SEC Proposes New Regulatory Framework for Use of AI by Broker-Dealers and Investment Advisers

• The SEC has proposed new rules designed to regulate potential conflicts of interest associated with broker-dealers’ and investment advisers’ use of certain AI-related technologies in their interactions with investors.
• The proposed rules would significantly expand the existing Federal fiduciary duty framework for broker-dealers and investment advisers by shifting focus to the elimination and neutralization of conflicts of interest instead of the traditional disclosure-centered approach to conflicts of interest.
• If adopted, the proposed rules would require firms to establish extensive governance and testing regimes and detailed policies and procedures with respect to covered technologies.

The Securities Exchange Commission proposed new rules on July 26, 2023, that if adopted would regulate conflicts of interest associated with broker-dealers’ and investment advisers’ use of predictive data analytics (PDA) and artificial intelligence (AI) technologies, including machine learning, deep learning, neural networks, natural language processing and generative pre-trained transformers (GPT), among other technologies that make use of historical or real-time data, lookup tables or correlation matrices. Proposed Rule 15l-2 under the Securities Exchange Act of 1934, as amended, and proposed Rule 211(h)(2)-4 under the Investment Advisers Act of 1940, as amended (collectively, the proposed conflicts rules), would apply where such PDA and AI technologies are used in “investor interactions.” Investor interactions for purposes of the proposed rules would consist of broker-dealers, investment advisers or associated natural persons (collectively, firms) engaging or communicating with certain investors (e.g., exercising discretion with respect to an account, providing information to an investor, or soliciting an investor), where such “investors” include a broker-dealer’s retail customers and prospective customers and an adviser’s clients and prospective clients, as well as investors and prospective investors in a private fund managed by the adviser.

The proposed conflicts rules would require firms to develop policies and procedures to: (1) identify and evaluate any conflict of interest resulting from the firm’s use or foreseeable use of a covered technology in an investor interaction prior to using such technology and periodically thereafter; (2) determine if any “conflict of interest” places or results in placing the interests of the firm ahead of investors; and (3) eliminate or neutralize promptly the effects of such conflicts of interest (with certain narrow exceptions).¹ The SEC also proposed related amendments to the Exchange Act and Advisers Act recordkeeping rules. The proposal is notable in that the SEC largely cites theoretical or potential (rather than actual or current) uses of PDA and AI technologies as the basis for a major rulemaking, in what appears to be an attempt to shape the development of these technologies and how the industry uses them.

The proposed rules would sweep much more broadly than the current Federal fiduciary duty framework. The proposed conflicts rules rely on broad definitions of “conflict of interest” (e.g., a broker-dealer that receives transaction-based fees has an incentive to maximize the frequency of a customer’s transactions and an adviser that earns asset-based fees has an incentive to persuade an investor to move assets into his or her account). Even more importantly, the proposed requirement to “eliminate or neutralize” covered conflicts of interest would represent a significant departure from the SEC’s standard approach toward addressing conflicts of interest, which is that full disclosure and informed consent generally are sufficient. In the release, the SEC stated that it believes that disclosure and consent are insufficient to address the complexity, opacity, scalability and speed of PDA and AI technologies in investor interactions. The SEC claims to have this authority under Section 15(l) of the Exchange Act and Section 211(h) of the Advisers Act, which were added by the Dodd-Frank Wall Street Reform and Consumer Protection Act and authorize the SEC to “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the [SEC] deems contrary to the public interest and the protection of investors.” Notably, the SEC did not rely on Section 206 of the Advisers Act, its traditional basis for fiduciary duty-related regulation. The SEC asserted a similarly broad interpretation of Section 211(h) in the recent private fund adviser rulemaking.² In response to the private fund adviser rulemaking, a coalition of trade associations has filed a petition challenging the SEC for overstepping its statutory authority in adopting the new private fund rules.³ The proposed conflicts rules follow an August 2021 request for information and public comment on the use of digital engagement practices by broker-dealers and investment advisers.⁴

