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Melanie Waddell

Regulation and Compliance > Federal Regulation > SEC

The SEC's New AI Plan Expands Reg BI — and More

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What You Need to Know

  • The proposal would require advisors and BDs to address conflicts of interest tied to predictive analytics and other technologies.
  • Even simple technologies like spreadsheets could be swept into the rule in its current form, attorneys and others say.
  • Regulating investor interactions, not just recommendations, would represent a broadening of authority.

While industry officials are busy digesting the Securities and Exchange Commission’s recently passed plan to address conflicts when broker-dealers and advisors use artificial intelligence and predictive data analytics, they are questioning whether the agency’s plan expands Regulation Best Interest and signals more compliance headaches under the SEC Marketing Rule.

The SEC’s plan, passed in mid-July, targets “conflicts of interest” associated with broker-dealers’ and advisors’ use of predictive data analytics related to certain investor interactions.

Early concerns are also being raised about the scope of the plan — with attorneys at Morgan Lewis suggesting it goes beyond AI and other sophisticated or “opaque technologies” to potentially cover “virtually any type of technology, ranging from basic spreadsheets and calculators to applications using large language models.”

Under the SEC’s plan, broker-dealers and advisors would be required “to take certain steps to address conflicts of interest associated with their use of predictive data analytics and similar technologies to interact with investors to prevent firms from placing their interests ahead of investors’ interests,” the agency said.

The SEC’s plan is out for a 60-day comment period; comments are already trickling in.

SEC Chairman Gary Gensler said that if adopted, “these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”

During the open meeting on July 26 to consider the plan, SEC Commissioner Hester Peirce, a Republican, asked: “Given the application of this rule to investor interactions, rather than merely recommendations, do we have the authority to apply it to broker-dealers? Is it a backdoor attempt to expand Regulation Best Interest?”

Jed Doench, an attorney at Morgan Lewis in New York, told me Monday in an email that the SEC’s proposal “can be viewed as an indirect expansion” of Reg BI.

“While Reg BI only applies to recommendations (a longstanding and appropriately narrow concept under the securities laws) to retail investors, this new proposal would apply a conflict of interest framework to potentially any communication with a retail investor that is generated by a ‘covered technology,’ which is defined very broadly in the proposal,“ Doench explained.

“Importantly, the proposal is even stricter than Reg BI because it would not allow brokers to address conflicts of interest through disclosure,” Doench relayed. “Additionally, the proposal does not contain any exemption from its requirements for communications that comply with Reg BI.”

According to Peirce, the definition of “covered technology” in the agency’s plan “is quite broad.” She questioned whether it would encompass “Excel spreadsheets, for example, and mathematical formulas used to price securities?”

Peirce added: “The rule claims to be technology neutral — and maybe it is because the definition of ‘covered technology’ is so broad — tell me how I am wrong to think that we are creating an especially harsh rule for particular types of technology.”

‘Additional Layer of Regulation’

Attorneys at Eversheds Sutherland weighed in with their thoughts after the SEC passed the plan by a 3-2 vote. They stated in an alert that while the SEC staff “was clear that they did not view the rule proposal as ‘expanding’ Reg BI … the rule proposal certainly imposes an additional layer of regulation beyond Reg BI and the advisory fiduciary duty.”

For instance, the attorneys wrote, “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 attorneys wrote.

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 attorneys said.

The attorney agreed that 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.’”

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,” the Eversheds attorneys said.

Attorneys at Morgan Lewis noted in their own alert that the proposed rules “are very broad in their application.”

The definition of “covered technology,” the Morgan Lewis attorneys state, “would apply to many of the investor- and financial professional-facing tools currently in use.”

This would include “even a simple financial model in a spreadsheet,” the attorneys said.

The Morgan Lewis attorneys opined that the rules, if adopted as proposed, “would impose broad and potentially burdensome conflict-of-interest requirements on broker-dealers and investment advisers that use even simple technologies to communicate with clients and fund investors or manage clients’ assets.”

The Morgan Lewis attorneys conclude that “given the resources that firms have invested in designing, implementing, and testing systems to comply with Reg. BI, the addition of duplicative requirements under the PDA Rules would be particularly disruptive and costly.”

Further, advisors “using interactive analysis tools in connection with the new Marketing Rule could be required to also comply with the proposed PDA Rules,” the Morgan Lewis attorneys said.

Crossing the Line

The proposed rules would apply when a broker-dealer or an advisor “uses or reasonably foreseeably may use covered technology in an investor interaction,” according to a fact sheet released by the agency.

Gensler has questioned when design elements and psychological nudges associated with digital engagement platforms “cross the line” and become recommendations.

“Today’s predictive data analytics models also provide an increasing ability to make predictions about each of us as individuals,” Gensler said. “This growing capability facilitates being able to differentially communicate to each of us — and do so efficiently at scale. How might we respond to individualized communications or nudges? How might we respond to individualized product offerings? How might we respond to individualized pricing? This includes means to optimize for, predict, guide, forecast, or direct investors’ investment decisions.”

Amy Lynch, founder and president of FrontLine Compliance, told me in a recent email that the SEC’s Conflicts of Interest and Predictive Analytics proposal “addresses a topic that is very close to Gensler’s past role at MIT, so he has a personal interest in getting this one passed.”

The meme stock frenzy of 2021, Lynch said, “initiated this rule and firms that utilize machine learning, AI, algorithms, etc. for their online applications or software used with customers will be affected” by the SEC’s proposal.

Reg BI “kicks in regarding any kind of investment recommendation (buy, sell or hold),” Lynch explained.

Concerns raised by Peirce and others, Lynch continued, seem “to be around how to differentiate between a software program that guides/nudges an investor to action, and when that action then crosses the line into advice under Reg BI. This will be the struggle that firms will need to deal with and identify if this rule passes in its current form.”


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