SEC Proposes Rules to Address Conflicts of Interest in the Use of AI by Investment Advisers and Broker-Dealers

On July 26, 2023, the Securities and Exchange Commission (SEC or the Commission) announced proposed rules (the proposal) under the Securities Exchange Act of 1934 (the Exchange Act) and the Investment Advisers Act of 1940 (the Advisers Act) targeted at eliminating potential conflicts of interest associated with broker-dealers’ and investment advisers’ interactions with investors through the use of predictive data analytics (PDA) or artificial intelligence (AI). The proposal generally requires broker-dealers and investment advisers (together, firms) to curb the use of AI technologies that place the firms’ interests above the interests of investors. Firms would still be permitted to use these tools, provided that they eliminate or neutralize the effects of any conflicts of interest. The proposal would also require firms to adopt policies and procedures that are reasonably designed to prevent a violation of the requirements set forth in the proposal.

Identification and Elimination or Neutralization of Effects of a Conflict of Interest

The proposed rules set out the affirmative steps firms must take as a precursor to eliminating or neutralizing the effects of a conflict of interest. First, a firm would be required to evaluate any use of a covered technology in any “investor interaction” (as defined below) to identify whether it involves a conflict of interest, including through testing the technology. This includes the requirement that firms test and periodically retest any covered technology. “Covered technology” is defined under the proposal as “analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behavior or outcomes.” The proposal does not set out a specific means by which a firm is required to evaluate its use of covered technology, instead giving firms flexibility to adopt an approach appropriate for each technology the firm employs. The approach a firm takes must, however, identify conflicts associated with how the firm has used the technology in the past and how it could be used in the future, including the variety of scenarios in which the covered technology could be deployed.

Second, a firm would be required to determine if any identified conflict results in an investor interaction that places the interest of the firm or an associated person ahead of investors’ interests. For these purposes, an “investor interaction” is defined as engaging or communicating with an investor,^[1] including by exercising discretion with respect to an investor’s account, providing information to an investor or soliciting an investor. The Commission notes that firms should consider a variety of factors and perform a facts and circumstances analysis in order to make the determination that an identified conflict needs to be remediated. The SEC notes that certain conflicts would be permissible under the proposed rules, so long as the covered technology does not place the interests of the firm ahead of those of investors. If use of a covered technology presents a conflict of interest but that conflict leads to an outcome that is equally favorable or more favorable to the investor, that conflict need not be remediated.

Third, the proposal would require a firm to eliminate or neutralize promptly the identified conflict of interest. The test for whether a firm has successfully eliminated or neutralized the effect of a conflict is whether the interaction no longer places the interests of the firm above those of investors. A firm could “eliminate” a conflict of interest by, for example, eliminating the practice that results in the conflict or removing the firm’s interest from the information considered by the covered technology. A firm need not go this far, however, and could simply take steps to neutralize the effects of a conflict by, for example, rendering the consideration of the firm-favorable information subordinate to investors’ interests. It is important to note that providing disclosure of the conflict and securing the informed consent of the investor is not sufficient.

Policies and Procedures

The proposal requires that firms adopt, implement and maintain written policies and procedures reasonably designed to achieve compliance with the proposed rules. These policies and procedures must include (i) a written description of the process for evaluating any use or reasonably foreseeable use of a covered technology in any investor interaction and a written description of any material features of any covered technology prior to implementation or material modification; (ii) a written description of the process for determining whether any identified conflict of interest under the rules results in an investor interaction that places the interest of the firm or its associated persons ahead of the interests of the investor; (iii) a written description of the process for determining how to eliminate or neutralize the effect of any determined conflicts of interest; and (iv) a review and written documentation of such review, at least annually, of the adequacy of the policies and procedures and written descriptions described above, including the effectiveness of their implementation. Firms using covered technology in investor interactions that do not identify any conflicts of interest are still required to adopt and implement these written policies and procedures.

In addition to the above requirements, the Commission recommends firms should consider including other elements in their policies and procedures, as appropriate, such as (i) compliance reviews of relevant systems and controls, (ii) procedures that clearly designate responsibility to appropriate personnel for supervision of relevant functions and persons, (iii) processes to escalate identified instances of noncompliance to appropriate personnel for remediation, and (iv) training of relevant personnel on the policies and procedures as well as the forms of covered technology used by the firm.

Proposed Recordkeeping Requirements

Finally, the proposal amends rules 17a-3 and 17a-4 under the Exchange Act and rule 204-2 under the Advisers Act to set forth requirements for firms to maintain and preserve books and records related to the requirements of the proposed rules.

The proposed rules, including the full text of the proposal, can be found here. Interested parties may make comments on the proposal on or before 60 days after the proposal is published in the Federal Register.

^[1] _{With respect to broker-dealers, the term “investor” includes only natural persons who receive or seek to receive services for personal, family or household purposes. As it relates to investment advisers, an “investor” includes “a client or prospective client, and any current or prospective investor in a pooled investment vehicle advised by the investment adviser.” Accordingly, the definition of “investor” as it applies to investment advisers is not limited to natural persons and would include institutional investors, for example.}