In an order sanctioning Wealthfront, the U.S. Securities and Exchange Commission concluded one of the first cases brought against a robo adviser since it issued guidance to the industry two years ago. Wealthfront agreed to settle charges brought by the SEC in connection with Wealthfront’s robo advising activities as well as the marketing of its services. The SEC’s order demonstrates the regulatory danger of not following through on representations made in whitepapers for services offered by fintech companies.
Tax-loss harvesting program
Wealthfront is a registered investment adviser that provides computer-driven investment advice to its clients. It is one of the largest so-called robo advisers. Investing and trading based on automatically generated investment advice can be attractive to many investors who perceive it to be safer, less biased, and more scientific. However, one of Wealthfront’s services, its tax-loss harvesting program (“TLH”), did not do everything it purported to.
The tax-loss harvesting program that Wealthfront ran from 2012 to mid-2016 was designed to identify losing positions in clients’ taxable stock portfolios. Once the losses were realized – that is, once the value-losing shares were sold – TLH would leverage those losses to offset taxable gains in other profitable trades. Wealthfront’s TLH worked as designed, but the service was not designed to prevent wash sales.
A wash sale occurs when an investor sells a stock and then repurchases it shortly after. The sale of stock at a loss would ordinarily create a tax event that would allow the owner to realize the loss. Repurchasing a stock that was sold within the past 30 days, though, can nullify the potential tax benefit of the original sale. Here, the Wealthfront system reportedly allowed clients to repurchase stock less than 30 days after it was sold. Clients inadvertently did so either on their own initiative or through portfolio rebalancing.
It should be noted that wash sales can occur for reasons other than tax avoidance, as part of an investment strategy. Wash sales of this sort are not per se illegal. The problem in Wealthfront’s case was that the sales simply did not generate the desired tax advantages that were Wealthfront’s stated strategy.
Wealthfront’s whitepaper specifically described the tax benefits of the tax-loss harvesting program. It stated, “Wealthfront monitors all the accounts it manages for each client to avoid any transactions that might trigger a wash sale.” But according to the SEC, Wealthfront’s software was simply not programmed to detect wash sales.
The SEC found that at least 31% of Wealthfront’s accounts that were enrolled in the tax-loss harvesting program experienced wash sales. This meant that those clients harvested fewer losses than they might have if the original sales had not been tainted with subsequent purchases. From the facts presented, is seems this was merely an oversight by the Company and not intended to circumvent taxes.
Still, the SEC brought charges, alleging violations of the Investment Advisers Act and Advisers Act rules. Specifically, the SEC charged that the disclosures in the whitepaper regarding the tax loss-harvesting program were not accurate and that Wealthfront did not have internal procedures designed to avoid making untrue statements.
Investment adviser marketing
Wealthfront also fell afoul of SEC regulations by using its Twitter feed improperly under the rules for investment advisers. For example, it re-tweeted testimonials from clients it had separately incentivized to promote Wealthfront, Wealthfront investors and Wealthfront employees without disclosing their relationships and financial incentives. Wealthfront also operated an “Affiliate Program” that paid bloggers to refer new clients without disclosing the arrangement to the clients. The bloggers were paid on the basis of the assets under management that the new clients placed with Wealthfront. The program brought in tens of millions of dollars in new assets. Wealthfront was cited for not having the proper policies and procedures in place to assure compliance, failing to follow the written procedures that it did have, and failing to follow the rules for using solicitors.
SEC fine and other penalties
Wealthfront agreed to censure and a fine of $250,000. It also agreed to inform all of its clients of the SEC’s order.
From the standpoint of building a product, the Wealthfront investigation is a reminder to anyone that wants to work in highly regulated markets that clear communication is imperative. Being one of the first to market is generally a good thing, but the time cost of a final review between compliance, coders, and marketing is worthwhile because it can help catch these slip-ups. If an SEC-regulated investment adviser promises clients a certain functionality in its software, the software must deliver. Required annual reviews of compliance procedures, with functionality tests in a test environment, will help companies find flaws and avoid unwanted actions from regulators.
From the standpoint of marketing, any investment adviser needs to understand the strict limitations put on them about advertising. It is not enough to disclaim control over a third party. If you create incentives for a third party to take action, you may experience the repercussions if that third party violates the rules. If you are taking the time to build an affiliate program, take the time to set up the rules and communicate them to your affiliates. Your shareholders and your wallet will thank you.