RISK, REWARD, ROBO-ADVISERS: ARE AUTOMATED INVESTMENT PLATFORMS ACTING IN YOUR BEST INTEREST?

• Author: Litz, Dominic

1. Introduction

   Robots are not taking over the world, but they are becoming more prevalent in everyday life, making daily chores simpler and even eliminating jobs altogether. (1) One industry that is heavily influenced by trends in technology is investment management. (2) Traditionally, an individual will seek the advice and services of a financial planner or an investment adviser to manage their money to save for retirement, increase their personal wealth, or diversify their personal assets. (3) Robo-advisers, an emerging form of investing, manage a client's funds on an automated investing platform, usually by way of investing in Exchange Traded Funds ("ETFs"). (4) A traditional human adviser may substantially profit from a commission-based or transaction-based fee, which differs from robo-advisers that operate on algorithmic investing and typically profit from flat fees. (5)

   Robo-advisers have been on the rise in recent years, as small independent automated investment platforms seeking to attract a younger generation of investors. (6) Robo-advisers initially made their way into the market by targeting the "millennial" generation given their attraction to the technology based platforms, low fee structure, and a hands off approach to investing and saving for retirement or growing personal wealth. (7) Robo-adviser accounts are easy to set up and begin investing with: there is a short questionnaire to calculate an investor's risk tolerance, the investor deposits money, and the algorithm creates and maintains an individualized diversified portfolio, usually consisting of ETF, for the client. (8) Similar to the expectations of traditional investment advisers, clients may expect their robo-advisers to be regulated by a governmental or regulating agency and held under a strict fiduciary duty, so their assets and investments are invested in a way that is in their best interest. (9)

   It is no surprise that technology plays a key role for investment firms, considering it has become a major facet in basic, everyday life. (10) In order to protect investors and provide transparency, the Department of Labor ("DOL") recently released a new rule, the Conflict of Interest Rule (the "Final Rule" or "Rule"), that will create a more stringent fiduciary standard, which seeks to eliminate all conflicts of interest between a client's best interest and an advisers desire to maximize their compensation. (11) The Final Rule's proposed implementation was originally April 2017, but with the new administration, the DOL has proposed a sixty-day delay from the phased implementation and continually delayed full implementation. (12) Shortly after the delay, the DOL has begun to implement this standard, requiring all investment advisers to act in their clients best interests. (13) Notwithstanding the delay, there is still confusion on how this standard will apply to robo-advisers and what their clients need to understand. (14) The Final Rule focuses on documenting recommendations and communications between advisers and clients; however, robo-advisers have little to no interaction with their clients past the initial account set-up. (15) Since more robo-adviser start-ups are increasing their assets under management ("AUM") and large investment firms are acquiring their own robo-advisers, there will likely be a hike in fees and costs to invest in these types of platforms as well as some regulation. (16) In anticipation of a shift towards lower cost investment advice, robo-advisers are hopeful the DOL's Final Rule will drive more customers to utilize their platforms, increasing an already growing business for them. (17)

   This Note analyzes the DOL's Final Rule and its definition of fiduciaries and how under this Final Rule, robo-advisers may be considered fiduciaries, but fall short of meeting this strict standard. Part II of this note beings with background of the fiduciary standard, the DOL's Rule and certain exceptions to the Rule, and conflicts which could arise from a breach of these duties. (18) Part II will discuss robo-adviser's emergence into the investment market. Additionally, it will also discuss how new technologies may aide advisers with specific documentation requirements. (19) Part III of this note will breakdown the DOL's exemptions and how advisers, including robo-advisers, can utilize them in compliance with the DOL's new Rule. (20) Finally, Part IV of this Note will get to the nuts and bolts of conflicts of interest and how under the DOL's new definition of fiduciary, even with the use of the exemptions, robo-advisers should not be considered a fiduciary. (21)