Release

Scope and Key Terms

The expansive, potential breadth and scope of the application of the proposed conflicts rules turn on key terms, including:

• Covered technology, which means “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.” As proposed, the SEC seeks to broadly define the scope of covered technologies, in part to address technologies that are likely to develop in the future. The release states that “design elements, features, or communications that nudge, prompt, cue, solicit, or influence investment-related behaviors or outcomes from investors” are covered technologies. The release provides additional examples of such covered technologies (e.g., technologies that analyze investor behavior, algorithmic-based tools, conditional auto-encoder model that predicts stock returns, and the model in “a spreadsheet that implements financial modeling tools or calculations, such as correlation matrices, algorithms, or other computational functions, to reflect historical correlations between economic business cycles and the market returns of certain asset classes in order to optimize asset allocation recommendations to investors . . . because the use of such financial modeling tool is directly intended to guide investment-related behavior”). The release also provides examples that would not be a covered technology, including a technology that is “designed purely to inform investors,” such as a website with account balances and past performance or a chatbot assisting investors with basic customer service.
• Conflict of interest, which means a firm’s use of “a covered technology that takes into consideration an interest” of the firm.
• Investor, which is proposed to be defined in proposed Exchange Act Rule 15l-2 the same as “retail customers” in Regulation Best Interest, but in proposed Advisers Act Rule 211 as an adviser’s “prospective or current client” or an adviser’s pooled investment vehicle’s “prospective or current investor.”
• Investor interaction, which 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 the release, the SEC explains that “use” of a covered technology includes both an investor’s direct use of a covered technology (e.g., behavioral feature on a digital platform that prompts an investor behavior) and indirect use of a covered technology by firm personnel that results in an investor interaction (e.g., a broker uses a covered technology to generate a recommendation that results in an email from a broker recommending to an investor an investment product. According to the release, a “use” does not include technologies used by the firm for metrics (e.g., intra-day liquidity needs, working capital requirements), its own assets, or to enhance ministerial or back-office operations.

For broker-dealers, the SEC noted that the definition of investor interaction would include interactions that have historically been viewed as outside the scope of “recommendations.” For example, the proposed definition would include technologies that collect investor data to provide research reports, alerts, and news to which investors subscribe and broker-dealers disseminate. Although the SEC concedes that these activities do not rise to the level of “recommendations,” it asserts that the interactions are designed to or have the effect of directing investor-related action.

The proposed conflicts rules would be even more broadly applicable to the conduct of investment advisers, for several reasons. First, the definition of “investors” includes all current and prospective clients, as well as pooled investment vehicle investors, whereas the definition applicable to broker-dealers is aligned with the term “retail investor” in Form CRS. For example, the proposal currently defines a pooled investment vehicle investor in reliance on Rule 206(4)-8 under the Advisers Act; however, the SEC seeks comment as to whether CLO investors should be excluded from the scope of the proposed conflicts rules or whether the current definition of investor should be even broader to encompass other vehicles excluded from the definition of investment company such as 3(c)(5)(C) or 3(c)(11) funds. Alternatively, the SEC seeks comment on whether the definition should be narrowed to a retail investor as defined in Form CRS. Second, an investment advisers’ discretionary advisory services would be within the scope of the rules because an “investor interaction” is defined as engaging or communicating with an investor, including by exercising discretion with respect to an investor’s account: the release makes the SEC’s view clear that the proposed conflicts rules would apply to conduct that involves an investment advice or recommendations even without investor engagement.

Key aspects of the proposed conflicts rules about which the SEC specifically invites input include:

• Whether the proposed definition of a “covered technology” is sufficiently clear and whether such definition is properly scoped by only applying to technologies that are used to optimize for, predict, guide, forecast or direct investment-related behaviors or outcomes and whether firms can identify what “investment-related behaviors or outcomes” is intended to capture.
• Whether the scope of the definition “investor interaction” should include discretionary management of accounts “even if there is no communication or other interaction with investors themselves at the time of trades in their accounts” or exclude interactions that meet legal or regulatory obligations or provide clerical, ministerial or general administrative support.
• Whether the proposal adequately addresses “how a firm would treat a single covered technology that features functions that are both included and excluded from the investor interaction definition” or if dual-purpose covered technologies should be treated “differently than covered technology used solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support.”

