Investment Management Update

The SEC’s Division of Enforcement has recently stepped up its enforcement activity against “robo-advisers”—investment advisers that operate an automated digital investment advisory program marketed to clients over the internet. The prevalence of robo-advisers has grown tremendously in the last few years.

Hedgeable, Inc.

In the matter of Hedgeable, Inc., the SEC charged a relatively small New York based robo-adviser with fraud, dissemination of false or misleading advertising, failing to maintain books and records, and failure of its compliance policies and procedures. Hedgeable admitted to the SEC's allegations and accepted the terms of an administrative order, including sanctions.

To try to recruit clients over the internet, Hedgeable created an index of robo-adviser performance based on competitor robo-advisers' advertised performance. Hedgeable compared the index performance to a Hedgeable composite that was supposed to reflect the performance of a typical Hedgeable client strategy. Hedgeable marketed its favorable composite performance against the “Robo-Index” it created. Both the composite and the index were materially misleading.

The Hedgeable composite was not reflective of Hedgeable’s clients and involved classic cherry-picking. The composite included only a small subset of clients during the comparison period.  Hedgeable used only 4% of its client accounts during the comparison period, ignoring 96% of its accounts.

The so-called “Robo-Index” created by Hedgeable to compare its performance against its competitors was not a real index derived from competitors’ actual trading models. Hedgeable calculated the Robo-Index based on its own analysis of publicly available information from competitors’ websites using estimates of the competitors’ trading models. Hedgeable made its own assumptions on when the competitors would have rebalanced their portfolios, without any basis in fact. Hedgeable touted its misleading superior performance in website advertising, widely disseminated fact sheets, and other disclosures.

An Index Must Be Genuine and a Composite Must Be Representative

If an adviser compares its performance to an index, the index must be an established index and not one created by the adviser. If an adviser creates a composite, the composite must accurately reflect client account strategies.

WealthFront, LLC

In the matter of Wealthfront Advisers, LLC f/k/a Wealthfront, Inc., the SEC’s Enforcement Division brought an enforcement action against a robo-adviser for making misleading statements concerning the tax advantages of the robo-adviser’s strategy. Wealthfront is a Silicon Valley based robo-adviser that has over $11 billion in assets under management. Wealthfront claimed that it developed a proprietary tax loss harvesting strategy that would allow clients to sell certain assets at losses to offset taxable income or gains on other transactions, which would reduce client tax liabilities. Wealthfront admitted to the SEC's allegations and accepted the terms of an administrative order, including sanctions. 

Wealthfront advertised that it monitored its client account activity to avoid the application of the “wash sale” rule of the Internal Revenue Code. Under the “wash sale” rule, a client cannot recognize a loss on sale of a security if the client trades the same or a substantially identical security within a 30-day period. Wealthfront did not in fact monitor client accounts for compliance with the wash sale rule, and a large percentage of accounts had wash sales negate the benefit of Wealthfront’s tax strategy.   

In addition to misleading advertising about its proprietary trading strategy, Wealthfront used its Twitter feed to republish posts by other Twitter users making positive statements about Wealthfront. These Twitter users were undisclosed Wealthfront employees, Wealthfront investors, and Wealthfront clients who would receive free services from Wealthfront if a client came to Wealthfront through a Twitter post. In so doing, Wealthfront violated the prohibition in the Adviser’s Act against the use of testimonials.

Finally, Wealthfront also violated Rule 206(4)-3, the “Cash Solicitation Rule.”  Wealthfront created an affiliate program in which it paid bloggers who successfully solicited new clients on behalf of Wealthfront.  The Cash Solicitation Rule requires advisers to enter into a written agreement with solicitors, and requires that the solicitor make certain disclosures to solicited clients.

Advertising Rules, the Cash Solicitor Rule and the Restrictions on Testimonials Apply to All Advisers—Robo-Advisers Included

The Wealthfront enforcement matter is a reminder that the SEC remains vigilant about misleading advertising and advisers must be careful in what they claim. It is also a reminder that advisers may not pay to solicit business unless they comply with the Cash Solicitation Rule.

These recent cases reflect increased SEC focus on robo-advisers, but also serve as reminders that the rules apply equally to brick-and-mortar and internet-based advisers.

by Jonathan B. Levy

SEC OCIE Issues Risk Alert on Instant Messaging and Books and Records; Reminds Advisers on Best Practices

Rule 204-2(a)(7) requires advisers to make and keep original records of all written communications related to, among other things: (1) investment recommendations; (2) receipts, disbursement, or delivery of funds or securities; (3) placing or execution of orders to purchase or sell securities; or (4) the performance or rate of return on client accounts or securities recommendations. The Books and Records Rule also requires that advisers keep records of all advertising, investment newsletters, and bulletins.

OCIE examinations revealed that advisers are using electronic communications such as text/sms messaging, instant messaging, personal email, and personal or private messaging. These communications were often sent using third-party platforms, and some firms do not have appropriate systems to archive, supervise, and maintain books and records for electronic communication.

Best Practices for Private Electronic Messages

OCIE identified the following best practices to meet an adviser’s record-retention obligations under the Books and Records Rule with respect to electronic messaging:

Policies on Electronic Messaging:

• Advisers should only permit electronic communications for business purposes that can be used in compliance with the Advisers Act.
• Advisers should prohibit use of applications that can be readily misused, such as those that allow anonymous communications, allow for automatic destruction of messages, or prohibit third-party viewing or backup.
• If an employee receives a message using a technology prohibited by the firm, the firm’s policy should require the employee to move the applicable message to a system that complies with the Books and Records Rule.
• If an adviser permits use of personal devices, the adviser must adopt policies and procedures to capture messages on such devices.
• Advisers that allow employees to use social media platforms, personal email, or personal websites for business purposes must adopt policies and procedure to ensure business communications are maintained through those avenues.
• Employees should be informed that violations of the adviser’s policies and procedures for electronic messaging could result in discipline or even termination.

Training Employees on Electronic Messaging:

• Advisers should institute training on compliance and obtain attestations of compliance with the policies from employees.
• If advisers allow the use of social media for business purposes, advisers’ compliance professionals should monitor social media posts and websites and archive business communications to ensure compliance.

Supervision Responsibilities:

• Advisers should regularly review social media sites to make sure employees are using social media in an approved manner.
• Advisers’ compliance professionals should run regular internet searches or set automated alerts to capture when an adviser’s name or employee’s name appears on a website to identify if unauthorized activity is occurring online.
• Advisers should adopt a reporting program to allow employees to confidentially report potential violations.
• Advisers should require approval from adviser’s compliance and IT professionals before using firm servers on personal devices.
• Cybersecurity applications should be required for personal devices. 

OCIE’s Risk Alert is a good reminder that advisers need to make sure that compliance programs continue to evolve with changes in technology and communications.

by Jonathan B. Levy