Introduction

This alert highlights recent artificial intelligence (AI)-related enforcement actions that the Securities and Exchange Commission (SEC) has brought against investment advisers under the “Marketing Rule.”¹ The enforcement actions generally allege that the investment advisers inaccurately marketed how they used AI and other algorithms and data. Given the public interest in AI and similar technology, regulatory enforcement in this space is not surprising. This alert also highlights other Marketing Rule enforcement actions as well, including actions related to firms’ use of hypothetical performance metrics in their advertising.

Takeaways: As always, investment advisers must ensure consistency between their marketing and their actual business practices. The SEC is focusing on buzzworthy terms like AI, algorithmic investing, and big data. Differences between what advisers claim they are doing and what they actually are doing can create liability under the Marketing Rule.

Marketing Rule Background

For background, the SEC heavily regulates advertising by investment advisers. The term investment adviser traditionally includes registered investment advisers and private fund managers for long/short equity, private equity, and venture funds. Increasingly, however, investment advisers also may include quantitative and data-driven hedge funds, crypto hedge funds, and trading and other digital advisory apps, as well as certain non-discretionary research and analytics providers. Perhaps expectedly, these technology-oriented kinds of firms tend to incorporate AI and other algorithms into their investment processes. Therefore, to the extent they advertise their advisory services, the firms are subject to the Marketing Rule.

Although the SEC's principles of regulating advertising date back to the 1960s or earlier, the Marketing Rule was revamped in 2020. Since then, the Marketing Rule has been an area of focus for the SEC staff. Since the Marketing Rule’s adoption, there have been at least 10 (depending on how you keep score) notable regulatory developments:

The timeline of the Marketing Rule’s recent implementation coincides with the recent rise of AI in the investment advisory space.

Below, we dive into two recent SEC enforcement actions that offer an initial look at the Agency’s attitude with respect to AI-related advertising by investment advisers.

Enforcement Actions: “AI Washing”

On March 18, 2024, the SEC announced settled enforcement actions against fintech companies Delphia (USA) Inc. and Global Predictions, Inc. involving alleged "AI Washing." According to the SEC, these companies marketed that they used AI, data and other inputs in various ways on behalf of investors, but the fintechs' actual practices differed from what was advertised.

Delphia²

Delphia managed private investment funds and traded for more than 29,000 individual retail accounts. For retail client portfolios, Delphia used data and software in trading and other investment processes, including using algorithms to manage portfolios based upon clients' differing investment objectives and risk profiles. Delphia intended to use AI and machine learning to collect data from its clients, such as information gathered from social media and banking and credit card transactions, etc., and use the data as inputs into its algorithms. Delphia, however, never succeeded in using AI and machine learning to analyze client data. Yet, Delphia already advertised on its website and in a press release that it was using AI and machine learning to manage client funds, in addition to making the claim in regulatory filings (Form ADV). For example, Delphia problematically claimed:

• Client data was used in “a predictive algorithmic model” for the selection of “stocks, ETFs and options"; and
• "It uses machine learning to analyze the collective data shared by its members to make intelligent investment decisions.”

According to the SEC, Delphia never used AI or machine learning to analyze client data. The SEC alleged in a settled enforcement action that Delphia violated the Marketing Rule, among other things. Delphia agreed to pay $225,000 in civil monetary penalties, as well as a cease-and-desist order and censure.

Global Predictions³

Global Predictions provides investment tools and insights for retail clients. In particular, Global Predictions offers investment advisory services through PortfolioPilot, an interactive online platform that uses algorithms to make investment allocation recommendations. According to the SEC, Global Predictions advertised on its website, social media and elsewhere, that:

• Global Predictions' technology incorporated “[e]xpert AI-driven forecasts"; and
• Global Predictions was the “first regulated AI financial advisor.”

Unfortunately, according to the SEC, Global Predictions did not use AI as advertised. When pressed by the SEC, Global Predictions could not produce documents to substantiate its advertised use of AI. Additionally, the SEC alleged that Global Predictions inaccurately represented model portfolio performance, including by providing inaccurate depictions of the relevant time horizon and benchmark references in its advertising. Global Predictions settled charges that it violated the Marketing Rule, among others, and agreed to a cease-and-desist order, a censure, and a $175,000 civil money monetary penalty.

Takeaways

The Delphia and Global Predictions actions demonstrate that the SEC is focused on “AI washing” and overall Marketing Rule compliance.

