The Securities and Exchange Commission (SEC) held an open meeting of its Investment Advisory Committee on June 6, 2024, which featured a panel to review the use of artificial intelligence in investment decision making.
In July 2023, the SEC proposed new rules1 to address conflicts of interest associated with the use of predictive data analytics (PDA) by broker-dealers and investments advisers (firms) in investor interactions. The proposal would require:
- Elimination or neutralization of the effects of conflicts of interest associated with the firm's use of covered technologies in investor interactions;
- Written policies for any firm that uses covered technologies in investor interactions; and
- Recordkeeping with respect the conflicts rules.
At its meeting on June 6,2 panelists from the SEC Staff, academia, law and industry debated if anything should be done regarding the proposed regulations and whether they go too far or not far enough in protecting investors.
Technologies covered by the new rules would include a firm's use of analytical, technological or computational functions, algorithms, models, correction matrices or similar methods that optimize for, predict, guide, forecast or direct investment-related behaviors. This definition is broad enough to cover both traditional and generative AI.
There is a natural skepticism in the regulated investment space that the adviser and brokerage functions for which humans are licensed, tested and continually evaluated will be usurped by the computers. Part of this might be paranoia from those who have seen too many robot movies where the robots rise up and take over.3 But the fact is that most firms are using AI to make certain functions easier and more efficient. The SEC is concerned that the essential human element of being a licensed professional does not give way to a computer algorithm which has not been tested and for which there is little accountability.
The SEC wrote, "We believe the current regulatory framework should be updated to help ensure that firms are appropriately addressing conflicts of interests associated with the use of PDA-like technologies. As a result, we are proposing specific protections to complement those already required under existing regulatory frameworks to better protect investors from harms arising from these conflicts." The SEC continued, "While the presence of conflicts of interest between firms and investors is not new, firms' increasing use of these PDA-like technologies in investor interactions may expose investors to unique risks. This includes the risk of conflicts remaining unidentified and therefore unaddressed or identified and unaddressed. The effects of such unaddressed conflicts may be pernicious, particularly as this technology can rapidly transmit or scale conflicted actions across a firm's investor base."
Under the SEC's proposed rules, firms using PDA must adopt a policy to identify and neutralize the potential conflict for investors. The use of PDA must be in the context of investor interaction, which means communicating, exercising discretion with respect to an investor's account, soliciting an investor and providing information. Conflicts would generally be any feature that puts the needs or best interests of the investor behind those of the firm. Those conflicts include, but are not limited to, (i) excessive trading, (ii) using trading strategies that carry additional risks (e.g., options trading or trading on margin), (iii) trading in complex securities products that are more remunerative to the firm but pose undue risk to the issuer.4
Firms are required to evaluate each conflict, disclose and neutralize it.5 For example, if the PDA programs are recommending excessive trades, licensed professionals are required to prevent such transactions from being executed. If the AI-driven customer service system results in a customer essentially unable to reach a firm employee, that system needs to be modified or shut down.
The June 6 panel participants were largely supportive of the proposed PDA conflict rules. Some raised the point that it will be impossible to isolate every use of AI in a firm, but others note that it is the firm's responsibility as a customer fiduciary under the Investment Advisers Act of 1940 or under suitability and best interest rules applicable to broker-dealers.6 Others noted that firms and their professionals must never let the temptation of using efficient PDA or AI-driven strategies eliminate the necessary human element of communicating with a client and ensuring that a recommendation is in the client's best interest.
Notably, in January 2024, the CFTC requested public comment on the use of AI in markets that it regulates.7 The CFTC sought comment on the definition of AI and its applications, including its use in trading, risk management, compliance, cybersecurity, recordkeeping, data processing and analytics, and customer interactions. The request also sought comment on the risks of AI, including risks related to market manipulation and fraud, governance, explainability, data quality, concentration, bias, privacy and confidentiality and customer protection. The CFTC did not propose new rules and may decide not to, depending in part on the outcome of the comment process.
As with all institutions dealing with possible regulation of AI, technology and its applications will proceed at a fast pace. Regulators are being careful not to stifle innovation nor implement rules that will quickly be eclipsed or made irrelevant quickly after their passage.
Footnotes
1 See SEC.gov | SEC Proposes New Requirements to Address Risks to Investors From Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers and https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf.
2 See https://www.sec.gov/news/upcoming-events/iac-060624 for agenda and webcast.
3 See, e.g., The Matrix Trilogy, Terminator Salvation, I, Robot, Oblivion, and dozens of others.
4 See https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf at 28.
5 The mitigation requirement differs from the corporate financing issuer disclosure regime which is largely based on disclosure of the conflict or related-party transaction. See, cf, 17 CFR § 229.404 - (Item 404) Transactions with related persons, promoters and certain control persons. | Electronic Code of Federal Regulations (e-CFR) | US Law | LII / Legal Information Institute (cornell.edu) and https://asc.fasb.org/850/showallinonepage.
6 See https://www.finra.org/rules-guidance/key-topics/regulation-best-interest.
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