On July 26, 2023, the SEC proposed new rules that would require broker-dealers and SEC-registered investment advisers ("RIAs") to take certain steps to identify and address potential conflicts of interest associated with their use of predictive data analytics and similar technologies in investor interactions. The proposed rules are wide-ranging in their application, and this summary focuses on the proposed rule under the Investment Advisers Act of 1940 (the "Proposed Rule") and its potential impact on RIAs.
Overview
The Proposed Rule would apply in cases where an RIA uses "covered technology" in an "investor interaction." "Covered technology" is defined as 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. For RIAs, the term "investor" would include a client or prospective client, and any current or prospective investor in a pooled investment vehicle advised by the RIA. The Proposed Rule broadly defines "investor interaction" as engaging or communicating with an investor and, importantly for RIAs, includes exercising discretion over an investor's account, providing information to an investor, or soliciting an investor.
The Proposed Rule would require RIAs to evaluate any use or reasonably foreseeable potential use by the RIA or its associated persons of a covered technology in investor interactions to identify any potential conflicts of interest. An RIA would then need to determine whether such conflict places the RIA's interests ahead of its investors and, if so, the RIA would need to either eliminate or neutralize the effect of the conflict. RIAs must also create written policies and procedures reasonably designed to prevent violations of the rule, conduct an annual review of their policies and procedures, and maintain books and records relating to their compliance with the rule.
Practical Implications for RIAs
The rule proposal discusses several examples of covered technology that RIAs may utilize in investor interactions. For instance, an RIA that uses a financial model or algorithm in a spreadsheet to guide investment decisions would fall within the purview of the Proposed Rule, and a conflict of interest would arise if such model were to take into account the RIA's projected revenue or profit in generating its data. The RIA would then need to determine whether the conflict results in the RIA's interests being placed ahead of its investors. For an RIA that utilizes a simple financial model that forecasts investment performance, the RIA's interests may not actually be elevated over its investors – a conclusion which the RIA could document to demonstrate its compliance. If, however, an RIA utilizes a financial model that projects investment performance and automatically screens out any investment that fails to generate a minimum level of profits for the RIA, the RIA would need to eliminate or neutralize the associated conflict inherent in such technologies as screened-out investments may have generated acceptable returns for investors. The use by an RIA of natural language processing technology to prepare initial drafts marketing materials and offering documents is also captured by the Proposed Rule. For those technologies, the RIA would need evaluate whether using that technology leads to a conflict of interest, such as the drafts overemphasizing discussions of positive investment performance while underemphasizing the risks associated with investments. In this case, the RIA could neutralize the conflict of interest by establishing a policy that requires that AI-generated drafts undergo internal review to ensure discussions are fair and balanced.
Conclusion
The Proposed Rule is open for public comment until the expiration of the 60-day period running from publication in the Federal Register (which has yet to occur). Although on its face the Proposed Rule appears focused on conflicts associated with covered technology usage by broker-dealers and robo-advisers in their interactions with retail investors, certain RIA practices would also be captured. RIAs should evaluate their use of predictive data analytics and AI to understand how the Proposed Rule, if adopted, will affect their current and future operations.
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