Proposed Requirements to Identify, Determine, Eliminate or Neutralize the Effect of a Conflict of Interest

In general, the proposed conflicts rules would require firms to:

• Evaluate any use, or reasonably foreseeable potential use, of covered technology in any investor interaction to detect whether such use or potential use is associated with a conflict of interest, including by testing the technology prior to use and periodically thereafter.
• Determine if any such conflict of interest places the firm’s interest ahead of investors’ interests.
• Eliminate or neutralize the impact of any such conflict of interest.
• Adopt, implement, and in the case of broker-dealers, maintain, written policies and procedures reasonably designed to achieve compliance with the proposed conflicts rules, if they use covered technology. Such policies and procedures must include:
  • A written description of the firm’s process for assessing any use or reasonably foreseeable potential use of a covered technology in any investor interaction.
  • A written description of any material features of any covered technology used in any investor interaction and conflicts associated with that use.
  • A written description of the firm’s process for determining whether any identified conflict of interest results in an investor interaction that places the firm’s interest ahead of investors’ interests.
  • A written description of the firm’s process for establishing how to eliminate, or to neutralize the impact of, any such conflicts of interest.
  • A review and written documentation of that review, at least annually, of the adequacy of the policies and procedures and written descriptions established pursuant to the proposed conflicts rules, as well as the effectiveness of their implementation.

The release explains that these proposed conflicts rules are intended to “supplement” existing regulatory obligations related to conflicts of interest through requiring “additional steps” to address conflicts of interest due to the “nature of these technologies” including their complexity and scalability.

Evaluation and Identification

The purpose of the proposed evaluation requirement is to “help ensure that a firm has a reasonable understanding” of whether a firm’s use (or reasonably foreseeable potential use) of a covered technology in an investor interaction results in an identifiable conflict. The SEC does not intend that the proposed conflicts rules “mandate a particular means” of evaluation. Instead, firms would be directed to use an approach that is “appropriate” to the covered technology, including accounting for any past deployment of the technology and how such technology could be used (e.g., how a firm intends to use such technology and reasonably foresees using such technology unless steps are taken to prevent such use). This evaluation could differ based on the covered technology, including its nature, use, and planned future use. The scope of the evaluation will vary based on a technology’s complexity, with simpler covered technologies (e.g., basic financial models in spreadsheets, simple algorithms) involving a simpler evaluation, and a more advanced covered technology potentially requiring additional steps (e.g., firm personnel with sufficient programming and regulatory knowledge to evaluate the technology’s documentation and inputs). Moreover, an “especially complex” covered technology might need other procedures (e.g., adding an “explainability” feature to tell the user how a model reached a particular outcome, recommendation or prediction and then firm personnel reviewing such output). The release notes that certain covered technologies may be licensed from third parties, and the firm may have limited access to information or the underlying code of the covered technology, but that an evaluation “could be satisfied” by reviewing third-party documentation and relying on the testing methodology to determine if “any undocumented functionality” could result in a conflict.

Evaluating a technology would account for its use and would depend on how such technology is deployed with an investor (e.g., operating autonomously with such investor could require more scrutiny while providing a first draft to firm personnel could require less scrutiny). The release cautions that even in cases where it is “difficult or impossible” to evaluate a technology (e.g., “black box” algorithms, large data set, third-party technology), a firm’s lack of visibility “would not absolve it” of complying with the proposed conflicts rules. In these cases, the release states that such technologies could only continue to be used if the proposed conflicts rules’ requirements could be met, which could involve modifying the technology.

