Massachusetts Issues Regulatory Guidance for State Investment Advisers Who Use Third-Party Robo-Advisers

The Massachusetts Securities Division (the “Division”) recently issued regulatory guidance for state investment advisers who use third-party robo-advisers to provide advisory services to clients.  Robo-advisers have enjoyed a significant growth in popularity in the financial services industry based on perceived simplicity, ease of accessibility, and ability to service investment advisory clients who may not have sufficient assets to begin a relationship with a traditional investment adviser.  As discussed previously, the Division issued a policy statement in April 2016 declaring that because automated robo-advisers cannot provide fiduciary duties to clients as traditional human investment advisers can, the Division will evaluate their Massachusetts registration applications on a case-by-case basis.

The new regulatory guidance provides that to the extent a state-registered investment adviser (“state-registered adviser”) uses a third-party robo-adviser’s services to provide asset allocation and trading functions to clients, the state-registered adviser must meet a minimum of six requirements.  These six requirements are as follows:

First, the state-registered investment adviser must clearly identify robo-advisers with which it contracts to allow them to provide concurrent investment advisory services to clients.  In doing this, the state-registered investment adviser should identify the entity as a robo-adviser or use other phraseology clearly indicating that the third party is an entity that uses algorithms or equivalent methods in the course of giving automated portfolio management services.  The identification should also include factors the state-registered adviser considered in choosing to affiliate with the robo-adviser, such as why that specific robo-adviser was selected, potential conflicts of interest, potential additional fees, potential benefits that the state-registered investment adviser believes that its clients will receive, and any disadvantages that the clients may receive.  Furthermore, the state-registered adviser must provide a detailed explanation of the services that the robo-adviser provides.

Second, if it is applicable, the state-registered adviser must inform clients that advisory services could be obtained directly from the robo-adviser without using the services provided by, or paying additional fees to, the state-registered investment adviser.

Third, the state-registered adviser must explain the ways in which it provides value to the client for the fees it collects over and above the value provided by the robo-adviser.  A state-registered adviser owes a fiduciary duty to clients, and part of that duty includes rendering personalized investment advice and making investment decisions appropriate for a particular client.  Pursuant to that fiduciary duty, the state-registered adviser could explain to its clients that it could work with the clients to establish financial goals and practices, provide comprehensive and ongoing financial planning services, or continuously re-evaluate the clients’ portfolio.  All of these are services that would likely not be as personalized if a client used a robo-adviser.  In outlining these services, a state-registered investment adviser should distinguish the services it provides from the services provided by the robo-adviser to demonstrate the value of the state-registered adviser’s services.

Fourth, the state-registered adviser must detail the services that it cannot provide to clients.  As stated above, a state-registered adviser owes a fiduciary duty to clients, and part of that duty includes rendering personalized investment advice.  For that reason, the state-registered adviser must make a clear distinction to clients in detailing the services it can offer to clients in meeting their financial goals and the services provided by robo-advisers with which it may be affiliated or have a contractual arrangement.

Fifth, the state-registered adviser must inform the client, if applicable, that the robo-adviser may limit the investment products available to the client.  For example, most robo-advisers currently use exchange-traded funds as the main investment vehicle for their clients.  This could prove problematic for a client whose portfolio requires investments other than exchange-traded funds.

Sixth, the state-registered adviser must use unique, distinguishable, and plain-English language to describe the adviser’s and the robo-adviser’s services.

State-registered investment advisers using robo-advisers must also, in light of their fiduciary duties to clients, be mindful of 950 Mass. Code Regs. 12.205(9)(c)10, which provides that it is a dishonest or unethical practice for a state-registered investment adviser to charge “…an advisory fee that is unreasonable in light of the fees charged by other investment advisers providing essentially the same services.”  An investment adviser’s fiduciary duty includes the obligation to operate in a fashion that minimizes fees, thus requiring it to consider its fees in light of the services provided by third parties.

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