United States: Ropes & Gray's Investment Management Update: February 2017 – March 2017

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry:

SEC Issues Guidance Update on Robo-Advisers

Recently, the SEC's Division of Investment Management published a Guidance Update, Robo-Advisers, (the "Guidance"), principally intended for automated advisers that provide services directly to clients over the Internet ("robo-advisers"). The Guidance states that robo-advisers are typically registered investment advisers that use technologies "to provide discretionary asset management services to their clients through online algorithmic-based programs."

The stated purpose of the Guidance is to remind robo-advisers of certain unique considerations that may apply to their business under the Advisers Act. The Guidance recognizes that robo-advisers' different business models may affect the applicability of the Guidance, providing suggestions about how robo-advisers can satisfy their Advisers Act obligations. The Guidance categorizes its suggestions into three categories:

  1. The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
  2. The obligation to obtain information from clients to support the robo-adviser's duty to provide suitable advice; and
  3. The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

The suggestions in the Guidance for each of these three categories are summarized below.

Substance and Presentation of Disclosures

Robo-advisers rely principally on algorithms and the Internet to provide advisory services with limited, if any, human interaction and, therefore, the Guidance recommends that robo-advisers consider the most effective way to communicate to their clients required disclosures regarding their advisory services. When designing disclosures, the Guidance recommends that it may be useful for a robo-adviser to consider how it explains its business model and the scope of the investment advisory services it provides, as well as how it presents material information to clients.

Explanation of Business Model

The Guidance states that, in addition to other required information, a robo-adviser should consider disclosing information regarding its particular business practices and related risks. The Guidance provides the following examples:

  • A statement that an algorithm is used to manage individual client accounts;
  • A description of the algorithmic functions used to manage client accounts – i.e., that an algorithm generates recommended portfolios, and that client accounts are invested and rebalanced by the algorithm;
  • A description of the assumptions and limitations of the algorithm used by the adviser;
  • A description of the particular risks arising from the use of an algorithm to manage client accounts (e.g., rebalancing client accounts without regard to current market conditions);
  • A description of circumstances that might cause the robo-adviser to override the algorithm used to manage client accounts (e.g., the robo-adviser might halt trading or take other temporary defensive measures in stressed market conditions);
  • A description of any conflicts of interest arising from a third party's involvement in the development, management, or ownership of the algorithm used to manage client accounts, including an explanation of any conflicts of interest the third party's involvement may create (e.g., the algorithm directs clients into products from which the third party earns a fee);
  • An explanation of fees a client will be charged directly by the robo-adviser, and of any other costs that the client may bear either directly or indirectly;
  • An explanation of the degree of human involvement in the oversight and management of individual client accounts;
  • A description of how the robo-adviser uses the information gathered from a client to generate a recommended portfolio and any limitations arising from the adviser's approach; and
  • An explanation of how and when a client should update information he or she has provided to the robo-adviser.

Scope of Advisory Services

The Guidance cautions robo-advisers to use reasonable care to avoid creating a false implication about the scope of services they provide clients. The Guidance provides the following examples of potential false implications:

  • The robo-adviser is providing a comprehensive financial plan if it is not, in fact, doing so;
  • A tax-loss harvesting service also provides comprehensive tax advice; or
  • Information other than that collected by the questionnaire is considered when generating investment recommendations if such information is not, in fact, considered.

Presentation of Disclosures

The Guidance notes that robo-advisers utilize a variety of practices in providing important information to their clients. Because of robo-advisers' reliance on online disclosures to provide such information, the Guidance states that unique issues arise in communicating important information to clients. Therefore, the Guidance reminds robo-advisers to consider the effectiveness of their written disclosures and, in particular, the Guidance lists these considerations:

  • Whether key disclosures are presented prior to enrolling clients so that necessary information is available to clients before they make any investments with the robo-adviser;
  • Whether key disclosures are specially emphasized;
  • Whether some disclosures should be accompanied by interactive text or other means to provide additional details to clients who are seeking more information (e.g., through FAQs); and
  • Whether the presentation of disclosure made available on a mobile platform has been adapted for that platform.

Provision of Suitable Advice

This portion of the Guidance focuses on the information relied upon by a robo-adviser to support its reasonable determination that the investment advice provided is suitable for the client based on the client's financial situation and investment objectives.

Reliance on Questionnaires to Gather Client Information

Robo-advisers may provide investment advice based primarily, if not solely, on client responses to online questionnaires, which vary from adviser to adviser. The Guidance recommends that, given the limited interaction a robo-adviser has with a client, a robo-adviser should consider the following factors:

  • Whether the questions elicit sufficient information to allow the robo-adviser to conclude that its recommendations and ongoing advice are suitable and appropriate for each client;
  • Whether the questions are sufficiently clear, including whether the questionnaire seeks clarification or provides examples to clients when necessary; and
  • Whether steps are taken to address inconsistent client responses.

Client-Directed Changes in Investment Strategy

Robo-advisers may provide clients with the ability to deviate from a recommended portfolio, without consultation with investment advisory personnel. The Guidance recommends that a robo-adviser consider providing commentary about why it believes the recommended portfolio may be more appropriate in light of a given investment objective and risk profile, including pop-up boxes or other design features that could alert a client to an inconsistency between a stated investment objective and the chosen investment portfolio.

