SEC takes on AI use by broker-dealers and investment advisers - Expansive coverage of types of technology and investor interaction in play

Eversheds Sutherland (US) LLP

In a Legal Alert issued before the SEC's open meeting, we posed five questions that our Investment Services team would be looking out for as part of this meeting. We now have answers to some of these questions.

Investment advisers and broker-dealers would be subject to far-reaching requirements that would capture many interactions with investors and advisory clients under rulemaking proposed by the Securities and Exchange Commission (SEC). On Wednesday, July 26, the SEC voted by a 3-2 margin to propose new and amended rules under the Securities Exchange Act of 1934 (Exchange Act) and the Investment Advisers Act of 1940 (Advisers Act) that capture adviser and broker-dealer use of “covered technologies” in investor interactions. The rule proposal paints a broad stroke. Covered technologies include algorithms, models, and a lot more. To the extent a covered technology is used in connection with a firm’s engagement with an investor or advisory client, a firm would be required to eliminate or neutralize all conflicts of interest in connection with use of the technology to the extent the conflict places the firm’s or its associated person’s interest ahead of investor and advisory client interests. The proposed rulemaking goes much further than what many had anticipated.

  1. Conflicts or Beyond? The SEC’s announced agenda for its meeting indicates that the rule will be focused on conflicts. Will more be in the mix? There is an established framework already in place for addressing broker-dealer and adviser conflicts, and anything the SEC wants to say about conflicts can be handled in a risk alert. Earlier in the year, Chair Gensler hinted that the SEC may tackle AI via rulemaking or other avenues. It now seems that Chair Gensler has settled on rulemaking. What’s really going on? Will the proposed rulemaking seek to establish comprehensive guardrails regarding the use of artificial intelligence (AI) by broker-dealers and advisers that go beyond conflict disclosures?
While the release is focused on conflicts, it reflects an approach that is unique to what the SEC calls “a firm’s use of analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.” Under the Advisers Act, the combination of an investment adviser’s care and loyalty obligations (which together comprise its fiduciary duty) require an adviser to serve the best interest of its client at all times and not subordinate its client’s interest to its own. With respect to an adviser’s duty of loyalty in particular, an adviser that has a conflict of interest affecting a client relationship may meet its obligation when it provides full and fair disclosure to its client of all material facts such that the client can provide informed consent. Under Reg BI’s General Obligation, a broker-dealer must act in the best interest of its retail customer at the time of a recommendation without placing its interest ahead of the retail customer. With respect to a broker-dealer’s Conflict of Interest Obligation under Reg BI in particular, a broker-dealer may meet its obligations with respect to a firm-level conflict associated with a recommendation when it establishes, maintains and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, the conflict. The SEC’s proposal regarding predictive data analytics would significantly depart from those principles.

The SEC has now decided that the scalability, complexity and opacity of these technologies means that disclosure is insufficient. Instead, if a conflict causes the interest of the firm or an associated person to be placed ahead of the interest of investors, the firm must eliminate or neutralize the conflict. The proposal also appears to prescribe a methodology for evaluating the technology’s use or reasonably foreseeable potential use in investor interactions, identifying conflicts, determining whether any of those conflicts causes the interest of the firm or an associated person to be placed ahead of the interest of investors, and if so, for neutralizing or eliminating those conflicts that would not be able to readily leverage firms’ existing conflict identification and mitigation processes. This issue is magnified because the SEC proposes to adopt a definition of “conflict of interest” unique to this rulemaking – a conflict would exist whenever a technology takes into consideration an interest of the broker or dealer or the investment adviser, or a natural person who is an associated person of the broker or dealer or the investment adviser.

  1. Is AI Broadly in Scope? The open meeting agenda indicates that the proposed rulemaking will address conflicts in the use of “predictive data analytics” by broker-dealers and investment advisers. Has the SEC set its sights on predictive data analytics, or will its focus be broader, capturing the use of AI and machine learning by firms? The SEC’s prior request for comment on digital engagement practices (DEPs) contained many related issues and asked for comments broadly, so will the SEC include all of those issues within the scope of “predictive data analytics”?