On a closer look, these settled enforcement actions, although cast as about AI, really were garden variety inaccurate disclosure cases. For example, in Delphia, the adviser’s main violation was rooted in inaccuracies about its data usage. Delphia advertised that it used data – by incorporating certain client specific data into its algorithms – that it simply did not. Therefore, when advertising about AI, machine learning, other software improvements and data usage, advisers must accurately represent their intended and actual uses of technology and data. In other words, “if you claim to use AI in your investment processes, you need to ensure that your representations are not false or misleading.”⁴

Enforcement Actions: Hypothetical and Model Performance

Less than a month after the Delphia and Global Predictions settled enforcement actions, the SEC announced an enforcement action sweep against firms inappropriately advertising hypothetical performance and in certain instances, model performance in violation of the Marketing Rule.

Although what constitutes hypothetical performance under the Marketing Rule is broad, some examples include backtested, projected and model performance. Because hypothetical performance is theoretical, the SEC staff views it as potentially misleading. Consequently, the SEC expects advisers to accompany hypothetical performance with context, such as the assumptions made, the criteria used and any related risks and limitations.

In the sweep, the SEC concentrated on firms that had posted hypothetical performance metrics to their general, public-facing websites. The advertising of hypothetical performance in this way is fundamentally at odds with the goals of the Marketing Rule, which requires that firms advertise hypothetical performance only when it is relevant to the likely financial situation and investment objectives of the intended audience. By publicly posting hypothetical performance on their public-facing websites, the advisers did not tailor it or limit its distribution with the appropriate intent of making the advertising relevant to the likely financial situation and investment objectives of the intended audience. As such, these firms were censured by the SEC and ordered to pay civil monetary penalties.

The SEC also found violations in how one adviser depicted model performance on its factsheets. The adviser’s factsheets benchmarked model portfolio performance to the S&P 500. However, the factsheets showed the benchmark’s price returns rather than showing total returns with dividends reinvested, which was how the model portfolio performance was calculated. This adviser also had other performance advertising deficiencies, such as presenting gross performance without also presenting net performance.

Takeaways

A straightforward takeaway from these hypothetical and model performance settled enforcement actions is that firms should generally not advertise hypothetical performance publicly. Because the advertisements were available to mass audiences, the advisers could not form any expectations about their financial situation or investment objectives. The SEC observed in the Marketing Rule adopting release that, “We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation.”⁵

The settled enforcement actions also demonstrate the SEC’s under-the-hood focus on performance advertising, including on benchmark construction and comparison. This is consistent with the SEC’s 2024 Risk Alert on the Marketing Rule, in which the SEC identified the following examples of misleading information:

• Benchmark index comparisons that did not define the index or provide sufficient information to enable an investor to understand the basis for the comparisons or disclose that the benchmark performance did not include reinvestment of dividends; and
• Performance presentations including outdated market data (e.g., market data that was more than five years old); and investment products that were no longer available to clients and reflected lower investment costs than the products that actually were available to clients.

Conclusion

These settled enforcement actions—from hypothetical and model performance to “AI washing”—evidence the SEC’s focus on Marketing Rule compliance. The rise of AI and other novel technologies will likely increase this focus. Therefore, advisers must ensure that their marketing materials accurately describe their business practices when it comes to new technologies. Equally important, advisers must not neglect compliance with traditional Marketing Rule requirements, including ensuring that all performance-related metrics are tailored and distributed only to relevant audiences and that all statements made in advertisements are accurate.

¹ Investment Advisers Act of 1940 Rule 206(4)-1
²In the Matter of Delphia (USA) Inc., Inv. Adv. Act. Rel. No. 6573 (Mar. 18, 2024), available at https://www.sec.gov/files/litigation/admin/2024/ia-6573.pdf
³In the Matter of Global Predictions, Inc., Inv. Adv. Act Rel. No. 6574 (Mar. 18, 2024), available at https://www.sec.gov/files/litigation/admin/2024/ia-6574.pdf
⁴SEC Charges Two Investment Advisers with Making False and Misleading Statements About Their Use of Artificial Intelligence, U.S. Sec. & Exch. Comm’n (Mar. 18, 2024), available at https://www.sec.gov/news/press-release/2024-36
⁵ Investment Adviser Marketing, Release No. IA-5653 (December 22, 2020) (effective May 4, 2021) at 201

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