The SEC requested comments on the sufficiency of disclosure and whether to specify a particular method of identifying a conflict without accounting for the current infeasibility of what the SEC would require under the proposed evaluation and identification requirements. As proposed, the types of evaluation and explainability functions that the SEC would require do not fit easily within the scope of current technology and may currently be technically impracticable. In addition, a technology that does not comply with the proposed evaluation and identification requirements cannot be used, which strongly implies that the SEC is trying to shape the design and development of PDA and AI technologies before they are in widespread use by firms.

Testing

The purpose of the proposed testing requirement is to “help ensure that conflicts of interest that may harm investors are identified in light of how the covered technology actually operates.” The proposed conflicts rules do “not specify any particular method of testing or frequency of retesting” but would require testing of covered technologies (1) prior to implementation or (2) in the event of a material modification. The proposed conflicts rules do not define “material modification,” but the release notes that material modifications may include a new functionality but not “minor modifications” such as “standard software updates, security or other patches, bug fixes, or minor performance improvements.” The release envisions that during any interim testing an older version could be used if such older version complies with the proposed conflicts rule. The release does not require but appears to expect “retesting” on a periodic basis (which retesting coincides with a retest for material modifications), and it explains that such frequency “may vary depending on the nature and complexity” of the covered technology with simpler technologies subject to a simpler testing protocol perhaps with more effort on first deployment and any periodic testing focused “only on a sampling of the firm’s covered technologies.” Complex covered technologies would be expected to use tailored testing based on a review of the particular features that pose a conflict: for example, such a technology “may need to be tested using A/B testing to determine what factors are being optimized, to determine whether any of those factors are the firm’s interests (or act as proxies for the firm’s interests); or to estimate the effect of the methodology with and without the factors that involve the firm’s interests.” Firms also could review data for signs that firm-favorable factors are being optimized. In particular, the release explains that a model that is prone to “drift” or “decay” due to actual data encountered would cause a firm to consider such drift in the proposed evaluation requirement and testing requirement. The release also states that firms should consider if covered technologies continue to be used as originally intended and if there are substantial differences from the original use to retest them.

The SEC’s proposed testing requirements and requests for comment thereon are principles- and risk-based, but have the potential to be burdensome and slow product development because “material modifications” appears inclusive of all non-routine software improvements, and in this respect the SEC offers little practical guidance as to what is sufficient testing and when such testing would be required. Similarly, the SEC references to the risks of “drift” are purely theoretical and speculative, implying that any specific testing requirements in a final rule could be quickly disconnected from the realities of technological development.

Conflict of Interest

The proposed definition of a conflict of interest is broad, and the proposed conflicts rules would require that “if a covered technology considers any firm-favorable information in an investor interaction or information favorable to a firm’s associated persons, the firm should evaluate the conflict” and make the required determination as to whether such conflict places the firm’s interest ahead of the investor. The release does recognize that if such a firm-favored factor is one “among thousands in an algorithm or data set” then this “may, or may not, cause the covered technology to produce a result” that causes a conflict, however, the release makes clear that if a covered technology “takes into account the profits or revenues of the firm” this would be a conflict under the rule regardless of the weight of the interests. Examples of accounting for profits or revenues include a firm directly doing so by over-weighting funds with revenue-sharing payments or proprietary funds, displaying ranks of funds that account for revenue received or indirectly doing so by incentivizing trading or opening accounts that cause higher profits, commissions or revenue sharing. What the specific interest is and its weighting in the covered technology does not implicate whether a conflict exists, but whether a firm’s interests are placed ahead of the investors as discussed further below in the determination step.

The proposed definition of a conflict of interest is broad, as it encompasses all of an adviser’s potential interests except the interest in opening an account for an investor. Given the often opaque nature of correlation between different factors in PDA and AI technologies, it will be difficult to determine that a firm-favoring factor is not one that has a material impact on the outputs of the model or that such a factor would not have a material impact in the future. For example, a firm’s profits or revenues by way of asset-based fees or transaction costs could increase in a bull market, and investors might similarly be more amenable to opening accounts, transferring assets or initiating and/or approving trades, even though these events may potentially be correlated but not causally related.

