Inside FINRA's New Guidance On Digital Investment Advice

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1 Portfolio Media. Inc. 111 West 19 th, 5th Floor New York, NY Phone: Fax: Inside FINRA's New Guidance On Digital Investment Advice Law360, New York (March 18, 2016, 1:28 PM ET) -- Since the financial crisis, new, innovative online investment platforms have begun to offer financial advice to hundreds of thousands of customers. Many of these companies offer advanced portfolio designs using low-cost investments such as exchange traded funds (ETFs), automatic rebalancing and tax loss harvesting and charge substantially lower fees than traditional investment advisers. This has been a recipe for rapid growth among leading new online investment advisers such as Betterment (with more than $3.8 billion in assets under management) and Wealthfront ($3 billion in assets under management). As new market entrants have begun to disrupt a multitrillion-dollar industry, traditional asset managers have taken notice. Firms such as BlackRock, Charles Schwab and Vanguard have either acquired or launched their own online investment platforms to complement their traditional investment advisory businesses. And regulators, of course, from the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority to the U.S. Department of Labor, have taken notice as well. On March 15, one of those regulators, FINRA, released a new report on online investment advice. Although the report claims not to create any new legal requirements or to change any existing brokerdealer regulatory obligations, FINRA's recent guidance contains important implications both for new online advisers and new offerings from traditional asset managers. Indeed, having articulated expectations and best practices, the areas identified in FINRA's guidance for online investment advice are likely topics for examinations and, potentially, enforcement actions. The New FINRA Report on Digital Investment Advice FINRA's recent report on what it calls "digital investment advice" addresses both customer-facing online advisers and online tools offered to traditional financial professionals. It focuses on several areas: Governance, supervision and monitoring of online investment algorithms and portfolio construction; Investor profiling, risk tolerance and suitability; Conflicts of interest; and Rebalancing. Each of these areas also contains implications for investor disclosures for all those providing online investment advice.

2 Implications for Algorithm and Portfolio Governance, Supervision and Testing With respect to governance and supervision, FINRA focuses both on the initial creation of investment algorithms and their ongoing supervision and testing. At the outset, asset managers should assess the theoretical underpinnings of their algorithms, data inputs and critical assumptions. For example, firms relying on modern portfolio theory should consider potential changes to the correlation among asset classes in times of market stress, and assumptions about return rates and inflation, among others. FINRA's guidance also stresses the need to test coding and algorithm output to ensure that investment strategies are correctly implemented and result in suitable investments. FINRA emphasizes the need to implement a framework for ongoing testing of algorithm output on a regular basis as well. Asset managers offering online investment advice will need to be able to thoroughly explain how their online tools work, how their results satisfy regulatory requirements, and how the manager tests and monitors algorithm output on a regular basis. In addition, FINRA has indicated it will consider whether algorithms are tested by independent third parties, and what sort of exception reporting is used to identify potential deviations from expected outputs. Investment advisers should also consider and test how their algorithms will respond in times of market upheaval (e.g., the "Flash Crash," a foreign debt crisis or U.S. debt rating downgrade). Having put in place reasonable and documented testing procedures before a market event causes investor losses will be advantageous in regulatory examinations and potential enforcement matters, not to mention any private investor claims. For online tools from traditional asset managers, or hybrid offerings that offer both algorithm-driven strategies and the ability to connect with a human adviser, FINRA will also consider the training given to financial professionals who use online investment tools. In addition, FINRA will consider the ongoing support provided, the professional's ability to deviate from recommended strategies, and how the firm reviews adviser recommendations that deviate from the online investment tool's output. When an online investment firm offers "white label" solutions to traditional asset managers for their own offerings, the same factors should also be assessed. FINRA's guidance also emphasizes that online investment advice, like other recommended investment strategies, must be offered with a reasonable basis to conclude that the investments are suitable for the investors to whom they are offered. For example, online asset managers that make use of ETFs should consider potential liquidity risks to certain bond and emerging-market ETFs and the investors for whom such products are suitable. Written policies that document processes for portfolio creation and modifications should be considered. Of course, asset managers should be sure that they create workable policies that they will be able to implement and follow. A policy on paper that is "pie in the sky" but not followed in practice is unlikely to be viewed with favor during a regulatory examination. Implications for Onboarding and Investor Profiling FINRA's new guidance places great emphasis on whether asset managers are gathering sufficient information online to make suitable investment recommendations. The failure to use reasonable diligence to obtain and then analyze a customer's investment profile can result in a violation of FINRA Rule 2111 (Suitability). Having surveyed and reported on (anonymously) the practices of several online investment firms, FINRA appears to be concerned with the wide variety in the number of questions asked by different investment

