A new report contends that robo-advisors’ “goal-based” advice falls short of a “best interest” standard for fiduciary advice.
The paper, “Are Robo-Advisors Fiduciaries?” by attorney Melanie L. Fein argues that only “those investment advisers and broker-dealers whose advice meets the prudent investor standard of care should be permitted to hold themselves out to retail investors as offering ‘best interest fiduciary advice.’”
While noting that robo-advisors are “fiduciaries” in the sense that they are registered investment advisers and owe a duty of loyalty to their clients, Fein, who has previously questioned the suitability of robo-advisors as ERISA plan advisors, contends that the duty of loyalty should not be the relevant standard to apply in answering the question of whether robo-advisors are “fiduciaries.” Instead, she says how they fulfill the “duty of care” is the more appropriate inquiry.
Goal-Based Versus Portfolio-Based Advice
Fein explains that the typical robo-advisor model is designed to provide algorithmic “goal-based” advice limited to the investor’s self-selected investment goals rather than the investor’s complete financial situation and entire investment portfolio.
To that point, Fein argues that, “Robo-advisors are deficient in their ability to perform a critical function of a fiduciary under the prudent investor standard of care—constructing a diversified portfolio for a client and evaluating the prudence of investments in the context of the portfolio ‘as a whole’ and as a part of an ‘overall investment strategy’ having risk and return objectives suited to that client.”
Fein lays out a case that the principles of the prudent investor rule in trust law as spelled out in the Uniform Prudent Investor Act (UPIA) should be the basis for a “best interest” fiduciary advice standard at the federal level.
She explains that under this standard, an investment adviser would be required to use “reasonable diligence” in taking into consideration the customer’s total financial circumstances in providing investment advice, suggesting that robo-advisors do not currently do this.
Fein notes that this “best interest” standard is already reflected in the suitability rule applicable to investment advisers and broker-dealers, but emphasizes that its “contours have never been expressly formulated, leaving uncertainty as to what the standard consists of or requires, particularly as to robo-advisors.”
Regulatory Morass
While the UPIA was approved by the National Conference of Commissioners on Uniform State Laws in 1994 and has been adopted by nearly all states, Fein emphasizes that it has never been adopted by securities regulators in the securities law framework and the DOL has also “virtually ignored the prudent investor rule in its regulation of ERISA fiduciaries.”
She points out that the Dodd-Frank Act enacted in 2010 directed the SEC to study whether regulatory action is needed to clarify the standards governing investment advice and authorized the agency to promulgate regulations adopting a uniform “best interest” standard, but it has not yet adopted such a standard. Fein also argues that the DOL’s “best interest” contract exemption adopted under the fiduciary rule “suffers from the same deficiency” as the SEC’s articulation of the “best interest” standard in that it fails to adequately define “best interest.”
According to Fein, the DOL standard mirrors the general trust law standard of care, as required by ERISA, but fails to incorporate the “prudent investor standard.” She writes that the focus of the DOL’s “best interest” exemption is mainly on the duty of loyalty and regulating conflicts of interest, rather than formulating a standard of care for the quality of investment advice given to retirement investors.
She adds that the DOL’s exemption at any rate does not establish a “best interest” standard for robo-advice as robo-advisors are expressly excluded from the “best interest contract” exemption’s requirements, unless they are “level fee fiduciaries.”
Fein contends that the lack of guidance from regulators on what it means to act in the client’s “best interest” and what the corresponding standard of care is can only result in customer confusion and investment advice that may not be in the client’s “best interest.”
Fiduciary Uncertainty
Moreover, she contends that, like other investment advisers, some robo-advisors are seeking to satisfy their duty of loyalty by disclosing and obtaining customer consent to conflicts of interest. She notes, however, that the extent to which they can waive their duty of care and remain “fiduciaries” is uncertain.
She point outs that attempts by robo-advisors to disclaim their fiduciary obligation to give portfolio-based investment advice and conduct due diligence on the customer’s total financial circumstances and needs have met with regulatory criticism. She notes that in 2016 the Massachusetts Securities Division (MSD) issued a policy statement on robo-advisors acknowledging that federal law allows investment advisers to modify their duty of loyalty with customer consent, but declares that significant disclaimers of the duty of care will not be allowed.
She further notes that the MSD questioned whether robo-advisors qualify as “fiduciaries” under its state investment adviser law. The 2016 policy statement concluded that fully automated robo-advisers, as currently structured, may be inherently unable to carry out the fiduciary obligations of a state-registered investment adviser.
Fein concludes her paper by listing a number of questions that regulators should address as they consider how and whether robo-advisors fit within the existing regulatory framework or some future framework embracing a uniform “best interest” standard.
