SEC proposal would require brokers, advisors to remediate conflicts related to use of AI

Brokers and investment advisors would have to remediate conflicts of interest related to interactions with investors conducted through artificial intelligence, predictive analytics and similar technology under a proposal released Wednesday by the SEC.

By a 3-2 vote, the Securities and Exchange Commission approved releasing a 243-page proposal for public comment that would require brokerages and investment advisory firms to review their use of a “covered technology” and determine whether its algorithms optimize the interests of the firm or its financial advisors over the interests of investors.

Firms would have to “eliminate or neutralize” conflicts, according to an SEC fact sheet. They also would have to implement related policies, procedures and record keeping.

A covered technology “includes 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,’ the SEC fact sheet states.

Predictive analytics enable brokerages and advisory firms to nudge investors based on their individual characteristics to behave in certain ways related to product offerings and pricing.

Such “narrowcasting” can benefit clients or customers if it results in a unique investment approach that works particularly well for them, but it also can raise harmful conflicts, SEC Chair Gary Gensler said.

“If the robo advisor or brokerage app is using a function to optimize for its own interests and not solely for yours as an investor, therein lies a conflict,” Gensler said at an SEC open meeting. “Investors deserve to be protected from predictive-data-analytics-driven interactions. ”

Gensler added in a statement: “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 own interests ahead of investors’ interests.”

But SEC Commissioner Hester Peirce said the proposal was overbearing and would discourage financial advisors from using advanced technology.

“The proposal reflects a hostility toward technology,” Peirce said at the SEC meeting. “Requiring firms to subject certain types of technologies to an onerous review and conflict mediation process is not technology neutral. Let’s be honest about what we’re doing. We’re banning technologies we don’t like.”

Peirce asserted that the SEC proposal abandoned disclosure as a way to cure conflicts. She said it also was not necessary given that Regulation Best Interest, the broker standard of conduct, and investment advisor rules already require financial advisors to address conflicts.

“Disclosure is not an option,” Peirce said of the proposal. “We don’t need stand-alone rules.”

Gensler countered that a new rule is required for emerging technologies.

“I think this is more than just disclosure,” Gensler said. “It’s really about whether there’s built into these predictive analytics something that’s optimizing on our interests or is it also optimizing in part on the interest of the advisor of the broker?”

The Investment Adviser Association expressed concern about the proposal shortly after the SEC meeting concluded.

"The proposal again appears not to identify and support with data the need for a new regulation, seeming to dismiss existing regulatory obligations that already govern the conduct the proposal is trying to address," IAA general counsel Gail Bernstein said in a statement. "It also doesn’t seem to seriously consider operational difficulties or accurately describe the likely costs advisers will bear, particularly smaller advisers."

The Republican SEC commissioners — Peirce and Mark Uyeda — voted against releasing the proposal for public comment. Gensler and the other two Democratic commissioners — Caroline Crenshaw and Jaime Lizarraga — voted to open the proposal for public comment. The comment period will last for 60 days after the document is published in the Federal Register.

In other action Wednesday, the SEC approved a final rule to beef up public company disclosures related to cybersecurity incidents and approved releasing a proposal to tighten registration requirements for investment advisors who operate only on the Internet.