3 managers and the adequacy of the information solicited. FINRA's concerns are not limited to the factors expressly set forth in Rule 2111(a) the customer's age, other investments, financial situations and needs, tax status, investment objectives, investment experience, time horizon, liquidity needs and risk tolerance. Instead, FINRA is also interested in whether online advisers are obtaining sufficient information at the onboarding to answer the threshold question of whether investing is appropriate for the potential customer. For example, FINRA focused on whether the online investing firm inquires whether the potential customer has outstanding credit card debt that should be paid off prior to investing and whether that customer has sufficient savings to cover living expenses. In addition, FINRA encourages firms to ask questions that would determine whether an individual's needs can be met by the adviser's online platform. For example, some platforms or services may not be suitable for investors who maintain multiple investment accounts at different financial institutions or who have multiple investment objectives. Other online investment platforms may be designed to account for multiple investment objectives on an integrated basis and permit investment strategies to be recommended and implemented based on a holistic view of an investor's portfolio. FINRA appears keenly interested in how online investment firms address an investor's risk tolerance, whether the investor's expressed risk willingness and risk capacity are consistent across multiple questions, and how conflicting answers are addressed. FINRA recommends additional questions to resolve conflicting responses (whether online or with a human adviser) prior to recommending an investment strategy. In addition, where conflicting responses are not resolved, FINRA favors using the more conservative response rather than averaging results across questions, which FINRA describes as a "poor practice." FINRA has also indicated that it will look at whether investors are permitted to re-evaluate or modify their risk willingness as their financial situation and personal desires change. FINRA also expects advisers to monitor online profile changes and, in the case of frequent (or dramatic) profile changes, to take steps to understand the reasons for the change. Whether an online investment adviser requests sufficient information to address these factors, as well as each of the factors set forth in Rule 2111, is likely to be an area of focus at FINRA in the future. Prior FINRA guidance has indicated that an investment adviser need not actually obtain all of the customer-specific information identified in Rule Rather, asking a customer for the information generally satisfies the adviser's obligation to exercise reasonable diligence.[1] Likewise, investment advisers may determine that a particular factor is not necessary for a given investment recommendation, provided the adviser has a reasonable basis for doing so. But the latest report makes clear that FINRA does expect advisers using online tools to assess whether they have obtained sufficient information for making a suitability determination. Asset managers should be prepared to explain the circumstances in which their online tools would decline to make an investment recommendation and to explain how such criteria are established. And advisers should disclose to customers that the output of their online tools may not be suitable if the customer does not provide accurate information. Implications for Addressing and Disclosing Conflicts of Interest FINRA recognizes that online investment advice can eliminate (or minimize) some potential conflicts of interest between the interests of an investor and a human adviser. But FINRA is also focused on potential conflicts that may remain between an online investment adviser and its customers. For example, online investment advisers that offer investments from affiliates, that receive order-flow payments or revenue sharing payments, or that earn cash management fees on a portion of invested assets

4 should consider potential conflicts with investors, how such conflicts can be eliminated and, if not eliminated, whether they are adequately disclosed. Like all investment advisers, online advisers must adhere to principles of good faith and fair dealing, and offer a fair and balanced view of investment opportunities and risks and provide investors with a sound basis for evaluating an investment service or security.[2] So, for example, an online adviser should not tout a product or feature as "free" if investors will still bear costs, whether from underlying investments or indirectly through trading costs. In light of the rapid growth in this online investing market segment, FINRA and other federal and state regulators, like the SEC, Consumer Financial Protection Bureau and New York attorney general, are likely to be interested in potentially undisclosed conflicts of interest or "hidden" costs charged to unsuspecting investors. Implications for Rebalancing, Tax Loss Harvesting and Similar Features The FINRA report's discussion of rebalancing contains a number of implications of asset managers who offer that feature, as well as other features such as tax loss harvesting and direct indexing. FINRA recommends that investment advisers explicitly establish customer consent to have automatic rebalancing occur on an account after advising the customer of the potential cost and tax implications. Advisers should also adhere to this recommendation for other features with potential tax consequences or increased trading costs. Relatedly, during onboarding, investment advisers should seek to obtain sufficient information about other accounts owned by the customer, or the customer's spouse, to determine if automatic rebalancing, tax loss harvesting or direct investment in the securities of an index may generate wash sales. Likewise, whether an investor is subject to restrictions in trading a particular stock (such as the stock of the individual's employer), whether a spouse is subject to trading restrictions and whether the online platform can exclude stocks subject to restrictions may be important to assessing whether a particular feature is suitable for a given customer. FINRA also recommends disclosing how the rebalancing works. Where an investment adviser rebalances on a scheduled basis, the adviser should disclose whether it is monthly, quarterly or annually. Other online investment firms use drift thresholds, where rebalancing occurs based on a threshold percentage deviation from a target asset allocation. In this circumstance, FINRA recommends disclosing to investors what the percentage drift threshold is, and whether it varies for particular asset classes. FINRA also expressly recommends that investment advisers consider whether a rebalancing would result in excessive commissions or lead to adverse tax treatment for the customer. Although the FINRA guidance does not address this concern to tax loss harvesting features or direct indexing, FINRA's recommendations would appear to apply with equal force to these features and other features with similar potential trading costs or tax consequences. Conclusion Recent FINRA guidance evidences increased regulatory scrutiny for online investment advice, both from FINRA and other state and federal authorities. Increased prominence and continued rapid growth of assets under management in this new market segment is likely to lead to additional regulatory guidance (or new regulatory mandates), particularly as online investment offerings become more complex and sophisticated.

5 By Christopher H. Giampapa, Schulte Roth & Zabel LLP Christopher Giampapa is a special counsel in the Regulatory & Compliance and Litigation Groups at Schulte Roth & Zabel in the firm's New York office. He represents broker-dealers and other financial services companies in regulatory matters, government investigations and complex business disputes. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] FINRA Regulatory Notice [2] FINRA Rule 2010(d)(1). All Content , Portfolio Media, Inc.