On July 26, 2023, the Securities and Exchange Commission (“SEC”), in a 3-2 vote, issued a release (the “Release”) containing proposed rules to address conflicts of interest associated with broker dealers’ and investment advisers’ use of predictive data analytics (“PDA”) technologies, and PDA-like technologies, when interacting with investors.[1] The SEC’s proposed rules amend Rules 151-2, 17a-3, and 17a-4 under the Securities Exchange Act of 1934, and Rules 211(h)(2)-4 and 204-2 under the Investment Advisers Act of 1940 (the “Proposed Rules”). Generally speaking, the Proposed Rules seek to neutralize or eliminate “conflicts of interest” associated with broker-dealers’ and investment advisers’ use of PDA and PDA-like technologies in connection with their investor interactions.

Comments on all aspects of the Proposed Rules should be submitted to the SEC on or before October 10, 2023. And, in reviewing the Proposed Rules, there is ample room for comment. The scope of the Proposed Rules is very broad. On the one hand, in making its Release, the SEC highlighted the need for its regulatory interference due to “the rapid acceleration of PDA-like technologies and their adoption in the investment industry [and] the additional challenges associated with identifying and addressing conflicts of interest resulting from the use of these new technologies, and the concerns relating to scalability.”[2] To that end, the scope of the Proposed Rules was likely tailored to be as broad as possible — to throw out a net to catch any up-and-coming PDA and PDA-like technologies, as well as those not yet developed or even conceived. On the other hand, the scope of the Proposed Rules is so broad as to cover virtually every form of technology, even those which are rudimentary in sophistication and have been traditionally employed by investment advisers and broker-dealers for decades, such as models, spreadsheets, and even calculators, all of which are already regulated by existing laws and regulations.

Evaluation of PDA Technologies for Potential Conflicts of Interest

According to the new rules, a “conflict of interest” exists “when a broker or dealer uses a covered technology that takes into consideration an interest of the broker or dealer, or a natural person who is an associated person of a broker or dealer.” Broker dealers and investment advisors would be required under the Proposed Rules to vet whether their use (or proposed use) of a “covered technology” in connection with their “investor interactions” would take into consideration the firm’s (or any of its associated persons’) interests, and, if so, take steps to neutralize or eliminate such a conflict of interest.

The definition of “covered technology” under the Proposed Rules is broadly defined 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.” The SEC designed the definition to “capture PDA-like technologies, such as AI, machine learning, or deep learning algorithms, neural networks, NLP, or large language models (including generative pre-trained transformers), as well as other technologies that make use of historical or real-time data, lookup tables, or correlation matrices among others.”[3]

“Investor interaction”, for purposes of the Proposed Rules, means “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; except 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.” In practice, this includes a firm’s use (or potential use) of push notifications, computer-generated investment advice, communicating with investors through non-human chatbots, and delivering investors targeted digital advertising, among other things.

If a firm determines, or reasonably should determine, that a “conflict of interest” exists or would arise due to the use of a “covered technology” in its “investor interactions”, then the firm must “determine whether the conflict of interest results in the interest of the firm or an associated person being placed ahead of investors’ interests”; if that determination is affirmative, the firm would be required to eliminate or neutralize such conflicts of interest, rather than simply handling the conflict by disclosure and consent or other methods of addressing conflicts of interest.[4] Unsurprisingly, the Proposed Rules do not provide a black-and-white approach toward eliminating and neutralizing conflicts of interest.[5] Instead, the SEC posits that “[t]he 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,” either by eliminating the practice altogether, or neutralizing the conflict by “biasing the output towards the interest of the firm or its associated persons.”[6] Some neutralization efforts may include, among other things, providing investor-friendly information that is counterbalancing and which information would not have otherwise been considered in order to counteract the consideration of a firm-favorable factors, or changing how firm-favoring data is analyzed or weighted.