Effective Compliance Programs

The final portion of the Guidance reminds a robo-adviser to be mindful of the unique aspects of its business model in designing its compliance program required by Rule 206(4)-7 under the Advisers Act. In particular, the Guidance recommends that robo-advisers should consider whether to adopt and implement written policies and procedures that address the following areas:

  • The development, testing, and backtesting of its algorithm code and post-implementation monitoring of its performance;
  • The disclosure to clients of any changes to the adviser's algorithm code that may have a material effect on their portfolios;
  • The oversight of any third party that develops or manages the algorithm or software modules utilized by the robo-adviser;
  • The prevention and detection of, and response to, cybersecurity threats;
  • The use of social/electronic media to market its advisory services; and
  • The protection of client accounts and key advisory systems to assure business continuity.

SEC Provides Guidance Regarding Rule 3a-2 and Holding Companies

The SEC's Division of Investment Management recently issued a Guidance Update, Holding Companies and the Application of Rule 3a-2 Under the Investment Company Act (the "IM Guidance") to make Rule 3a-2 – the transient investment company exclusion – more available to holding companies that are engaged in various operating businesses through wholly-owned and majority-owned subsidiaries ("Holding Companies") that experience an "extraordinary event."1

Background. Rule 3a-2 provides a one-year safe harbor exclusion from the definitions of investment company within Sections 3(a)(1)(A) and (C) of the 1940 Act. Rule 3a-2's one-year exclusion begins to run upon the earlier of:

  1. the date on which an issuer owns securities and/or cash having a value exceeding 50% of the value of such issuer's total assets on either a consolidated or unconsolidated basis ("50% Threshold"), or
  2. the date on which an issuer owns investment securities having a value exceeding 40% of the value of such issuer's total assets (excluding government securities and cash items) on an unconsolidated basis ("40% Threshold").

The Problem. Holding Companies, by their nature, frequently cross the 50% Threshold without the occurrence of an extraordinary event. In contrast, as the IM Guidance notes, the occurrence of an extraordinary event may result in a Holding Company's owning a significant amount of securities issued by entities that are not majority-owned subsidiaries of the Holding Company (i.e., securities that are "investment securities") and holding investment securities in excess of the 40% Threshold. If, at the time of such an event, the Holding Company were to look to Rule 3a-2's one-year safe-harbor, the Holding Company, because it may have already crossed the 50% Threshold, could be deemed to have "run out the clock on its one-year period before ever needing to rely upon [R]ule 3a-2."

The Guidance. The IM Guidance states that it is the staff's view that, when adopting Rule 3a-2, the SEC did not intend to treat Holding Companies differently from other issuers. Accordingly, the IM Guidance, in effect, removes for Holding Companies the 50% Threshold as an event that triggers the clock running on the one-year safe harbor. Instead, in the case of a Holding Company, the IM Guidance provides that Rule 3a-2's one-year safe harbor does not begin until the occurrence of an extraordinary event.


The following brief updates exemplify trends and areas of current focus of relevant regulatory authorities:

SEC Publishes a List of the Top Five Compliance Deficiencies

On February 7, 2017, the SEC's Office of Compliance Inspections and Examinations published a risk alert, The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers (the "Alert"). The Alert categorizes the compliance deficiencies in five categories and, within each category provides examples, as summarized below:

Compliance Rule, including (i) compliance manuals that are not reasonably tailored to the adviser's business practices, (ii) failure to conduct annual reviews of the adviser's written policies and procedures, as required by Rule 206(4)-7 under the Advisers Act, (iii) among advisers that conducted annual reviews, failure to address the adequacy of the advisers' policies and procedures and the effectiveness of their implementation or to address problems identified in the review, (iv) advisers not following their own compliance policies and procedures and (v) policies and procedures that are not kept current.

Regulatory Filings, including advisers (i) making inaccurate disclosures in their Form ADVs or not promptly amending their Form ADVs when certain information became inaccurate; (ii) filing Form PFs that were incomplete or inaccurate or not filed on time and (iii) filing Form Ds that were incomplete or inaccurate and not filed on time.

Custody Rule, including advisers (i) not recognizing that they may have custody due to online access to client accounts, (ii) with surprise examinations (for advisers with custody) that do not meet the requirements of Rule 206(4)-2 under the Advisers Act and (iii) not recognizing that they may have custody as a result of certain authority over client accounts.

Code of Ethics under Rule 204A-1, including (i) codes that did not identify access persons or failed to specify required information, (ii) codes that did not specify review of the holdings and transactions reports or did not identify the specific submission timeframes, as required by the rule, (iii) access persons submitting transactions and holdings less frequently than required by the rule and (iv) advisers not describing their codes in their Part 2A of Form ADVs and not indicating that their code was available to any client or prospective client upon request.

Required Books and Records Rule, including advisers' (i) failures to maintain all required records, (ii) failures to maintain books and records that are accurate and updated and (iii) maintaining contradictory information in separate sets of records.

SEC Issues Information Update on Obtaining Letters to Support Tax Claims in Foreign Jurisdictions

Recently, the SEC's Division of Investment Management published an Information Update, Information Letters to Support Foreign Tax Claims (the "Information Update"), to assist registered funds in obtaining foreign tax refunds. The Information Update reports that, since late 2015, the Division has been providing U.S.-registered funds with letters addressed to foreign jurisdictions to assist such funds in obtaining refunds of any foreign taxes that were inappropriately withheld.

The purpose of the Information Update is to provide U.S.-registered funds with a framework for making requests for such letters from the Division. The Information Update requests, for funds that may have similar outstanding tax claims seeking a letter from the Division, that draft letters should be submitted to the Division. The Information Update specifies the recommended contents of the draft letters and the supporting documentation that should accompany the draft letters. Finally, the Information Update provides a special SEC email address to which the draft letters and supporting documentation should be submitted.

Download - Ropes & Gray's Investment Management Update: February 2017 – March 2017

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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