The term “robo-adviser” has become synonymous with a provider of automated, low-cost, investment advisory services through user-friendly web-based (and increasingly, mobile) channels. These digital advice platforms are intended to service the future generation of tech-savvy retail investors, and with its gaining popularity, has become a positive disruptor in the asset management community. Its surge toward mass adoption (particularly in the U.S.) has made it a prime example of how industry can occasionally outpace regulation.
On September 24, 2015, the Canadian Securities Administrators (CSA) published CSA Staff Notice 31-342: Guidance for Portfolio Managers Regarding Online Advice (CSA Notice 31-342), which provides guidance regarding how regulators expect the online advice industry will grow.
CSA notice 31-342 expands on the guidance previously provided by the Ontario Securities Commission (OSC), but in general does not materially change its overall import. In September 2014, the OSC stated in OSC Staff Notice 33-745: Annual Summary Report for Dealers, Advisers and Investment Fund Managers (OSC Notice 33-745) that they were seeing increased interest in advisers providing advice through online platforms, but noted that the know-your-client (KYC) and suitability obligations of portfolio managers (PMs) that provide services through online platforms remain the same as for any other PM. A PM’s obligations under securities law do not change as a result of the delivery method of providing services to a client.
OSC Notice 33-745 also provided some commentary on what would be expected of a registered advising representative (AR) in the context of an online advisory business:
“The online advice model that we have considered acceptable involves an interactive website used to collect KYC information, which will be reviewed by a registered AR. The AR will communicate with the client by telephone, video link, email or internet chats. The AR must ensure that sufficient KYC information has been gathered to support the PM firm’s obligation to make suitability determinations for the client.
Each of the firms that we have registered to provide online advice operates on a discretionary managed account basis, using portfolios of unleveraged exchange traded funds (ETFs) or low cost mutual funds. In most cases, these are model portfolios which are selected for a client based on a profile generated by the KYC collection process. An AR will review and approve the suitability of the portfolio for the client. The client’s account is periodically rebalanced to the parameters set for their portfolio.
This is not the so-called “robo-advice” model seen in the United States, where online advice has seen rapid growth in the last few years. The online advisers operating in Ontario are offering hybrid services that utilize an online platform for the efficiencies it offers, while ARs remain actively involved in decision making.”
In CSA Notice 31-342, the CSA reconfirms that there is no separate process for applicants who wish to become registered to conduct operations using an online platform, and no special registration exemptions. The registration and ongoing conduct requirements applicable to advisers under National Instrument 31-103: Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) are “technology neutral.” As a result of changes announced in OSC Notice 33-745 though, the OSC requires applicants for registration to meet with registration staff and provide, among other things, detailed business plans. Where such plans indicate that an applicant intends to provide online advice, the CSA staff will focus on the applicant’s KYC process (both the initial collection and review of client information and any regular information updates), client information system security and integrity, money laundering prevention, and the identification and assignment of model portfolios as being suitable to particular client profiles.
Online advisers should expect a compliance review within two years of their registration date.
The U.S. model of robo-advice does not require any human interaction, making it highly scalable due to the absence of involvement by ARs. Assuming adequate technology and systems, this allows customized investment advice to be provided to investors at a very low cost, while still providing a reasonable profit margin for the firms. In contrast, Canadian regulators will, at a minimum, continue to require some level of minimum human interaction between the investor and qualified ARs. Whether buying or building a digital platform in Canada, the expectation remains that as the number of clients grows so must the number of ARs in order to adequately service clients in fulfilment of their regulatory obligations. The extent to which this limitation may be reflected in Canadian digital advisers charging higher fees, as is sometimes typical in the Canadian asset management market, has yet to be seen. Nevertheless, early planning in building out the employee structure of a digital online-advice platform may prove to be central to finding long-term success.
All registerable functions (primarily, investment selection pursuant to discretionary authority granted by a client or the delivery of investment recommendations or asset allocation models tailored to a client’s needs) must be performed by an AR (as used herein, the term includes associate advising representatives), but the regulators also expect the AR to perform additional functions to support these registerable functions. A digital adviser must take reasonable steps to establish the identity of each client as well as his or her investment needs and objectives, financial circumstances and risk tolerances (KYC Requirement). Additional information must be obtained to fulfil requirements under applicable Canadian anti-money laundering and terrorist financing legislation. Digital advisers are also expected to take reasonable steps to ensure that before a purchase or sale recommendation is made to a client, or before a discretionary investment management decision is made to buy or sell a security for a client’s portfolio, that the security proposed to be bought or sold is a suitable one for the client (Suitability Requirement), except to the extent a client is a “permitted client” within the definition of that term in NI 31-103, which has waived a suitability review.