The SEC’s rule proposal includes a jargon laden-description of technologies, as it covers: “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 definition is quite expansive and, in the SEC’s own words, encompasses a broad swath of predictive data technologies, including artificial intelligence, machine or deep learning algorithms, neural networks, natural language processing and large language models (including generative pre-trained transformers). The SEC doesn’t stop there, as it includes other technologies such as uses of historical or real-time data, lookup tables or correlation matrices, along with spreadsheets with data analyzed to optimize asset allocation recommendations for investors.

The proposed rule further covers “design elements, features or communications that nudge, prompt, cue, solicit, or influence investment related behaviors or outcomes from investors.” This would include, for example, technologies used by firms to examine investor spending patterns, browsing histories and social media posts. The SEC is trying to cover a broad swath of technologies from simple interactive tools to more sophisticated applications that use predictive modeling techniques. The gating factor for the SEC is that the technology must predict, guide, forecast or direct investment-related behavior or outcomes. As a practical matter, the SEC is proposing to sweep many investment analysis tools, data analysis programs (including spreadsheets) and interactive investor communications into these proposed rules, and firms must carefully consider how this new viewpoint will affect their building, maintaining and using of such technology with investors. In sum, the proposed rule appears to cover any technology employed by a broker-dealer or adviser that analyzes data and then could potentially influence investors’ behaviors or outcomes.

  1. New Duties for Advisers and Broker-Dealers? Will the SEC use this rulemaking as an opportunity to re-visit Regulation Best Interest and an investment adviser’s fiduciary duty? Will the SEC use this as an opportunity to create new standards or stretch existing standards of care for broker-dealers and advisers (Reg BI and fiduciary duties) to the use of AI and machine learning activities and predictive data applications by investment advisers and broker-dealers? What type of AI-driven communications or digital prompts, when used by financial professionals, will now be subject to best interest and/or fiduciary standards?

As noted above, the proposed rules would apply broadly to any “investor interaction” using certain “covered technologies.” Broker-dealers and investment advisers would now need to determine whether those interactions create certain conflicts of interest that would need to be eliminated or neutralized. This represents a significant expansion of the applicable standard of care and duties for financial services firms when interacting with investors, even potential investors.

Although the SEC staff was clear that they did not view the rule proposal as “expanding” Reg BI (Commissioner Peirce even specifically asked whether this could be viewed as a “backdoor expansion” of Reg BI), the rule proposal certainly imposes an additional layer of regulation beyond Reg BI and the advisory fiduciary duty. For instance, Reg BI begins with an account or investment “recommendation,” and non-recommendation communications are not subject to Reg BI’s heightened standard of care. Likewise, an adviser’s fiduciary duty applies with respect to an advisory relationship with its clients. The rule proposal goes beyond both of these concepts, and imposes additional duties on any “investor interactions,” where such interactions may not be covered by Reg BI or an adviser’s fiduciary duties. While the SEC may not have explicitly proposed to revisit or amend Reg BI or the fiduciary duty, it proposed rules that would expand the scope of the type of “interactions” and activities that are now subject to SEC requirements.

The SEC did use this rulemaking as an opportunity to create new standards or requirements that would, if ultimately adopted, apply to AI, machine learning, and predictive data analytics. The definition of a “covered technology” is quite broad, and includes 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.”1 Remarks by SEC Commissioners during the open meeting publicly questioned whether the definition would include simple Microsoft Excel spreadsheets used by financial services firms. Given this broad definition, and statements by the SEC in the release proposing the rule, it seems clear the SEC is seriously considering imposing new standards for broker-dealer and investment adviser use of novel or algorithmic-driven analytical tools, such as AI, machine learning, and generative language models.2 

