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SEC Proposes Regulation Targeting AI Advising

Author: Jon-Jorge Aras|July 30, 2023

Use of AI in the Financial Industry

SEC Proposes Regulation Targeting AI Advising

Use of AI in the Financial Industry

SEC Proposes Regulation Targeting AI Advising

The Securities and Exchange Commission (SEC) is cracking down on using artificial intelligence in financial advising. The agency recently proposed regulations. These regulations would necessitate broker-dealers and investment advisers to address conflicts of interest. These conflicts are associated with their use of predictive data analytics and similar technologies in interactions with investors.

“We live in an historic, transformational age about predictive data analytics, and the use of artificial intelligence,” SEC Chair Gary Gensler said in a press statement. “Today’s predictive data analytics models provide an increasing ability to make predictions about each of us. This raises the possibility that conflicts may arise. Potentially to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their interests ahead of their investors’ interests. I believe 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 interests ahead of investors’ interests.”

Incorporating AI holds both promise and peril in a wide range of industries. The financial industry is no different. Over the past decade, traditional investment advisory delivery models have undergone significant evolution. This evolution includes the integration of new technology like AI, machine learning, and chatbot technologies.

Digital investment advisers are the fastest-growing segment of the financial technology industry.

In response, the SEC has begun raising concerns that firms use technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes that could negatively impact investors. In a fact sheet published with the proposal, the SEC acknowledged that technologies like predictive data analytics and AI can bring benefits, such as improving market access, efficiency, and returns. However, it also maintained that the scalability of these technologies and their ability to reach a broad audience at a rapid speed “could cause harm to investors in a more pronounced fashion and on a broader scale than previously possible.”

In further support of its proposal, the SEC also cited the review it conducted in the wake of the 2021 meme-stock frenzy, which saw the prices of GameStop stock fluctuate wildly in response to social media buzz. According to the SEC, numerous commenters expressed broader concerns. These concerns pertained to the conduct of broker-dealers and investment advisers while interacting with retail investors through digital platforms.

SEC’s Proposed Conflicts Rule

The SEC’s proposed rule, entitled “Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers,” would apply when a broker-dealer or an investment adviser registered or required to be registered under section 203 of the Investment Advisers Act of 1940 uses or reasonably foreseeably may use covered technology in an investor interaction. “Covered technology” is defined to include a firm’s use of analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.

Under the proposed rules, firms would be required to evaluate any use or reasonably foreseeable potential use of a covered technology in any investor interaction to identify any conflict of interest associated with that use. When such a conflict exists, the proposed rules would require a firm to eliminate or neutralize the effect of any conflicts of interest that place the firm’s or its associated person’s interest ahead of investors’ interests.

The SEC would also require a firm that has any investor interaction using covered technology to have written policies and procedures reasonably designed to achieve compliance with the proposed rules. The policies and procedures would require, among other things, a written description of the process for evaluating any use (or reasonably foreseeable potential use) of a covered technology in any investor interaction and a written description of the process for determining how to eliminate or neutralize the effect of any conflicts of interest determined under the proposed rule to result in an investor interaction that places the interest of the firm or an associated person ahead of the interest of investors. In addition, firms would be required to keep books and records related to the rules’ requirements.

What’s Next?

The SEC will now accept public feedback on the proposed rules. The public comment period will remain open until 60 days after the date of publication of the proposed release in the Federal Register. Our attorneys can help you navigate the SEC’s proposed rules and ensure your firm’s compliance. Let us assist you in crafting effective responses during the 60-day public comment period, strengthening your position in this regulatory landscape.

SEC Proposes Regulation Targeting AI Advising

Author: Jon-Jorge Aras
SEC Proposes Regulation Targeting AI Advising

The Securities and Exchange Commission (SEC) is cracking down on using artificial intelligence in financial advising. The agency recently proposed regulations. These regulations would necessitate broker-dealers and investment advisers to address conflicts of interest. These conflicts are associated with their use of predictive data analytics and similar technologies in interactions with investors.

“We live in an historic, transformational age about predictive data analytics, and the use of artificial intelligence,” SEC Chair Gary Gensler said in a press statement. “Today’s predictive data analytics models provide an increasing ability to make predictions about each of us. This raises the possibility that conflicts may arise. Potentially to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their interests ahead of their investors’ interests. I believe 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 interests ahead of investors’ interests.”

Incorporating AI holds both promise and peril in a wide range of industries. The financial industry is no different. Over the past decade, traditional investment advisory delivery models have undergone significant evolution. This evolution includes the integration of new technology like AI, machine learning, and chatbot technologies.

Digital investment advisers are the fastest-growing segment of the financial technology industry.

In response, the SEC has begun raising concerns that firms use technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes that could negatively impact investors. In a fact sheet published with the proposal, the SEC acknowledged that technologies like predictive data analytics and AI can bring benefits, such as improving market access, efficiency, and returns. However, it also maintained that the scalability of these technologies and their ability to reach a broad audience at a rapid speed “could cause harm to investors in a more pronounced fashion and on a broader scale than previously possible.”

In further support of its proposal, the SEC also cited the review it conducted in the wake of the 2021 meme-stock frenzy, which saw the prices of GameStop stock fluctuate wildly in response to social media buzz. According to the SEC, numerous commenters expressed broader concerns. These concerns pertained to the conduct of broker-dealers and investment advisers while interacting with retail investors through digital platforms.

SEC’s Proposed Conflicts Rule

The SEC’s proposed rule, entitled “Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers,” would apply when a broker-dealer or an investment adviser registered or required to be registered under section 203 of the Investment Advisers Act of 1940 uses or reasonably foreseeably may use covered technology in an investor interaction. “Covered technology” is defined to include a firm’s use of analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.

Under the proposed rules, firms would be required to evaluate any use or reasonably foreseeable potential use of a covered technology in any investor interaction to identify any conflict of interest associated with that use. When such a conflict exists, the proposed rules would require a firm to eliminate or neutralize the effect of any conflicts of interest that place the firm’s or its associated person’s interest ahead of investors’ interests.

The SEC would also require a firm that has any investor interaction using covered technology to have written policies and procedures reasonably designed to achieve compliance with the proposed rules. The policies and procedures would require, among other things, a written description of the process for evaluating any use (or reasonably foreseeable potential use) of a covered technology in any investor interaction and a written description of the process for determining how to eliminate or neutralize the effect of any conflicts of interest determined under the proposed rule to result in an investor interaction that places the interest of the firm or an associated person ahead of the interest of investors. In addition, firms would be required to keep books and records related to the rules’ requirements.

What’s Next?

The SEC will now accept public feedback on the proposed rules. The public comment period will remain open until 60 days after the date of publication of the proposed release in the Federal Register. Our attorneys can help you navigate the SEC’s proposed rules and ensure your firm’s compliance. Let us assist you in crafting effective responses during the 60-day public comment period, strengthening your position in this regulatory landscape.

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