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SEC Comment Period on Proposed AI Rules for Broker-Dealers and Investment Advisors Closes Oct. 10, 2023
Tuesday, October 3, 2023

On July 26, 2023, the SEC proposed new rules applicable to registered investment advisers and broker-dealers intended to prevent and neutralize the effects of certain conflicts of interest relating to the use of predictive data analytics (PDA), natural language processing (NLP), artificial intelligence (AI) and other “covered technologies” in interactions with clients. Click here to view the complete proposed rules. Under the proposed rules, firms would be required to:

  • Determine whether any use or reasonably foreseeable potential use by the firm of a “covered technology” in any investor interaction poses a conflict of interest that places the adviser’s interests ahead of those of its clients;
  • Affirmatively identify and eliminate or neutralize such conflicts of interest; and
  • Adopt policies and procedures designed to prevent violations of the rules, conduct annual compliance reviews, and comply with record-keeping requirements related to the proposed rules.

The proposed rules build upon, and expand, previous obligations relating to broker-dealers and investment advisors. Of note, the proposed definition of investor interaction would include interactions that have generally been viewed as outside the scope of “recommendations” for broker-dealers, and would include reviewing the firm’s sales practices and investor interactions more generally, including as design elements, features, or communications that might encourage more immediate and less informed action by the investor.

The Scope of “Covered Technology”

The SEC’s proposed definition of a “covered technology” broadly encompasses tools likely used by many entities. A “covered technology” is 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. Examples of covered technology include PDA-like technologies such as AI, machine learning, or deep learning algorithms, neural networks, NLP, or large language models, as well as other technologies that make use of historical or real-time data, lookup tables, or correlation matrices (among others). In addition to these advanced technologies, the term broadly covers technology such as a model in a spreadsheet that implements financial modeling tools or calculations to reflect historical correlations between economic business cycles and the market returns of certain asset classes to optimize asset allocation recommendations to investors. Also, use of third-party, commercial, off-the-shelf technology used by a firm is within the scope of the term.

Requirement to Identify Possible Conflicts of Interest

The proposed rules would require a firm to evaluate any use or reasonably foreseeable potential use by the firm of a covered technology in any investor interaction to identify any conflict of interest associated with that use or potential use. The rules do not mandate a specific approach to conducting this evaluation.

The firm may adopt an approach that is appropriate for its particular use of a covered technology, provided evaluation is sufficient to identify the conflicts of interest that are associated with how the technology has operated in the past and how it could operate once deployed by the firm. Firms that use more advanced covered technologies may need to take additional steps to evaluate technology and associated conflicts adequately. A firm’s lack of visibility (e.g., an AI model that uses a “black box” algorithm) would not absolve a firm of its obligation to comply with the rules. Further, firms are required to consider the effects of AI models that “drift” or “decay” over time when evaluating and testing a covered technology.

Requirement to Test the Covered Technology

As part of the identification and evaluation requirement, the proposed rules would include a requirement to test each covered technology to determine whether the use of such covered technology is associated with a conflict of interest. Although the proposed rules do not specify a method or frequency of testing that the firm must conduct, there are two specific times testing would be required: (i) prior to implementation of the covered technology, and (ii) before deploying any “material modification” of the covered technology, such as adding new functionality like expanding the asset classes covered by the technology. A firm’s testing methodologies and frequencies may vary depending on the nature and complexity of the covered technologies it deploys.

Requirement to Eliminate or Neutralize the Effect

After identifying a conflict of interest, the proposed rules would require a firm to determine whether the interest of the firm is being placed ahead of investors’ interests. Only where the firm makes (or reasonably should make) such a determination would the firm be required to “promptly” eliminate, or neutralize the effect of, the conflict of interest. To neutralize a conflict’s effect, a firm may take several approaches including changing how the firm-favorable information is analyzed, modification to factor weightings, or trained personnel screening for any conflicts. The current version of the rules would prohibit the use of any covered technology with an effect that cannot be eliminated or neutralized. Conflicts cannot be remedied through disclosure and consent.

Policies and Procedures Requirement

The proposed rules would require investment advisers that use covered technology in any investor interaction to adopt and implement written policies and procedures reasonably designed to

prevent conflicts of interest. Likewise, for broker-dealers, the rules would require a broker-dealer to adopt, implement, and maintain written policies and procedures. This would include:

  • A written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction;
  • A written description of the process for determining whether any conflict of interest results in an investor interaction that places the interest of the firm or its associated persons ahead of the interests of the investor;
  • A written description of the process for determining how to eliminate, or neutralize the effect of, any conflicts of interest; and
  • A review and written documentation of that review, at least annually, of the adequacy of the policies and procedures and written descriptions established.

Proposed Record-Keeping Amendments

The proposed rules would also amend rules 17a-3 and 17a-4 under the Exchange Act and rule 204-2 under the Advisers Act to set forth requirements for broker-dealers and investment advisers to maintain and preserve, for the specific retention periods, all books and records related to the requirements of the proposed conflicts rules. These would include:

  • Written documentation of the evaluation of any conflict of interest related to the use or potential use by the firm of a covered technology in any investor interaction. This would include a list or other record of all covered technologies used by the firm in investor interactions, including:
    • (i) the date on which each covered technology is first implemented (i.e., first deployed) and materially modified, and
    • (ii) the firm’s evaluation of the intended use as compared to the actual use and outcome of the covered technology.
  • Firms would also be required to maintain documentation describing any testing of the covered technology, including:
    • (i) the date when testing was complete,
    • (ii) the methods used to conduct the testing,
    • (iii) actual or reasonably foreseeable potential conflicts of interest identified as a result of the testing,
    • (iv) a description of any changes or modifications made to the covered technology that resulted from the testing and the reason(s) for those changes, and
    • (v) any restrictions placed on the use of the covered technology as a result of the testing.
  • Written documentation of the determination as to whether there was a conflict of interest.
  • Written documentation of how the effect of any conflict of interest has been eliminated or neutralized, including a record of the specific steps taken by the firm.
  • Written policies and procedures, including any written descriptions adopted, implemented and, regarding broker-dealers, maintained.
  • A record of any disclosures provided to investors regarding the firm’s use of covered technologies, including the date such disclosure was first provided or the date such disclosure was updated.
  • Records of each instance in which a covered technology was altered, overridden, or disabled; the reason for such action; and the date thereof.

The comment period is open until Oct. 10, 2023.

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