The SEC has proposed new rules to guard against conflicts of interest when investment firms use artificial intelligence, predictive analytics and other technologies in their dealings with retail investors.

The regulator proposed rules that would require broker-dealers and investment advisers to assess whether their use of certain technologies risks prioritizing their interests over their clients’ interests — and to avoid or ameliorate these kinds of conflicts.

“We live in an historic, transformational age with regard to predictive data analytics, and the use of artificial intelligence,” said SEC chair Gary Gensler in a release.

“Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests,” he said.

Since PDA-like technologies have the capacity to process data, scale outcomes from any analysis of data … this can also mean any transmission of conflicts of interest also happens at a great scale.

The SEC noted that financial services firms are using artificial intelligence and other tools in a multitude of ways, including responding to customer inquiries, automating back-office processes, quality control, risk management, client identification and monitoring, and portfolio management. The agency believes it is time to get in front of the conflicts of interest issue before this expansion furthers.

Comments on the proposal must be received on or before 60 days from its publication in the Federal Register, and an SEC Fact Sheet spells out what the agency means by “covered technology” as encompassed by the rule.

Predictive data analytics

As financial services firms increasingly adopt and use predictive data analytic (PDA) technologies, their use can bring potential benefits for firms and investors, such as more efficiently identifying investment opportunities that match an investor’s preferences, profile, and risk tolerances. But they also raise the potential for conflicts of interest and harm to investors, the SEC said.

Conflicts of interest can arise from the data the technology uses (including any investor data) and the inferences the technology makes (including in analyzing that data, other data, securities, or other assets, the agency said.

These issues may make identifying such conflicts in order to comply with federal securities laws more challenging. Specific effort is needed to fully understand the PDA-like technology used and to oversee conflicts created by or transmitted through use of such technology, the SEC said.

While the presence of conflicts of interest between firms and investors is not new, the SEC said, these PDA-like technologies may expose investors to unique risks, such as the risk of conflicts remaining unidentified and unaddressed.

And since PDA-like technologies often have the capacity to process data, scale outcomes from any analysis of data, and evolve at rapid rates – valuable in many circumstances – this can also mean any transmission of conflicts of interest also happens at a great scale.

Conflict of interest rules

To address these risks, the regulator is proposing rules that “build off existing legal standards” to require firms to determine whether their use of technologies in investor interactions involves a conflict of interest.

“Firms would be required to eliminate, or neutralize the effect of, any such conflicts, but firms would be permitted to employ tools that they believe would address these risks and that are specific to the particular technology they use,” the SEC said.

Firms would also be required to have written policies and procedures to ensure compliance with the rules, and to keep records related to these requirements.

The agency’s goal with this rule proposal pertaining to emerging technologies is to prevent such tools from undermining SEC-regulated firms’ legal obligation to act in the best interests of their clients.

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, the SEC said.

Under the proposed conflicts rules, a firm could “eliminate” a conflict of interest, for example, by completely eliminating the practice (whether through changes to 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 that determined covered technology used in investor interactions favored investments where its receipt of revenue sharing payments placed the firm’s interests ahead of investors’ interests could eliminate the conflict, among other methods, by ending revenue-sharing arrangements or by ensuring the technology does not consider investments that pay it revenue-sharing payments.

Best interest standard

The SEC’s Regulation Best Interest (Reg BI) under the Securities Exchange Act of 1934 establishes a “best interest” standard of conduct for broker-dealers when they make a recommendation to a retail customer of any securities transaction or investment strategy involving securities, including recommendations of types of accounts.

Both Reg BI and the investment adviser fiduciary standard for investment advisers are drawn from key fiduciary principles that include an obligation to act in the retail investor’s best interest and not to place their own interests ahead of the investor’s interest.

“It serves, perhaps unintentionally, as a mirror reflecting the Commission’s distorted thinking. In that mirror, you will see the Commission’s attitude toward technology, which is not neutral, but hostile.”

Hester M Peirce, SEC Commissioner

The Reg BI obligation is comprised of four component obligations – Care, Disclosure, Conflict of Interest, and Compliance. The SEC’s guidance documents on Reg BI highlight the importance for firms in having strict guardrails around investment recommendations with regard to conflicts of interest.

The agency’s goal with this latest rule proposal pertaining to emerging technologies is to prevent such tools from undermining SEC-regulated firms’ legal obligation to act in the best interests of their clients.

Whether one agrees that the proposed requirements are narrowly designed to accomplish this, or were even needed in the first place, is a matter of opinion, and comments from industry participants could lead to some changes in the text.

Dissenting commissioners

The Commission voted 3-2 to advance the proposal – voting along party lines, with the two Republican commissioners criticizing the proposal as being overly broad and potentially stifling innovation.  

SEC Commissioner Hester Peirce had a particularly straightforward rebuke for the agency in response to this proposed rulemaking, expressing her belief that the SEC is hostile to technology.

“The best thing I can say for this proposal is that it serves, perhaps unintentionally, as a mirror reflecting the Commission’s distorted thinking. In that mirror, you will see the Commission’s attitude toward technology, which is not neutral, but hostile. It reflects this Commission’s loss of faith in one of the pillars of our regulatory infrastructure: the power of disclosure and the corresponding belief that informed investors are able to think for themselves.

“Another glance through the looking glass will reveal the Commission’s continued degradation of a principles-based regulatory regime, replacing it once again with overly prescriptive rules. And a final look reveals the Commission’s indifference to operational feasibility.”

SEC Commissioner Mark Uyeda highlighted how wide a net the SEC has cast with the proposed rules. “The release in fact acknowledges that a spreadsheet that embeds financial calculations would be a ‘covered technology,’” he says.

“It also appears that a myriad of commonly-used tools could qualify 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. In this regard, the proposed standard for interacting with investors also suffers from vagueness: virtually any investor interaction that is not purely administrative appears to be covered,” he added.