The Massachusetts Securities Division (the “Division”) recently published an interesting statement on Robo-advisers seeking state investment adviser registration in Massachusetts. Robo-advisers have flooded the market offering low-cost portfolio management through web-based applications where clients can populate a brief questionnaire which develops a risk tolerance used to direct investments, most often in Exchange-Traded Funds (“ETFs”). Robo-advisers fall under the category of “investment advisers,” which by definition owe a fiduciary duty of care and loyalty to their clients. However, the Division cautions that Robo-advisors may fall short on several key obligations that must be fulfilled by all investment advisors.
The Division noted some of the key differences between traditional investment advisers and Robo-advisers are as follows:
| Traditional Investment Advisers | Robo-advisers |
| Meet with and gather information from clients as part of a due diligence process | Do not meet with or conduct significant (or any) due diligence on a client |
| Provide personalized investment advice to clients with an eye to the information gathered | Provide investment advice that is minimally personalized |
| Use gathered information to make appropriate investment decisions on clients’ behalf | May fail to meet the high standard of care that is imposed on the appropriateness of investment advisers’ investment decision-making |
| Act in the best interests of his or her clients, unless otherwise disclosed | Specifically decline the obligation to act in a client’s best interests |
Due Diligence
The Division has several concerns with the task of information collecting that is performed by Robo-advisors. Specifically, the brief questionnaire completed by clients often fails to inquire about outside holdings as well as tax, distribution, and income needs. These elements are considered essential in creating a financial profile for each client. Robo-Advisers often attempt to use disclaimers to avoid these duties, which shift the burden to the client and classify themselves as “portfolio managers” rather than “financial planners” or “wealth managers.”
Further, the Division has concerns related to the lack of personal touch and on-going monitoring of accounts. Investment selections are made solely based on the brief questionnaire and changes can potentially only be made after client intervention. Using an online platform, the adviser has no way of knowing whether a client suffers from diminished capacity or if the actual client populated the questionnaire. Also, Robo-advisers attempt to shift the burden of on-going due diligence to the client by including contractual language that requires the client to notify the Robo-adviser of any change in his or her financial situation. Although this language is not uncommon in traditional Investment Adviser contracts, it is problematic considering that Robo-advisors do not have annual meetings with their clients and do not know their clients personally.
Based on these issues, some question whether Robo-advisors should be classified as broker-dealers or mutual funds.
Fiduciary Duty and Disclaimers
Several Robo-advisors attempt to avoid their fiduciary duty with disclosure language. For example, a Robo-advisor may include language such as: “the client is responsible for determining that investments are in the best interest of his or her financial needs”, “the client is responsible for notifying the advisor for any changes in financial circumstances”, and/or “the advisor is not responsible for account losses.”
The Division points that while federal law does permit advisers to disclaim certain aspects of their fiduciary duty of client, such as a conflict of interest, a full disclaimer of fiduciary duty would never be permissible.
Final Thoughts
Any industry professional has most likely had some of the same thoughts and concerns that the Division published. However, it is my belief that the Division’s opinion was slanted in that it failed to mention a few key points.
Several of the issues noted throughout the statement are not unique to Robo-advisors – most broker-dealers and traditional advisory firms permit online accounts that lack the human element. These firms along with Robo-advisors need to develop a process to ensure that clients are in-fact entering information and that the clients are not suffering from diminished capacity.
It is clear that regardless of the fee charged, investment advisers have a fiduciary duty to their client. That being said, the Division failed to point out that Robo-advisor fees are often substantially less than those charged by traditional advisors, most often 10-20% percent of the fees that traditional advisors charge. The clients using these online-applications understand that they are not getting personalized service because of this reduced fee.
The Division cautions that it will scrutinize Robo-advisor firms filing for state registration. However, most Robo-advisors are SEC registered as large investment advisors, internet advisers, or as multi-state advisors. As such, the Division will likely have to defer to the SEC for enforcement on this matter.
Red Oak will continue to monitor the regulatory landscape and issue updates as other states or the SEC offer guidance on how Robo-advisors must fulfill their fiduciary duty to their clients.
About Red Oak Compliance Solutions
Red Oak Compliance Solutions is a leading provider of intelligent compliance software, offering a range of AI-powered solutions designed to help firms of all sizes successfully navigate the increasingly complex regulatory landscape. Our suite of 17(a)-4/WORM compliant features offer risk minimization, cost reduction, and process optimization capabilities with features that are designed to evolve with our client’s needs. Our flagship advertising review software enables firms to deliver compliant content to the market with confidence, faster. Our Disclosure Management and Intelligence solution simplifies the management of disclosures, while our Registration Management solution automates and streamlines the licensing and registration process, further enhancing your internal processes.