Determination

The proposed determination requirement would require the firm “to reasonably believe that the covered technology either does not place the interests of the firm or its associated persons ahead of investors’ interest” or if it does, to take additional steps to eliminate or neutralize the conflict. The release states that this would be a facts-and-circumstances determination that depends on a variety of factors such as “the covered technology, its anticipated use, the conflicts of interest involved, methodologies used and outcomes generated, and the interests of the investor.” These determinations should be tailored “based on the circumstances and the complexity of the underlying covered technology as well as the complexity of the conflicts of interest.” For example, a firm that uses a financial model that includes a potential performance-based fee could determine that the firm’s interests are not favored over an investor (because the outcome is equally or more favorable to the investor); however, if the covered technology was designed to screen out investments that would not result in a sufficient performance-based fee (even though the opportunity presented acceptable returns to the investor), the firm should determine that its interests are favored and eliminate and neutralize such conflict. As another example, a firm that sends an automatic message to investors in a volatile market to “hold steady” could determine that no further action is needed (e.g., holding benefits investors) but if such an email is only triggered after a certain threshold of fee-earning assets are withdrawn from the firm then a determination should be made to eliminate or neutralize the conflict.

The release also states that firms “should consider carefully reviewing” technology outputs to determine if the firm’s interests are being placed ahead of the investor. The release also explains that if a determination is difficult or indeterminable, then a firm may need to use different tools to comply (e.g., adding an “explainability” function, ceasing use of the technology, presuming that an ambiguity results in a conflict that must be eliminated or neutralized, or applying a “counterweight” to the conflict). However, this determination likely will be difficult or indeterminable much more often than the SEC anticipates. Thus, under a final rule, the SEC likely would either expect that PDA and AI technologies will not be able to be used, or that firms will be required to undertake the design of new systems and models with explainability features that the SEC favors, but which have not yet been developed.

Elimination or Neutralization of Effect

The proposed elimination or neutralization requirement is triggered if a conflict places the firm’s interests ahead of investors: the proposed conflicts rules seek to address practices that “incentiviz[e] specific types of activity . . . that is particularly profitable to a firm (and is not always in investors’ interest).” However, the rules are not intended to limit a firm’s ability to attract clients and customers and thus do not apply to conflicts of interest that arise solely from seeking to open an account, unless the data is used to target particular types of customers, such as those who are heavy gamblers.

The test for when a conflict would be eliminated or neutralized is whether the “interaction no longer places the interests of the firm ahead of the interests of investors.” The release further states that, under the proposed conflicts rules, a conflict of interest would be considered “eliminated” if the firm completely eliminates the practice or otherwise removes the firm’s interest from the information considered by the covered technology (e.g., if the firm eliminates revenue sharing or ensures that the covered technology does not consider it) or limits use in those circumstances where the firms interest are placed ahead of investors. Alternatively, a firm could “neutralize” a determined conflict of interest by retaining the firm-favoring data or algorithm in a covered technology but preventing biased output (e.g., elevating investor interests) through modifying how such information is analyzed or weighted (e.g., holistically weighting other factors over firm-favored factors), counterweighting the effect (e.g., adding investor-favorable information), requiring firm personnel with training to review information prior to providing it to investors, and confirming through testing such bias towards the firm was eliminated. While this proposed rule requirement “does not prescribe a specific way” to eliminate or neutralize conflicts, reasonable steps “are likely to vary and would depend on the nature of the conflict, the nature of the covered technology, the circumstances in which the covered technology is used, and the potential harm to investors.”