2. History

   1. Fiduciaries and Fiduciary Standards

      A fiduciary is a person who is held to one of the highest ethical standards, in which an agent must act in the principal's best interest regardless of their own interests. (22) An investment adviser is a common example of someone who is held to a fiduciary standard, because they are entrusted to advise a client on the movement of their financial assets. (23) Furthermore, traditional investment advisers are required to act in their client's best interest and disclose any conflict of interest that may arise, even if the financial compensation is not advantageous to themselves. (24) In terms of regulating Registered Investment Advisers ("RIA") and firms, the Investment Advisers Act of 1940 ("'40 Act") was created, which sets forth standards of disclosure, policies regarding a change in investment plans, causes of action and remedies for breach of fiduciary duties, and general standards all RIA's must meet. (25) The Final Rule recently approved by the DOL is an attempt to reduce conflicts of interest and breaches of fiduciary duty between clients and investment advisers. (26)

   2. Overview of Department of Labor's Conflict of Interest Rule and Exceptions

      In April of 2016, after many hearings, petitions, and comments, the DOL adopted the Conflict of Interest Final Rule, which includes different fee exemptions for investment advisers. (27) The Final Rule defines who is considered a fiduciary investment adviser and describes what investment advice gives rise to fiduciary responsibilities. (28) Furthermore, the Final Rule provides exemptions to advisers which could allow them to maintain current fee structures, which normally be prohibited, so long as their advice is in the best interest of the client and meets certain exemption requirements. (29) The exemptions, the Best Interest Contract Exemption ("BIC Exemption") and Principal Transactions Exemption ("PT Exemption") are two of the major exemptions of the Final Rule. (30) The BIC Exemptions have two major subsections, BICE Lite and BICE, for advisers to maintain their compensation structure, so long as they adhere to specific standards. (31)

      Advisers "must either avoid payments that create conflicts of interest or comply with the protective terms of an exemption issued by the Department." (32) The Final Rule places a substantial amount of emphasis on "recommendations" made by advisers and whether the advice given by the fiduciary is considered a recommendation as defined in the Final Rule. (33) Certain communications and advice will not constitute a recommendation if it involves information pertaining to education, general communications, and platform providers. (34) With a looming full implementation date, advisers and firms are searching for ways in which they will comply with this more stringent fiduciary standard. (35) In anticipation of the tightening standards and with the hope of maintaining certain fee structures, investment advisers have begun integrating technology to help them comply with the Rule's requirements and maintain their fee structure. (36)

   3. Breach of Fiduciary Duty and Conflict of Interest Controversies

      Generally, an adviser generates their profits through commissions and fees, which has the potential to lead to conflicts with clients. (37) A client may file a claim for breach of fiduciary duty under the '40 Act if an adviser does not act in the client's best interest or the adviser's compensation is disproportionate to the services provided. (38) The Supreme Court, as decided in Gartenberg v. Merrill Lynch Asset Management Inc., (39) recently affirmed that the plaintiff has the burden of proving advisers' fees are so excessive or unfair to constitute a breach of fiduciary duty as set forth by statute governing compensation. (40)

      The DOL aims to reduce conflicts of interest for clients by increasing the scrutiny for advice being given by advisers, assuring that such advice is in fact in the best interest of the client. (41) Conflicts of interests between advisers and clients is another controversial area, often prone to regulatory action. (42) Some experts believe this is more prevalent in the financial services industry, stating, "[c]onflicts of interest arise in any fiduciary relationship, and perhaps no more so than in the financial service industry." (43) Investment advisers often run into ethical dilemmas when deciding between a transaction that is in the best interest of the client or an investment that is financially beneficial to themselves or the firm. (44) Regulating agencies are wary to the temptation an adviser has to be deceitful when a decision is more financially beneficial to themselves and not in their client's best interest. (45) Furthermore, the Vernazza v. SEC (46) case held that conflicts of interest, resulting in the misrepresentation of reporting information and financially benefiting without disclosure could warrant fines and sanctions. (47)

      Additionally, clients need to be aware of whether they are dealing with an investment adviser, who are held to a fiduciary standard and avoid conflicts of interest, or if they are dealing with a broker-dealer, who might not be held to the same standard and thus can avoid conflict of interest regulations. (48) There are several differences between investment advisers and...