SEC Predictive Tech Ban Causes Confusion for Investment Advisers

The Securities and Exchange Commission is considering banning brokers and investment advisers from using predictive technologies—which have grown dramatically through artificial intelligence, machine learning, and other emerging tech—unless they eliminate all conflicts of interest that could arise from using such technologies in their services.

The vagueness of the SEC’s proposed rule, coupled with an active enforcement environment, could deter US brokers and investment advisers from deploying quickly evolving technology in their operations, putting them and their clients at a competitive disadvantage with international competitors.

It would be understandable if the SEC’s proposal banned practices that intentionally recommended trades based on what was more profitable for the broker or investment adviser. However, the definition of “conflicts” that would trigger the ban is so broad under the proposed rule that it could capture anything that “takes into consideration” the interests of a broker or investment adviser.

The scope of the regulation could unintentionally and potentially encumber most activities that use emerging technologies, as every time someone engages in commerce, outside the scope of purely charitable endeavors, they “take into consideration” their own interests.

It’s notable that the SEC’s proposed rule isn’t tethered by the potential costs and benefits of a conflicted practice and doesn’t allow for situations where the attributes of a practice outweigh any competing conflicts.

Conflicts exist in most business operations, whether or not they’re related to securities or investment advisory matters. When a party engages in any relationship with a counterparty to provide services, the party has a motivation to act in both the interests of the counterparty and its own interests.

If there was a general rule to eliminate conflicts in business transactions, most commerce would grind to a halt, as conflicts are endemic anytime parties in a transaction have even slightly differing motives.

Regulation, at least for investment advisers, traditionally has focused on identifying, disclosing, and possibly mitigating conflicts, rather than on effectuating an outright ban on any business practice where conflicts present themselves.

With respect to disclosure, which has been the traditional focus of regulation, a practice has been permitted provided there is clear disclosure of the conflicts and related risks so investors can make informed decisions.

Investors often decide rationally that a proposed investment is still beneficial even when there are conflicts of interest.

The SEC’s proposed rule follows a trend in investment advisory matters, in which a merit-based regulatory regime replaces a disclosure-based regime. Merit-based regimes disallow a practice even if the conflicts and risks are fully and clearly explained to a counterparty, and the counterparty still wishes to engage in the related investment activity because the perceived benefits outweigh the negatives of the identified conflicts.

The SEC’s proposal further complicates the situation by not differentiating the proposed regulation between retail investors and institutional investors. The latter category of investors frequently analyzes disclosed conflicts and often has the acumen and skill necessary to discern whether a conflicting practice voids an investment opportunity that would otherwise be attractive.

A shift to a merit-based regime could have the unintentional effect of harming investors in emerging technology. There’s an inherent danger of unintended consequences in attempting to regulate emerging tech that evolves faster than regulators’ understanding of it.

Overly broad regulation can quash technological development. Despite how the SEC has framed the proposed rule, it may be unnecessary in its current form to protect investors. Investors can benefit from existing practices, even if there may be conflicts embedded in them. There’s a risk the SEC’s deliberations may inadvertently wage a war against technological evolution itself.

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

Author Information

James A. Deeken is partner at Akin Gump and adjunct lecturer at Southern Methodist University School of Law.

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