Summary

The U.S. Securities Exchange Commission (SEC) has proposed additional compliance obligations on broker-dealers and investment advisers and their use of artificial intelligence (AI), predictive analytics, and related technologies in customer interactions. The SEC proposal, if adopted, would require firms to evaluate their existing policies, eliminate or neutralize any conflicts, develop additional written policies and procedures, and maintain related records for potential examination.

The Upshot

• The proposed rule raises several issues, including whether it is a solution in search of a problem: In the investment context, it is not clear that any nefarious or self-serving deployment of technology cannot be policed through the SEC’s existing disclosure regime.
• The sole concrete example of AI manipulation by an investment adviser described in the proposed rule resulted in a disclosure-based enforcement action.
• Another issue is whether targeting certain technologies for more onerous compliance obligations will chill the use of those technologies, thereby depriving investors of powerful tools primarily designed to maximize investor value by better and more efficiently evaluating markets and trends and more quickly and efficiently delivering useful investment advice.
• The SEC vote to propose the rule was 3-2, so debate is expected. The aforementioned concerns and others will be deliberated through the comment period, as the SEC considers whether to adopt the proposed rule in its current form, a revised form, or not at all.

The Bottom Line

We will continue to monitor this proposal and will advise on developments and any actions broker-dealers and investment advisers need to take to prepare for and/or comply with any new rules.

Citing the “accelerated” deployment of predictive data analytics (PDA) by broker-dealers and investment advisers in serving investors, the SEC has issued a proposed rule aimed at addressing “the potential for conflicts of interest associated with the use of these technologies to cause harm to investors more broadly than before.”

The proposed rule targets artificial intelligence and machine learning and predictive data analytics used by broker-dealers and investment advisers to perform such functions as developing and sending personalized push notifications, offering computer-generated investment advice, delivering targeted digital advertising and communicating with investors through chatbots.

The SEC has based the proposed rule on its concern that broker-dealers and investment advisers may deploy these technologies, either intentionally or unintentionally, to optimize their own interests in a way that places their interests ahead of their investors. This concern stems from two observations about these technologies.

First, they largely depend on human determinations of relevant data sets from which the technologies function. Therefore, PDA and other similar technologies are susceptible to being tainted by incomplete, inaccurate, or biased data that can undermine its objectivity or accuracy. Consequently, depending on the data and assumptions supporting the technologies’ algorithms, they could produce interactions more designed to optimize the firms’ interests at the expense of their investors’ interests. Second, by automating formerly individual human-to-human interactions, broker-dealers and investment advisers can massively scale the dissemination of any tainted investment advice, greatly compounding the potential and actual investor harm. While fairly light on specifics, the proposed rule does describe a single instance where an investment adviser had pre-set its no-fee robo-adviser to hold certain percentages of customers’ accounts in cash because the adviser was guaranteed a certain amount of revenue at those specified levels. The SEC had charged this investment adviser with disclosure violations for failing to disclose its conflict of interest in setting the cash allocations.

Rather than continuing to pursue such actions under failure to disclose theories, the SEC is proposing a new body of rules imposing numerous affirmative requirements on broker-dealers and investment advisers.

First, the proposed rule would impose a look-back obligation requiring broker-dealers and investment advisers to evaluate their technology usage to determine whether their use of these technologies in investor interactions involves a conflict of interest. If so, they must take steps to eliminate or neutralize the effect of such conflicts. Next, the rule would require firms to develop and maintain written policies and procedures to remain in compliance with the rule. Third, firms will have to keep and maintain records concerning their compliance program for potential SEC examination.

The SEC vote to propose the rule was 3-2, so debate is expected. The aforementioned concerns and others will be deliberated through the comment period, as the SEC considers whether to adopt the proposed rule in its current form, a revised form, or not at all.

Public comment will remain open until 60 days after the date of publication of the proposing release in the Federal Register.