Policies and Procedures; Record-Keeping

Firms utilizing PDA and PDA-like technologies would be required under the Proposed Rules to adopt, maintain and implement written policies and procedures that are reasonably tailored in order to achieve compliance with the Proposed Rules.[7] Broker dealers and investment advisers will also be required to maintain and preserve all books and records related to the requirements of the Proposed Rules.[8]

Criticisms

The Proposed Rules were not unanimously supported by the top brass at the SEC, and have drawn heavy criticism from two SEC Commissioners in particular. SEC Commissioner Mark Uyeda believes, among other things, that the “covered technology” is too broad, such that it “encompasses nearly everything.”[9] According to Commissioner Uyeda “a myriad of commonly-used tools could qualify [under the definition of ‘covered technology’,] such as a simple electronic calculator, or an application that analyzes an investor’s future retirement assets based on changing the asset allocation mix among stocks, bonds, and cash.”[10] Commissioner Uyeda also believes that the Proposed Rules layer on duplicative requirements and overall create a prescriptive approach to firms’ policies and procedures, “all of which can lead to a ‘check the box’ mentality at firms.” Id.

Similarly, SEC Commissioner Hester M. Peirce, warns investment advisers and broker-dealers: “Get out your abacuses, I guess.”[11] Like the criticisms put forth by Commissioner Uyeda, Commissioner Peirce also believes that the definition of “covered technology” goes too far, such that “spreadsheets, commonly used software, math formulas, statistical tools, and AI trained on all manner of datasets, could fall within the ambit of this rulemaking.”[12] Commissioner Peirce also believes that the SEC’s stance on disclosures being insufficient to combat the conflicts of interests posed by the use of PDA and PDA-like technologies deprives investors from making their own decisions. While Commissioner Peirce acknowledges that “some covered technologies may create unique challenges,” she emphasizes that investment advisers are already bound by their obligations as fiduciaries, and broker-dealers are bound by Regulation Best Interest and FINRA rules, indicating that the Proposed Rules are unnecessary in light of the existing regulatory regimes. Id.

Conclusion

The Proposed Rules are anticipated to generate fierce debate internally at the SEC and from industry groups. As evidenced by criticisms from Commissioners Uyeda and Peirce, these discussions will likely focus on the proposed definitions and the necessity thereof, given existing regulations. Just as we have witnessed with the rapid adoption and use of AI in our day-to-day lives, it will be necessary for the SEC to act quickly to prevent the implementation of out-of-date rules, while also tailoring the breadth of the Proposed Rules to prevent imposing unnecessarily duplicative requirements on investment advisers and broker-dealers and delicately balancing the concerns of industry groups so as to not stymie further adoption and implementation of revolutionary technologies.

[1] See Proposed Rule, Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, available at https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf.

[2] See id. at 26.

[3] Id. at 43-44.

[4] See id. at 27, 99.

[5] See id. at 101.

[6] Id. at 99-100

[7] This includes: (1) 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 any such technology’s material features, including any conflicts of interest associated therewith, prior to the implementation or material modification of such covered technology (which description must be updated periodically); (2) procedures for determining whether a conflict of interest that puts the firm’s interests in front of an investor’s exists; and (3) the steps necessary in order to eliminate or neutralize the conflict.

[8] Such written documentation would include: (1) the evaluation of any conflict of interest associated with the use or potential use by the firm or associated person of a covered technology in any investor interaction; (2) the determination of whether any identified conflict puts the interest of the firm, or associated person of the firm, ahead of the investors’ interests; (3) information evidencing how the conflict of interest has been eliminated or neutralized; (4) policies and procedures, including any written descriptions, adopted, implemented, and, with regard to broker-dealers, maintained; (5) records of any disclosures provided to investors regarding the firm’s use of covered technologies, including the date such disclosure was first provided or the date such disclosure was updated (as applicable); and (6) records of each instance in which a covered technology was altered, overridden, or disabled; the reason for such action; and the date thereof. Id. at 137-142.

[9] Carl Ayers, SEC Commissioner Uyeda believes PDA proposal goes too far, Regulatory Compliance Watch (Jul. 27, 2023), available at https://www.regcompliancewatch.com/sec-commissioner-uyeda-believes-pda-proposal-goes-too-far/.

[10] Id.

[11] Commissioner Hester M. Peirce, Statement, Through the Looking Glass: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Proposal, (Jul. 26, 2023), available at https://www.sec.gov/news/statement/peirce-statement-predictive-data-analytics-072623.

[12] See id.

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