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SEC Must Set Due Diligence Standards for Use of Alternative Data

Dec. 9, 2022, 9:00 AM

The alternative data market allows investors to access hyper-detailed information about commercial activity, supplementing traditional financial analysis. Steady demand from investors for this cutting-edge data has rapidly expanded its market.

Alternative data isn’t found in company filings, press releases, analyst reports, or other conventional sources. Instead, automated methods allow gathering of web traffic, social media, product reviews, commercial transactions, GPS data, and other sources for insights that help investors.

According to a recently released Lowenstein Sandler survey of over 100 respondents in the investment community, one in 10 indicated they use alternative data or plan to use it soon. Demand is expected to increase even more, with one source predicting the total market across all industries increasing from $4.49 billion in 2022 to $149.1 billion by 2030.

Despite major advancements in sources and tools, engineering and regulatory challenges may interfere with the expanding alternative data market. The SEC should provide further guidance so overly burdensome regulations don’t limit participation.

Hefty Overhead

Firms with more resources can take advantage of economies of scale to use data more efficiently than their competitors.

In the past, it took an immense engineering effort to support analysis of the data. Today, most of those barriers are much lower due to advances in engineering. However, one barrier that persists is the immense engineering effort to undertake foolproof access monitoring and other compliance requirements for very large sets of complex data, which are common in alternative data.

Another complication is that as data vendors compete to provide the most useful data to their customers, they risk crossing a line and furnishing data that might be deemed material non-public information. Access controls and monitoring may be implemented to manage and confine risks if MNPI is found so it doesn’t result in firmwide trading restrictions.

But for large and complex data sets, such controls and monitoring become much more complex and expensive, and may require investment firms to develop new specialized IT systems to support compliance requirements.

SEC Guidance

In an April 2022 risk alert, the SEC’s Division of Examinations identified investment firms’ policies and procedures around alternative data as a common area of deficiency in complying with Section 204A of the Investment Advisers Act.

The alert stated advisers’ policies and procedures often inadequately addressed the risk of exposure to MNPI. These risks include not implementing consistent due diligence of all vendors and failing to implement systems for determining when diligence must be re-performed based on changes in vendors’ business practices or data offerings.

The SEC’s October 2022 rule release proposed enhanced due diligence requirements in respect to certain outsourced service providers, which may include data vendors. This proposal adds further uncertainty to the depth and scope of diligence required in connection with onboarding and monitoring data vendors.

Many investment firms have proactively and carefully followed SEC guidance around alternative data use. Along these lines, they have adopted and implemented thorough policies and procedures regarding the use of this data. But no case law has directly addressed the application of securities laws to the use of alternative data.

Moreover, the SEC’s guidance, while somewhat vague, leaves the impression that firms should devote significant resources to their due diligence activities with respect to alternative data and should conduct the same thorough diligence of every vendor, and continuously monitor vendors’ data collection practices and relationships with data sources, regardless of the relative risk of their receipt of MNPI.

Firms with adequate resources may easily be able to implement such a broad-scale compliance infrastructure, but smaller firms may become lesser users of alternative data due to the compliance burden.

Firms may devote significant resources to compliance efforts to demonstrate to the SEC that they are keeping up with their peers. This will allow bigger firms with significant legal and compliance resources to set the standard for alternative data due diligence, even though that standard may be largely inefficient.

Risks to Smaller Firms

Taken to its logical conclusion, the SEC may punish smaller firms for merely expending inadequate legal and compliance resources in this area, rather than actually receiving MNPI.

The result could be that firms that cannot afford to match the efforts of their larger competitors may simply choose not to participate in the alternative data market, or to only use well-known and “safe” alternative data sources.

This risk is particularly concerning considering there is already a mismatch in the comparative ability of different-sized firms to efficiently use alternative data—due to technical and personnel requirements to effectively trade upon this data.

In this environment, only the largest players with the most resources will fully participate in the market. This inequity will lead to less efficient capital markets, because a critical source of information has become less widely available. There is also a risk that lesser-known or start-up data vendors will be shut out of the market, in part due to incentives created by legal and compliance requirements of investment advisers.

The SEC, rather than the largest firms, should set the standard for best practices in alternative data due diligence by providing further guidance on which areas of focus and concern to investment advisers. This would at least clarify that investment firms need not expend excessive resources policing their vendors’ business practices and relationships with data sources in all instances.

Without further SEC guidance, inefficient and overly burdensome legal and compliance practices may become standard and entrenched, which could unfortunately limit participation and hamper innovation in a currently flourishing market.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Steve Cannon is chief data scientist at e-TeleQuote Insurance. He previously served as the first head of model data at AQR Capital Management and was a member of the big data team at Two Sigma Investments.

George Danenhauer is counsel in Lowenstein Sandler’s investment management group. He advises investment management clients with an emphasis on commercial agreements, alternative data, and compliance issues.

Scott Moss is a partner in Lowenstein Sandler’s investment management group and chairs the firm’s fund regulatory and compliance group.

Lowenstein Sandler attorneys Boris Liberman and Michael Scales contributed to this article.