ANALYSIS: Does SEC Really Need a New Conflict-of-Interest Rule?

Technological advancements, like the development of predictive data analytics (PDA) and other forms of artificial intelligence (AI), are changing how investment advisers and broker-dealers interact with investors. The tech may improve returns for investors by reducing costs or yielding better investment advice. However, conflicts of interest baked into underlying algorithms could harm clients if their use isn’t properly managed, leading the Securities and Exchange Commission to reevaluate the sufficiency of the current regulatory framework in the securities market.

Indeed, the SEC proposed new rules on July 26, 2023, to guard against these increased risks associated with AI. But the SEC should have no trouble keeping the use of AI in check during 2024 with the enforcement tools already at its disposal. That’s because the SEC has long possessed the authority to regulate how investment advisers and broker-dealers—or “firms,” in the SEC’s lexicon—identify and manage conflicts of interest under the Exchange Act and Advisers Act. In 2024, the SEC will use enforcement actions to ensure the proper management of conflicts of interest—regardless of the technology from which the conflicts originate.

Firms Are No Stranger to PDA

Investment firms have used artificial intelligence in various forms to improve workflow, detect fraud, and monitor market trends. Recently, firms have been developing a subset of AI—PDA technology—to process historical data, build forecasts, and test hypotheses to enhance the services they provide.

For instance, executives at several investment firms recently told Bloomberg of their plans to develop PDA-like technology to aid in the construction of personalized financial plans using client-provided information and market data, educate employees, and help customers prepare for financial planning meetings.

The SEC’s Conflict-of-Interest Proposal

As the industry advances, the SEC has begun to take targeted action. Its proposed rules aim to address conflicts of interest arising from PDA-like technology where an underlying algorithm may serve a firm’s interests over its clients’.

For instance, an algorithm may prioritize a firm’s financial interests, by encouraging excessive trading or the selection of securities that bear fees higher than cheaper alternatives. The proposed rules would address these concerns by requiring firms to assess potential conflicts of interest related to their use of PDA-like technologies; adequately disclose, mitigate, or eliminate such conflicts; and enact internal written policies and record-keeping procedures to manage them. The proposal would also expand conflicts rules to cover client interactions beyond the provision of advice and recommendations.

Although many market participants recognize the importance of guarding against conflicts of interest, the SEC will need to contend with some of the criticism it has received.

Although the comment period closed Oct. 10, and seeing as the proposal isn’t final, it may be pared back in light of pushback from two SEC commissioners, Hester Peirce and Mark Uyeda, and the sentiment reflected in public comment letters submitted to the SEC.

In particular, Commissioner Uyeda observed that the proposed rules are duplicative of existing law, and would deter the use of widely acceptable technologies that benefit investors while presenting negligible risks. Commissioner Uyeda said that he believes investors would be better served by narrow regulations meant to address identified gaps in the existing regulatory framework. Commissioner Uyeda’s belief has been shared by several commenters, including a subcommittee of the American Bar Association and SIFMA, an influential trade group in the financial services industry.

The Sufficiency of Existing Law

Existing principles-based regulatory frameworks require financial firms to act in investors’ best interests—meaning that they must disclose, mitigate, or eliminate certain conflicts of interest that may influence investors. As recognized by the Supreme Court 60 years ago in SEC v. Capital Gains, the Advisers Act imposes fiduciary duties upon advisers. At the same time, the Exchange Act and Regulation Best Interest, impose corresponding obligations upon broker-dealers. It is well-established that Capital Gains and its progeny provide ample guidance applicable to enforcement actions to this day.

SEC Chair Gary Gensler has emphasized that the mass proliferation of AI increases the likelihood that a given conflict of interest could adversely affect a broker-dealer’s or adviser’s entire investor base. Given that Regulation Best Interest covers conflicts of interest that may influence investors’ trades, especially when those communications are tailored to a specific customer or group, Gensler’s stated concerns appear to have already been addressed under Reg BI.

The Effectiveness of Current Enforcement Actions

The SEC has brought several enforcement actions in recent years, like those discussed below, that may also apply to issues that the agency has raised with regards to the increased prevalence of AI. As the SEC already possesses the ability to bring these actions in the absence of AI-specific regulations, the necessity of the proposed rules is therefore called into question.

Take for example, the concern that a bias in an underlying algorithm in PDA technology may result in the selection of securities that serve the interests of an adviser or broker-dealer at their investors’ expense.

For instance, an algorithm may tend to suggest that investments be made in a certain share class that bears a higher fee to be paid to the firm or its affiliate than a comparable share class. In that case, the firms’ interest in higher fees is at odds with its clients’ interest in lower-cost investments.

In September, the SEC demonstrated its ability to address conflicts of this nature with a cease-and-desist proceeding against a firm, in part, for its failure to disclose to its client the existence of lower fee alternatives to the securities in which they invest, where investment in the lower fee/lower expense ratio alternatives would result in the investment adviser not receiving a payment it had received (and disclosed to investors) in connection with the investment. Seeing as PDA technology may inappropriately increase fees, there is no indication that a conflict of interest of a similar nature involving PDA technology would be treated any differently under federal securities law.

In addition to presenting conflicts-related risks, an investment adviser’s use of untested PDA technology may be problematic from an SEC enforcement perspective. For example, in 2018, the SEC obtained a cease-and-desist order against an investment adviser for failing to ensure the technology worked accurately as intended and for failing to disclose associated risks to investors. Applied in the context of PDA technologies, the principle is no different—firms must ensure that the technology they use operates as marketed and intended and they must adequately disclose the risks associated with the use of the technology.

While the AI boom may cause conflicts of interest to impact many investors simultaneously, the principles-based conflicts rules in place today apply without regard to the number of clients who may be affected by the existence of a conflict. The SEC has demonstrated its present ability to regulate conflicts of interest and its intent to continue doing so with the current regulatory framework.

Accordingly, investment firms shouldn’t be tempted to exploit the current absence of AI-specific conflict-of-interest rules. Firms that treat emerging technology as unregulated may be in for a rough 2024 if the SEC comes knocking.

The Bloomberg Law 2024 series previews the themes and topics that our legal analysts will be watching closely in 2024. Our Artificial Intelligence analyses explore the most compelling challenges that generative AI will bring to legal professionals in the year ahead.

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