the ability to freeze sales (not let you sell your investments for cash for a certain period of time)?”

(v) “How often is your account rebalanced? Rebalancing can have tax implications, depending on the type of account. What would trigger a change in the asset allocation or investment categories of your portfolio?”

(vi) “What Fees and Costs Will the Robo-Adviser Charge?”

(vii) How is the robo-adviser compensated? Does the way it is compensated create any conflicts of interest with you, the investor? For example, is the robo-adviser paid to offer particular products or does it offer only products with which it is affiliated (e.g., mutual funds sponsored by the robo-adviser or its affiliates)?” . . . Are there penalties or fees if you want to withdraw your investment, or transfer or close your account? Liquidating an account may have tax implications for you as well. Does the amount you are charged depend on how much money you invest? Can the costs and fees change over time?”

(viii) Does the robo-adviser pay a referral or marketing fee, or other incentives for finding new clients? Robo-advisers may use different marketing techniques, such as paying money to others or providing discounted fees for making client referrals. You should understand if a robo-adviser has that kind of feature, even if you are not paying a fee yourself.”

Last are the following list of questions and sources of information and a reference to the Form ADV, which robo-advisers, like traditional human advisers, must file with the Commission. Investors are advised to regularly check the form and the robo-adviser’s website for updated information. Sources of additional information: are (1) an investor alert on automated investment tools, (2) a link to an investor complaint form and an investor question form, a form to report enforcement tips and complaints, (3) a link to the Commission’s website for individual investors, (4) links to receive Investor Alerts and Bulletins from the Commission Office of Investor Education and Advocacy (“OIEA”), (5) the OIEA’s Twitter feed, and its Facebook page.

In contrast, the Massachusetts securities regulator reacted to the rise of Robo-advisers by stating, in no uncertain terms, that robo-advisers are fiduciaries, as are all advisers.

It is difficult to understand the issue of robo-advisers without noting the background of the brokers’ recent issue concerning their sales talk and its classification as possible advisory services. Starting with the Department of Labor’s rule which was negotiated with representatives of brokers for more than five years, the pressure to impose fiduciary duties on brokers has been persistent, if not growing.

The robo-advisers seem to represent the brokers’ attempt to avoid personal advice (sales talk) to clients but give indirect advice and input on the clients’ investment decisions. When the client conveys the investment decision to the robot, the broker is insulated from the burdens and legal liabilities of giving advice. Yet the client is still linked to, if not locked into, the broker’s organization, and the transaction results in trading.

In conclusion, the Securities and Exchange Commission’s guide demonstrates the shift of the required expertise and investigation from the advisers to the investors. No longer can the investor be asked factual questions that might lead to the determination of the level of risk appropriate for the investor. The guidelines ask the investors to give the expert conclusions to the factual question. These are usually questions that the adviser explains. What is a risk level is not merely an emotional or intellectual decision. It is an expert decision based on facts including emotional factors. According the guidelines the investor must be asked the questions and be able to understand the question and able to answer the question. What this guideline does is assume that the investors have the expertise to answer the questions. Presumably, the machine can then determine what investments would fit this uneducated answer.

The evaluation of risk depends on how risk is explained and quantified, in light of age, which is advancing, and health, which is deteriorating, and assets, about whose value and amounts the investors may not be sure because someone else does the investor’s books and the markets are swaying continuously. This questionnaire is similar to a possible questionnaire by a lawyer who would ask the client: What is your risk level in bringing this action? How much money do you believe you should invest in this case? How good are you as a witness on being cross-examined?

Legal Issues for Brokers Who Use Robo-Advisers

May the robo-advisers help brokers to use the word “advisers,” yet avoid the duties involved in giving advice, which would impose on them fiduciaries duties to their advisees?

After all, the machine provides the brokers with information about the clients’ desires and judgments (right or wrong). Presumably, the machine speaks not for the brokers but for the investors. Therefore, the brokers receive the investors’ orders and give no advice whatsoever, except a machine, which is then filled with the investors’ directives.

Are robo-advisers fiduciaries?

It is doubtful whether a machine is imposed with human liabilities for breach of law. Therefore, to the extent that the machine, for example, did not transfer the answers of the investors accurately, no one is liable for the mistakes.

Are the designers of these machines fiduciaries, even if the investors input their own needs and orders?

Advisers are those who give advice, not those who design the questions eliciting information on which advice is based. Therefore, it seems that the designers of the machines are not liable for any actions and any use of the machines.

The real questions involve the use of the robo-adviser and its effect. Our assumption is that the investors are not experts in securities trading. The assumption is that the investors must rely on the experts the way they rely on physicians and lawyers, to name a few.

If we aim at protecting investors who are not experts in financial management management, how do robo-advisers absorb the fiduciary duty on determining the investment decisions of the clients and for the clients?

Without examining most of the investors, and especially the current and near future retirees, my guess is that most of these investors do not understand the basis of these questions and cannot answer them intelligently. The word “adviser” is misused because an adviser is the one who both asks the questions and mainly answers them for the client. In this case, the adviser asks the questions, but they involve the expert answer and the machine follows the expert answer, rather than creating it.

Most importantly is the impact of robo-advisers on our entire trust system. America is rich in talent and in specialized advice. America is rich because of talent-riches. However, America will become poor if the experts abdicate their position and shift their liabilities to machines that seem to give advice but in fact elicit expert advice from an ignorant client.

In sum, how do robo-advisers affect the current regulation, if at all?

Brokers aim at being advisers without bearing the fiduciary duties of advisers. The machine would protect them from giving advice and bearing fiduciary duties of which they are rightly very afraid of. Yet, when you read a Commission staff Guidance Update about robo-advisers you find the word “suitable” sandwiched in the description. The staff spoke about a machine called an adviser that is regulated as a broker. This is not an adviser. Not all clients know the difference and appreciate it. That is, until it is too late.

Perhaps surprisingly, there may be no new problems in the rise of robo-advisers. Rather, old problems might creep up and surface on this new route to people who rely and trust experts. So long as conflicts of interests are not disclosed and do not receive the consent of the clients to the conflict, the old, historic problems and their painful results might stay with us.