Compliance Lessons from Star Wars – Man Versus Machine

With the release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. (I saw the movie last night, but I will refrain from revealing anything other than it was terrific.) One of the central themes of the Star Wars franchise is man versus machine.

Luke turns off his targeting computer and relies on the Force during his photon torpedo run on the Death Star. Obi Wan Kenobi describes Darth Vader as more man than machine. It’s primitive Ewoks that crush the technology driven imperial forces at the Battle of Endor. It is when Vader once again finds his humanity that he lives up to the prophecy as the one that will bring balance to the Force.

The Star Wars does not say that technology is bad. How could that be with the beloved R2-D2 and C-3PO, the only characters to appear in all of the movies. In the prequels, it is the rise of robot army that leads to the deployment of the clone troopers and the beginning of the Empire.

Compliance professionals are trying to deal with its own robot uprising: robo-advisers. How to do you regulate a robot or an algorithm that goes bad? How do you create a compliance program from preventing them from going bad? (For a good book on the dangers of algorithms and big data, add Weapons of Math Destruction to your reading list.)

The Securities and Exchange Commission brought an action against AXA Rosenberg in 2011 for a failure in the computer code for its investment model. The SEC did not bring charges against the computer for the fault in the program. It brought it against the people who controlled the model. In this case, it was the fund managers who hid the problem. The computer had done what it was told and it was told to do the wrong thing.

Earlier this year, the SEC released guidance on Robo Advisers.

Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Investment Advisers Act. This presents some complications and uncertainties under the Act. Robo-advisers rely on algorithms and likely offers little, if any, human interaction with their advisory clients. The SEC guidance focused on three distinct areas identified by the SEC, with suggestions on how robo-advisers may address them:

1. The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
2. The obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advice; and
3. The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

Can a robo-adviser even meet the duty of care under the Investment Advisers Act? It’s clear what that duty of care is or how personalized the service needs to be. The biggest element is conflicts of interest. As with most conflicts, they can be dealt with by disclosures and robust policies and procedures.

Even with the concerns, robo-advisers are rising in assets under management. They are providing a good service at a low cost, allowing humans to oversee the process. Robots are helping humans succeed.