The OSC initially discussed the extent to which the KYC and Suitability Requirements must be performed by an AR in OSC Staff Notice 33-734: 2010 Compliance and Registrant Regulation Branch Annual Report, and then, because it did not appear as if the industry was paying sufficient attention to such notice, in OSC Staff Notice 33-736: 2011 Annual Summary Report for Dealers, Advisers and Investment Fund Managers? (OSC Notice 33-736). Notice 33-736 contains the following discussion:
“In last year's report, we highlighted our concern that some portfolio managers delegate their know your client (KYC) and suitability obligations to other parties. Since we continued to identify this practice during this year's reviews, we are re-emphasizing this deficiency again, in addition to taking appropriate regulatory action when identified.
Some portfolio managers enter into arrangements with mutual fund dealing representatives (and their firms) or financial planners, for the referral of clients to the portfolio manager for a managed account. We have concerns when the portfolio manager does not have a meaningful discussion with each referred client to fully understand their investment needs and objectives, financial circumstances and risk tolerance. We have noted that some portfolio managers are relying on the mutual fund dealing representative or financial planner to perform these duties, along with assisting the client in completing the portfolio manager's managed account agreement, and updating KYC information. We have also seen cases where an individual working for the portfolio manager firm is performing these duties but is not registered as an advising or associate advising representative. These practices are contrary to securities law, as registrants may not delegate their KYC and suitability obligations to other parties. Furthermore, portfolio managers cannot adequately perform their suitability obligations if they do not have complete and accurate KYC information for their clients.
Portfolio managers are required by sections 13.2 and 13.3 of NI 31-103 to establish the identity of each of their clients and to ensure they have sufficient and current KYC information for each client (including the client's investment needs and objectives, financial circumstances, and risk tolerance) so that they can assess the suitability of each trade made for their clients. Furthermore, mutual fund dealing representatives, financial planners, and non-registered individuals at the portfolio manager firm do not have the proficiency or registration required to perform these activities for a managed account. Referral arrangements must not allow an individual or firm to perform registerable activities unless the individual or firm is appropriately registered.”
In OSC Notice 33-736, there are some suggested best practices given to advisers seeking to satisfy their KYC and suitability obligations:
- Have a meaningful discussion with each client to understand their KYC information before managing their portfolio (preferably by meeting the client in-person, but in some cases telephone discussions may be appropriate, for example when the client does not reside near the PM's offices)
- Explain the firm’s investment process and strategy and other relationship information to the client
- Assist the client in completing necessary forms and agreements, such as an investment policy statement and managed account agreement
- Regularly communicate (on at least an annual basis) the investment holdings and performance of the managed account to the client
- Keep each client’s KYC information up-to-date by immediately contacting the client when they know that their circumstances have changed, and periodically contacting the client (at least annually) to assess if their circumstances have changed
Accordingly, the role that non-registered employees can play in this regard would be quite limited, requiring firms to add expensive ARs as their client base grows.
LEAVING ROOM FOR INNOVATION?
What is new in CSA Notice 31-342 from previous regulatory pronouncements is the suggestion that it might be possible for an AR not to have to initiate contact with every prospective client, but simply be available to respond to every client-initiated request for contact with an AR. Assuming a digital adviser is able to satisfy the CSA that it has adequate policies, safety measures and tickler systems in place to ensure that an AR will contact clients whenever it is appropriate to do so (no guidance is given as to what the appropriate circumstances might be in this regard), then the CSA may permit registration on this basis.
Registration might, however, be as a restricted dealer in these circumstances, with terms and conditions imposed on the registration to restrict the types of investment products that could be used for clients to those of a relatively simple nature. Given that online advisers operating under a structure where an AR will contact every prospective client are said to be limited to using “uncomplicated asset allocation models, made up of relatively basic ETFs or mutual funds”, it is unclear what types of securities beyond Guaranteed Investment Certificates might be permitted in this regard.
Prospective digital advisers are advised to contact their counsel and the CSA at an early stage if their business model is in a manner materially different from that contemplated in CSA Notice 31-342. The scope for innovation is uncertain at this time as a number of regulatory initiatives are currently in progress. For example, depending on the full impact of the Client Relationship Model - Phase 2 or a potential ban on embedded commissions, both of which may force investors to seek out cheaper alternatives to investing or obtaining financial advice, then digital advisers may well be looked on with greater favour by the CSA, and this may encourage more accommodating rules to be developed that may bring the industry back in-line with the U.S. “hands-off” robo-adviser approach.