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FINRA Weighs in on Robo-Advisors

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FINRA Weighs in on Robo-Advisors

Written by: Stephen P. Wilkes | The Wagner Law Group

With the imminent release of the proposed ERISA fiduciary regulation in final form, many financial advisors are weighing the pros and cons of delivering participant investment advice.

Does the “Best Interest Contract Exemption” impose costs and responsibilities that are too onerous for my firm?   Should I move from a varying commission- based compensation structure to a level fee payout?

For many broker-dealer firms, there may be a viable path forward by going to a robo-advisory program that incorporates the statutory computer model exemption under ERISA Section 408(b)(14) and (g)(1) or its predecessor, the SunAmerica advisory opinion. However, be advised that FINRA is also looking closely at rob-advisory programs and issued a report on March 15, 2016 (Report on Digital Investment Advice, the “Report”), dealing with its perspective on suitability and conflicts of interest where digital investment advice tools are used to render investment advice. The Report does not appear to change or create any new legal requirements, but certainly stands for the proposition that firms must identify and maintain appropriate procedures involving digital tools used for investment advice.

Governance and Supervision.  

The Report indicates that firms should establish appropriate governance and supervisory procedures that enable the full understanding of the digital tool, including how both the financial adviser and the client will use it. It also recommends that the firm test and review all aspects of the digital tool including the underlying algorithms used to develop investment strategies and models. Testing should be especially sensitive to preferences or biases that are built into the methodology, so as to avoid inappropriate results for any client.  

Customer Portfolio Construction and Conflicts of Interest.

In addition to algorithms, the Report takes a close look at the construction and rebalancing of portfolios, and the overlay of suitability and conflict of interest rules. The Report is quite clear in its recommendation that a financial advisor needs to have all of the appropriate data about a customer in order to advise on the establishment or adjustment of a portfolio that is suitable and conflict fee. FINRA rules call for a proper vetting of a client profile at account opening and subsequently when offering investment recommendations. Proper due diligence should consider many factors, including but certainly not limited to age, tax status, investment objectives, liquidity needs, and time horizon. These traditional elements of due diligence and defining suitability for each client are not superseded or reduced in any way by the use of digital investment tools. In fact, the Report provides an example of a relevant questions for profiling purposes and offers some guidance on how to address incomplete or contradictory answers to client profile questions

The Report emphasizes that conflicts of interest principles as articulated by FINRA rules are very much applicable to the digital platform. Disclosure remains the primary means of addressing conflict situations.

Training.

The proper training of registered representatives on the use of digital investment tools, including their inherent strengths and weaknesses, is highly encouraged. Good training would not only include the proper use of the digital investment tool, but appropriate indicators for when its use may not be suitable for a particular client.  

Lessons for Investors.

The Report states that clients should also consider various issues when using a digital investment advice. The lessons fall into three main categories: suitability of investment, rebalancing of portfolios, and conflicts of interest.

Robo-advisory programs are becoming more prevalent as technology improves and the financial services market develops new approaches to the long standing problem of delivering investment advice to clients in a fashion that not only is legally compliant, but reflects best practices and is meaningful to the individual. The ERISA final regulation may provide yet another incentive for the robo-advisory market to grow. The DOL will be looking for compliance by financial service firms with the terms and conditions of the computer model exemption.   FINRA has effectively announced that it, too, will require its member firms to structure robo-advisory programs within the current regulatory framework of suitability and conflict of interest disclosure.   It is incumbent on those firms using a robo-advisor platform to identify and assess potential issues now, and be sure to incorporate appropriate processes and procedures that will satisfy not only DOL but FINRA as well.

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