In terms of whether AI-driven communications or digital prompts would be subject to these new standards, the answer is simple: Yes. The definition of an “investor interaction” broadly captures any engagement or communication with an investor.3 The SEC’s release further clarifies that the rule proposals are meant to address digital prompts such as app-based push notifications and communications with a firm’s AI-programmed chatbots.4 If firms are engaging in these types of “interactions,” the rule proposal would require firms to review them to determine whether or not the interactions create conflicts that place the interests of the firm ahead of the investors’ interests – and if such conflicts are created, then firms must eliminate them or neutralize their effects.

  1. Changing Landscape for the Scope of Recommendations and Advice? What will the SEC say about what constitutes a broker-dealer recommendation and the provision of investment advice? These concepts seem to be the doors through which the SEC may seek to regulate AI and machine learning. In seeking information and comment in August 2021 regarding the use of DEPs by broker-dealers and investment advisers, the SEC asked various questions, including:
  • Do broker-dealers/advisers consider the observable impacts of DEPs when determining if they are making “recommendations” or providing investment advice? How does the fact that a DEP might impact the behavior of a statistically significant number of retail investors affect this determination?
  • What additions or modifications to existing regulations or new regulations or guidance might be warranted to address investor protection concerns identified in connection with the use by broker-dealers and investment advisers of DEPs.

We will be reviewing the SEC’s proposal to see how the agency addresses these questions.

One of the largest surprises with the proposed rule set is the SEC’s determination to apply them to a broker-dealer’s or investment adviser’s use of a covered technology in any “investor interaction,” which is defined 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 . . . ” While Regulation Best Interest and the fiduciary obligations of an adviser are centered on a broker-dealer’s recommendation of a security or investment strategy and an adviser’s provision of investment advice, the proposed rules would apply in the absence of a recommendation or the provision of investment advice. Any engagement or communication with an investor via a covered technology (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”) would trigger the rules. Under the proposed rules, it would not matter whether the investor interaction involves a recommendation or investment advice; the proposed rules would apply so long as the investor interaction involves a covered technology. This shift by the SEC from focusing on recommendations and the provision of investment advice to mere interaction with investors via certain technology is a seismic shift by the agency. Interacting with investors via covered technology would trigger the need for broker-dealers and SEC-registered investment advisers to identify conflicts of interest associated with the use of technology and determine whether the conflicts place the interest of the broker-dealer or investment adviser ahead of the interests of investors; if there are such conflicts, the broker-dealer or investment adviser would have to eliminate or neutralize the effect of these conflicts. In addition, the broker-dealer or investment adviser would have to adopt and implement various written policies and procedures to ensure compliance with the foregoing requirements and maintain certain books and records.
  1. Coordination? The Executive Branch and certain members of Congress have strongly indicated their interest in developing a federal-level approach to AI. Given the size and importance of the financial services industry, will the SEC indicate in its proposal a desire to coordinate with other agencies so that the financial services industry is not subject to standards more onerous than those imposed on AI developers and others, by other agencies?
In the open meeting, Commissioner Crenshaw noted the White House’s initiative, announced last week, to develop a federal-level approach to AI and the proposing release cites (in a footnote) to Congressional hearings that took place in 2021, which focused on uses of AI that can harm investors. However, the broader issue of possible SEC coordination with other branches of government and other government agencies in a consistent federal-level approach to AI, does not seem to have been a focus of this rulemaking. It may be an area that commenters nonetheless wish to explore.

The proposal awaits publication in the Federal Register. Upon publication there will be a 60-day comment period. One would expect significant industry comment regarding the scope of covered technology and the reach of the rule broadly to investor interactions. We are continuing to analyze the proposal and will be back with additional thoughts.


1 See Proposing Release at pages 234 and 241.
2 See Proposing Release at page 6.
3 See Proposing Release at pages 234 and 241.
4 See Proposing Release at page 11.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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