In a move to address the implications of integrating emerging technologies into the financial markets, the U.S. Securities and Exchange Commission (the “SEC”) recently proposed new rules aimed at regulating potential conflicts of interest created through the use of “covered technology”—a broad category that potentially includes everything from computational algorithms to artificial intelligence. If adopted, the proposed rules would impose a novel regulatory regime on broker-dealers and investment advisors geared towards neutralization or elimination of such conflicts, rather than relying on the traditional expectation of full and fair disclosure.
On July 26, 2023, the SEC voted 3–2 to propose new regulations (the “Proposed Rules”) dedicated to addressing conflict of interest issues related to utilizing certain technology to direct and enact investor decisions.1 According the SEC, the Proposed Rules “would apply to all broker-dealers and to all investment advisers registered, or required to be registered, with the [SEC],” and trigger “only when a firm uses covered technology in an investor interaction.”2
The Proposed Rules broadly define “covered technology” as “an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes.”3 Additionally, “investor interaction” is defined as “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”—a broad definition which the proposal itself acknowledges “would capture a firm’s correspondence, dissemination, or conveyance of information to or solicitation of investors, in any form.”4
If a regulated firm uses covered technology in investor interactions, the Proposed Rules would impose two sets of requirements.
First, the Conflicts Requirements would require the firm to:
(1) “evaluate any use or reasonably foreseeable potential use of a covered technology in any investor interaction to identify whether it involves a conflict of interest, including through testing the technology”5;
(2) “determine if any such conflict of interest results in an investor interaction that places the interest of the firm or an associated person ahead of investors’ interests”6; and
(3) “take a particular action—elimination or neutralization—to address any conflict of interest the firm determines in step two results in an investor interaction that places its or an associated person’s interest ahead of investors’ interests.”7 “The test for whether a firm has successfully eliminated or neutralized the effect of a conflict of interest is whether the interaction no longer places the interests of the firm ahead of the interests of investors.”8
Second, the Policies and Procedures Requirements would require regulated investment advisors to “adopt and implement written policies and procedures reasonably designed to prevent violations of” the Conflicts Requirements.9 Likewise, regulated broker-dealers would be required to “adopt, implement, and maintain written policies and procedures reasonably designed to achieve compliance with” the Conflicts Requirements.10 According to the proposal, these written policies and procedures would need to include “a written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction” and “a written description of the material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction.”11 The Proposed Rules also include amendments to existing recordkeeping requirements, which would require firms to maintain and preserve books and records related to their work pursuing compliance with the Conflicts Requirements.
In his accompanying public comments, SEC Chairman Gensler highlighted the need for this new regulation, in particular, to address the capacity for features driven by conflicted optimization algorithms to taint communications with investors—even when those interactions do not amount to providing investment advice or recommendations.12 In his view, predictive data analytics involving even something as subtle as color preferences used in digital “push” notifications or stock recommendations could lead to a problematic result where an investment platform uses that information to optimize communications with the investors for the purpose of benefitting its own revenues, profits, and interests rather than the individual investors.13 Commissioner Crenshaw likewise echoed concern over such communications, particularly in connection with the increasing retail investor participation in the securities markets, noting that conflicts of interest built into the technology “could lead firms to influence investors to use more services, increase transactions, or invest in risky investments that yield higher profits for the firm at the investor’s expense.”14
On the other hand, the Proposed Rules themselves also represent an unprecedented move by the SEC both in terms of the scope of the requirements and the burdens they will place on market participants. With respect to scope, dissenting Commissioner Uyeda noted that the Proposed Rules “encompass nearly everything.”15 Far beyond the predictive date analytics on which Chairman Gensler’s comments focused, Commissioner Pierce noted in her dissent that the broad, catch-all language used to define “covered technology” risks encompassing any modern analytical, technological, or computational tool that is used as some part of the process to provide investment services to investors.16 Likewise, the proposed definition of “investor interaction” carries the potential to cover “virtually any investor interaction that is not purely administrative.”17 The burdens that could be imposed by the Proposed Rules are similarly vast. Under the proposal, firms utilizing any modern technological tools may be required to investigate, periodically review, and document the specific steps taken to determine whether and how the use of the technology poses a risk of conflicts of interest.18 Further, and perhaps most significantly, the Proposed Rules’ requirement that firms “eliminate, or neutralize the effect of,”19 conflicts of interest imposes an unusually exacting standard—representing a major departure from the SEC’s traditional approach of simply requiring full and fair disclosure of all conflicts.
However, the Proposed Rules are not set in stone. The SEC requested public comments on the rules—which are due 60 days after the date of publication in the Federal Register.20 Registrants who stand to be regulated by the Proposed Rules are encouraged to work with counsel to consider submitting timely comment to the SEC.
Additionally, registrants should consider working with counsel and technological support to begin preparing a plan for compliance should the Proposed Rules be adopted in a substantially similar form. As currently proposed, it may not be enough that a firm has eliminated or neutralized conflicts of interest implicated by its use of covered technology. Rather, the Proposed Rules indicate that the firm must also maintain sufficient policies, procedures, and records to explain what potential conflicts its use of technology implicate and how those conflicts are being adequately addressed. Failure to sufficiently “show your work” with respect to these conflicts, if and when federal regulators feel compelled to inquire, could risk undermining government confidence into the firm’s compliance and drawing additional investigation or enforcement action.
1 Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, 88 Fed. Reg. 53,960 (proposed Aug. 9, 2023) (to be codified at 17 CFR Pts. 240, 275), https://www.govinfo.gov/content/pkg/FR-2023-08-09/pdf/2023-16377.pdf.
2 Id. at 53,972, § II(A)(1).
3 Id. § II(A)(1)(a).
4 Id. at 53,973, § II(A)(1)(b).
5 Id. at 53,976, § II(A)(2).
6 Id.
7 Id.
8 Id. at 53,986, § II(A)(2)(e).
9 Id. at 53,990, § II(A)(3).
10 Id.
11 Id. 53,991, § II(A)(3)(a).
12 Chairman Gary Gensler, Statement on Conflicts of Interest Related to Uses of Predictive Data Analytics, Sec. & Exch. Comm’n (July 26, 2023), https://www.sec.gov/news/statement/gensler-statement-predictive-data-analytics-072623.
13 See id.
14 Commissioner Caroline A. Crenshaw, Statement on Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Proposal, Sec. & Exch. Comm’n (July 26, 2023), https://www.sec.gov/news/statement/crenshaw-statement-predictive-data-analytics-072623.
15 Commissioner Mark T. Uyeda, Statement on the Proposals re: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, Sec. & Exch. Comm’n (July 26, 2023), https://www.sec.gov/news/statement/uyeda-statement-predictive-data-analytics-072623.
16 See Commissioner Hester M. Peirce, Through the Looking Glass: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Proposal, Sec. & Exch. Comm’n (July 26, 2023), https://www.sec.gov/news/statement/peirce-statement-predictive-data-analytics-072623#_ednref6 (“Given that broad language, spreadsheets, commonly used software, math formulas, statistical tools, and AI trained on all manner of datasets, could fall within the ambit of this rulemaking.”).
17 Supra note 15.
18 See supra note 14.
19 See Press Release, U.S. Securities and Exchange Commission, SEC Proposes New Requirements to Address Risks to Investors From Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers (July 26, 2023), https://www.sec.gov/news/press-release/2023-140.
20 Id.
