On July 26, 2023, the Securities and Exchange Commission (SEC) proposed new rules (the Proposed Rules) under the Investment Advisers Act of 1940 (Advisers Act) and the Securities Exchange Act of 1934 (Exchange Act) to address conflicts of interest associated with the use of predictive data analytics (PDA) by registered investment advisers and broker-dealers. As noted in the proposing release (the Proposal), the Proposed Rules are designed to address the SEC’s concern that “the use of certain PDA-like technologies in an investor interaction that places the firm’s interests ahead of the investors’ interests involves a conflict of interest that must be eliminated or its effects neutralized.”
“Covered technology” as defined in the Proposed Rules would mean various technological methods or processes, including algorithms and models, that “optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” As such, the specific type of technological medium is not the focus of the Proposed Rules, but rather whether the technology could affect investor behavior. In the accompanying Proposal, the SEC stated that this proposed definition is intended to capture a broad range of actions by firms using technology, in addition to providing, in the case of investment advisers, investment advice and, in the case of broker-dealers, recommendations, including “design elements, features, or communications that nudge, prompt, cue, solicit or influence investment-related behaviors or outcomes from investors.”
For investment advisers, the Proposed Rules broadly define “investor” to include (i) clients (prospective or current) that receive investment advisory services from an investment adviser and (ii) investors (prospective and current) in a pooled investment vehicle advised by an investment adviser. The SEC specifies in the Proposal that the same investor protection concerns are presented from the use of PDA-like technology by fund sponsors, such as algorithmically targeted advertisements that are designed to solicit investors in a fund or algorithmically designed investment strategies in funds, as advisers that use the same or similar technology to target or advise more traditional advisory clients.
In contrast, for broker-dealers, the Proposed Rules limit the definition of “investor” to natural persons or their legal representatives seeking or receiving services primarily for personal, family, or household purposes from the broker-dealer. This is, of course, consistent with the SEC’s definition of “retail customer” in Regulation Best Interest, which, similarly to the Proposed Rules, seeks (among other things) to prevent conflicts in broker-dealers’ recommendations to their retail customers.
To fall within the Proposed Rules, a covered technology must be used in an “investor interaction.” The Proposed Rules define “investor interaction,” in relevant part, as “engaging or communicating with an investor, including by exercising discretion with respect to an investor’s account; providing information to an investor; or soliciting an investor.” The Proposal notes that the term does not apply to interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support. Still, when firms use generative artificial intelligence tools such as chatbots, they should ensure that the tool’s output is limited to such ministerial communications, as more all-encompassing tools may veer into the territory of “investor interactions” (or veer outside the territory of investments entirely).
The concept of “investor interaction” is notably broader than the concept of a “recommendation” in Regulation Best Interest, which the SEC characterized in the adopting release for Regulation Best Interest as a communication that can reasonably be viewed as a “call to action” and could reasonably influence an investor to trade a particular security or group of securities.Broker-dealers’ suitability obligations under FINRA Rule 2111 are also triggered when a broker-dealer makes a “recommendation.” The introduction of the concept “investor interaction” as a trigger for broker-dealer customer obligations under the Proposed Rules thus would constitute a significant change to the existing paradigm. Indeed, the SEC acknowledges this difference in the Proposal and states that interactions that may not be deemed “recommendations” — such as providing or making available research reports, news, and quotes, or sending update emails based on investor preferences — can qualify as “investor interactions.” The SEC further states in the Proposal that broker-dealers would be subject to both Regulation Best Interest and the Proposed Rules when using covered technology to make a recommendation to a retail customer, but would only be subject to the Proposed Rules when using covered technology to engage in an investor interaction with the retail customer that does not amount to a recommendation.
In remarks that preceded the release of the Proposal, SEC Chair Gary Gensler previewed the scope of conflicts that would be captured by the Proposal while also noting that firms’ use of technology could “heighten financial fragility” and, therefore, require regulatory attention.SEC Chair Gary Gensler, “Isaac Newton to AI” Remarks before the National Press Club, Sec. & Exchange Comm’n (July 17, 2023), available at https://www.sec.gov/news/speech/gensler-isaac-newton-ai-remarks-07-17-2023. (Chair Gensler stated “as advisers and brokers incorporate these technologies in their services, the advice and recommendations they offer — whether or not based on AI — must be in the best interests of the clients and retail customer and not place their interests ahead of investors’ interests… If the optimization function in the AI system is taking the interest of the platform into consideration as well as the interest of the customer, this can lead to conflicts of interest. In finance, conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. That’s why I’ve asked SEC staff to make recommendations for rule proposals for the Commission’s consideration regarding how best to address such potential conflicts across the range of investor interactions.”) Under the Proposed Rules, a conflict of interest exists if a firm “uses a covered technology that takes into consideration an interest” of the firm or its associated persons. Moreover, the SEC explained that when covered technology takes into account the firm’s profits or revenues, a conflict of interest would arise under the Proposal regardless of whether the technology places the firm’s interests ahead of investors’ interests. As one example of a conflict of interest covered by the Proposed Rules, the SEC noted that “if a firm deploys a covered technology to interact with an investor, such as by displaying selected or ranked options for retirement accounts that takes into account the amount of revenue the firm would receive, the firm’s use of the covered technology would involve a conflict of interest regardless of whether the firm places its interest ahead of investors’ interests.”