The proposed conflicts rules would require that any conflict of interest be acted upon “‘promptly’ after the firm determines, or reasonably should have determined, that the conflict results in its own (or an associated person’s) interests being placed ahead of investors’ interests.” The release states that what constitutes “promptly” will depend on the facts and circumstances and on the process to eliminate or neutralize the effect of the interest (e.g., whether the firm needs to update a setting or restrict access as opposed to undertaking a substantial amount of new coding, resulting in a material modification that triggers retesting). For example, a schedule for elimination should consider the nature and use of the covered technology and complexity of the remedial method and seek to minimize potential risks to investors (e.g., additional reviews, monitoring any continued use and weighing the risks of offline technology). The release cautions that not acting for an extended period of time to eliminate or neutralize a conflict could raise questions about a firm’s promptness and standard of care obligations. The elimination or neutralization requirement aims to be “in addition” to the standard of conduct rules that apply when a firm provides advice or makes a recommendation.

The release states that the “reasonably should have identified” standard is designed to promote a firm understanding “all the material features of the technology” throughout the evaluation and determination steps, and to comply with the proposed conflicts rules that a firm would be required to “use reasonable care” to make such determinations. The release also explains that firms should “identify future and evolving conflicts” when evaluating potential uses as part of determining what “should have” been determined.

The “eliminate or neutralize” requirement and the guidance in the release assumes a degree of knowledge of, and precision in, understanding how PDA and AI models reach their conclusions that does not yet appear to exist. Thus, the SEC’s release and request for comments does not consider whether these proposed requirements are feasible at all.

Proposed Recordkeeping Amendments

The proposal would amend Rules 17a-3 and 17a-4 under the Exchange Act and Rule 204-2 under the Advisers Act to set forth new requirements for firms to make and maintain books and records related to the proposed conflicts rules.

• Written Documentation of Evaluation. Firms would be required to make and maintain written documentation of their evaluations of any conflict of interest associated with the use or potential use by the firm of a covered technology in any investor interaction. This written documentation would need to include a list of every covered technology used by the firm in investor interactions and documentation describing any testing of covered technology.
• Written Documentation of Determination. Firms would be required to create and maintain written documentation of the determination of whether any identified conflict of interest places the firm’s interest ahead of investors’ interests as well as the rationale for any such determination.
• Written Documentation of Each Elimination or Neutralization. Firms would be required to make and maintain written documentation demonstrating how the impact of any conflict of interest was eliminated or neutralized. The documentation should also include the rationale and methodology for any such determination.
• Written Policies, Procedures and Descriptions. Firms would be required to maintain written policies and procedures with respect to the proposed conflicts rules and review such policies and procedures at least annually.
• Record of Disclosures. Firms would be required to make and maintain a record of any disclosures provided to investors concerning the firm’s use of covered technologies.
• Record of Each Alteration, Override or Disabling of Covered Technology. Firms would be required to make and maintain records of each instance in which a covered technology was altered, overridden, or disabled; the reason for such action; and the date when such action was taken.

Implications for Broker-Dealers

The proposed conflicts rules would present significant and inconsistent obligations for broker-dealers with respect to their existing regulatory requirements, including Regulation Best Interest. Under the conflicts of interest obligation of Regulation Best Interest,⁵ a broker-dealer must have in place and enforce written policies and procedures that are reasonably designed to identify, and, at a minimum disclose, all conflicts of interest associated with recommendations to retail customers. However, under the proposed conflicts rules, the requirements relating to conflicts of interest are triggered when a broker-dealer uses a covered technology in an investor interaction, and as noted by the SEC, this would capture a broker-dealer’s “correspondence, dissemination, or conveyance of information to or solicitation of investors, in any form . . . would include engagement between a firm and an investor’s account, on a discretionary or non-discretionary basis . . . [and] would also capture any advertisements, disseminated by or on behalf of a firm, that offer or promote services or that seek to obtain or retain one or more investors.” This would mean that essentially all communications with investors, including those for non-recommendation purposes, would be covered. This broad application would extend beyond Regulation Best Interest to other rules applicable to broker-dealers, such as FINRA Rule 2111 relating to suitability, as these rules are triggered at the time a recommendation is made to an investor. This could also mean that certain technologies and processes that broker-dealers have implemented to comply with Regulation Best Interest could be subject to the proposed conflicts rules, placing on broker-dealers additional compliance burdens. In addition, unlike under Regulation Best Interest where most conflicts of interests can be addressed through full and fair disclosure and obtaining the informed consent of the retail customer, the proposed conflicts rules require broker-dealers to neutralize or eliminate conflicts of interest.

Implications for Investment Advisers

If adopted in their current form, the proposed rules would represent a significant departure from the SEC’s standard approach toward addressing investment advisers’ conflicts of interest, which is that full disclosure and informed consent generally are sufficient. The SEC asserts that the proposed requirement to eliminate or neutralize covered conflicts is “consistent with” the existing fiduciary standard of conduct that applies to investment advisers; the SEC claims that this standard has always required eliminating or mitigating conflicts where full and fair disclosure is not feasible. Relying on this claim, the release asserts that concerns over the scalability of AI technologies “rapidly exacerbat[ing] the magnitude and potential effects of conflicts” mean that disclosure is insufficient to address such conflicts. However, this reasoning flips the traditional framework on its head to favor elimination and neutralization over disclosure and consent: the SEC breathtakingly asserts that because it has theoretical and speculative concerns about the scale and speed of application of AI technologies, it concludes that disclosure and consent are categorically infeasible. In so doing, the SEC would convert what is currently a context-driven, facts-and-circumstances test—whether particular disclosure is sufficient for a particular conflict with a particular set of investors—to a per se legal conclusion that applies without exception to an entire family of technologies and their use.

This broad mandate to eliminate or neutralize conflicts would have impacts beyond the use of what is currently understood to be PDA or AI technology. Under the proposed rules, the definition of “covered technology” includes even simple spreadsheets and models that are used to formulate investment advice, and these technologies are ubiquitous. Thus, the rules could require the elimination or neutralization of conflicts arising from interactions through such commonly used technologies. Even if the SEC were to scale back this particular aspect of the proposed rules’ scope, they would still impose (similar to the effect on broker-dealers) additional obligations on advisers in the form of explicit and detailed policies and procedures that would be necessary to sort covered from uncovered technologies, as well as related recordkeeping requirements. In addition, the proposed rules would be inconsistent with the recently adopted marketing rule, which applies to any advertisement of the adviser’s advisory services regardless of the medium and includes requirements for the use of technologies that are interactive analysis tools used by an investor (or used by a financial professional on their behalf) as defined in FINRA Rule 2214 with slight modifications. The marketing rule is a comprehensive regime, and yet the SEC does not analyze or even discuss its effectiveness.

Conclusion

The proposed conflicts rules would impose significant and potentially paradigm-shifting new requirements on broker-dealers and investment advisers. If applicable, firms would be required to develop an extensive governance and testing regime and detailed policies and procedures for these technologies. Broker-dealers and investment advisers might consider if they can identify technologies that would be impacted by the proposed conflicts rules, and if such impact would be significant. Firms can also consider commenting on the proposed conflicts rules. We expect there will be significant industry comment on the proposed conflicts rules. The 60-day public comment period is currently scheduled to close on October 10, 2023, and while industry groups have rallied together to request an extension to the comment period, such requests recently have gone unheeded by the SEC.

1. Conflicts of Interest Associated with the Use of Predictive Analytics by Broker-Dealers and Investment Advisers, SEC Proposed Rule, SEC Rel. Nos. 34-97990 and IA-6353 (July 26, 2023) (release).
2. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Final Rule, SEC Rel. No. IA-6383 (Aug. 23, 2023). For further information, please refer to the Dechert NewsFlash SEC Finalizes Changes to Private Fund Rules.
3. Petition for Review, Nat’l Ass’n Private Fund Managers, et al. v. SEC, No. 23-60471 (5th Cir. Sept. 1, 2023).
4. Request for Information and Comments on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches, SEC Rel. Nos. 34-92766 and IA-5833 (Aug. 27, 2021).
5. Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (2019).