First, the Proposed Rules would require a firm to evaluate any use or reasonably foreseeable potential use by the firm (or its associated persons) of a covered technology in any investor interaction, and to identify any conflict of interest associated with that use or potential use. Second, the firm would be required to determine whether any such conflict of interest places or results in placing the firm’s or its associated person’s interest ahead of the interest of investors. Third, the firm would have to eliminate, or neutralize the effect of, those conflicts of interest that place the firm’s or its associated person’s interest ahead of the interest of investors.
As part of the identification and evaluation of conflicts, the firm would be required to test each covered technology used in investor interactions prior to the implementation of, or material modification to, the technology and to continue to test the technology periodically to determine whether the use of the technology is associated with a conflict of interest. The Proposed Rules do not mandate a specific means by which a firm is required to evaluate its particular use or potential use of a covered technology or identify a conflict of interest associated with that use or potential use. Instead, the firm would be permitted to tailor its approach based on its particular use of covered technology and adopt different approaches for different covered technologies, provided that its evaluation approach is sufficiently designed to identify the conflicts of interest that are associated with how the covered technology has historically operated and how it could operate once deployed by the firm.
The SEC notes that it may be difficult for firms to test certain types of PDA technologies, especially more complex models that are trained on vast amounts of data, as well as conduct necessary internal reviews of third-party PDA tools. The SEC adds that the lack of ability to test such models would not absolve firms of the requirement to comply with the Proposed Rule, but also asks whether complex models trained on vast amounts of data (such as the entire internet) should be excluded if the firm believes that the training data considers the interests of the firm.The Proposed Rules do occasionally conflate training data as opposed to input data or queries used to evaluate and make specific decisions. For example, while a PDA’s training data could include products where the firm has a revenue share, as long as the investment types actually considered by the PDA model did not include such products the conflict would appear to have been eliminated. While the SEC suggests that explainability features be built into such models, it acknowledges that this may be impossible to do. In such cases, the SEC recommends allowing only limited personnel to access such tools in limited circumstances.
Under the Proposed Rules, a firm could eliminate a conflict of interest by eliminating the practice entirely (by, for example, changing the algorithm, technology, or otherwise) that results in a conflict of interest or removing the firm’s interest from the information considered by the covered technology. For example, a firm could eliminate a conflict by ending revenue-sharing arrangements or by ensuring that its covered technologies do not consider investments that pay the firm revenue sharing payments or higher commissions. Alternatively, if the conflict cannot be eliminated, the firm could seek to neutralize the conflict by rendering consideration of the firm-favorable information subordinate to investors’ interests in order to render the conflict harmless. This could be achieved by either applying a “counterweight” (such as considering additional investor-favorable information that would not have otherwise been considered in order to counteract consideration of a firm-favorable factor) or by changing how the information is analyzed or weighted so the technology always holistically weights other facts as more important to preclude biased data from affecting the outcome. However, the SEC adds that in some cases, PDA technologies must only be used by personnel who are familiar with applicable conflicts of interest requirements and that all output should be reviewed by such personnel.
The Proposed Rules would require a firm that uses covered technology in any investor interaction to adopt and implement written policies and procedures reasonably designed to achieve compliance with the Proposed Rules, including written descriptions of the processes for evaluating covered technology for conflicts of interest and for determining how to eliminate or neutralize the effect of any such conflicts. The Proposed Rules would also require the policies and procedures to include a review and written documentation of such review, no less frequently than annually, of the adequacy of the policies and procedures and written descriptions established pursuant to the policies and procedures requirement and the effectiveness of their implementation.
The SEC also proposes to amend the recordkeeping rule for investment advisers and broker-dealers to require firms to make and keep books and records related to the requirements of the Proposed Rules, including each step in the process of identifying and eliminating or neutralizing the effect of conflicts of interest associated with the use of covered technology in investor interactions. Given the amount of testing that may be required for certain types of PDA technologies, this could result in a significant recordkeeping burden.
While the Proposal generally indicates the SEC’s interest in technology and desire to learn how firms’ use of technology could be helpful or harmful to investors, the adoption of the Proposed Rules would substantially change the regulatory landscape for both investment advisers and broker-dealers.
With respect to investment advisers, the Proposal is the latest example of a continual shift by the SEC toward a framework of more prescriptive rules under the Advisers Act as opposed to the principles-based framework that has existed for decades. It is already well-understood, for example, that an adviser owes a general fiduciary duty to its clients and, as such, may not place its own interests ahead of the interests of its clients, including through the use of technology.
At the same time, with respect to broker-dealers, the Proposal signals the SEC’s desire to impose principles-based conflicts of interest standards (in addition to the existing rules) on broker-dealers within the realm of technology like those imposed by Regulation Best Interest, which was adopted in 2020. However, the Proposed Rules for broker-dealers are broader than Regulation Best Interest, since they are triggered by any “investor interaction” rather than a “recommendation.”
Finally, for both investment advisers and broker-dealers, the Proposal is a move away from regulatory frameworks that permit mitigation of conflicts of interest through disclosure. With respect to investment advisers, in its 2019 “Interpretation Regarding Standard of Conduct for Investment Advisers,” the SEC stated that “an adviser must eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.” Similarly, under the Exchange Act, Regulation Best Interest states that broker-dealers must disclose or eliminate conflicts of interest when making recommendations to retail customers. The proposed PDA rules, however, would not permit mitigation of conflicts through disclosure. As the SEC stated in the Proposal, “disclosure alone could be insufficient to adequately address the conflicts of interest” associated with the use of covered technology in investor interactions.
More broadly, the Proposed Rules join a substantial slate of recently adopted and proposed Advisers Act and Exchange Act rules that are expected to significantly increase compliance burdens and costs for registered firms, including: