AI in the Asset Management Space
Introduction
On July 26, 2023, the Securities and Exchange Commission ("SEC") proposed new rules under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 "to eliminate, or neutralize the effect of, certain conflicts of interest associated with broker-dealers' or investment advisers' interactions with investors through [the] use of technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes" (the "Proposed Rules"). The Proposed Rules would have far-reaching negative consequences not just for the asset management industry, but also the investors they serve. As explained below, the SEC's release fails to justify the need for such a sweeping and harmful set of rules; not only are the potential harms identified by the SEC framed only through the agency's imagined possibilities—as opposed to being grounded in reality—there is no reasonable justification for replacing the current regulatory regime for managing conflicts. The industry as a whole seems to agree, submitting over one hundred comments detailing the potential harms of the proposal.
The Proposed Rules
At its core, the Proposed Rules place onerous burdens on brokers and advisers who use technology to serve investors, completely barring such technology if it may result in firms placing their own interests above those of investors. In particular, the SEC appears to be concerned with 1) conflicts of interests derived from the use of such technology; 2) corruptible or mislabeled data garnered from unknown sources; and 3) the so-called "black box" of information that leads to unrecognized or unsubstantiated results.
The Proposed Rules provide that investment firms would be required to evaluate their use of technology to identify potential conflicts of interest, adopt and implement certain policies and procedures reasonably designed to prevent any such conflicts, and comply with new record-keeping requirements related to the use of technology. The first two of these requirements are, for the most part, already covered by existing law. For at least investment advisers, the record-keeping requirement would supplement the long-standing approach of allowing advisers to disclose the conflict with an outright prohibition. The SEC does not provide a convincing reason for such a departure and as noted above, the industry has pushed back staunchly against the proposal—noting numerous significant challenges with the rules as proposed.
Problems with the Proposed Rules
As discussed in comment letters to the SEC, there are two significant problems with the Proposed Rules. First, the definition of "covered technology" is so overly broad that it essentially includes most forms of "technology," no matter how rudimentary. Second, the requirement that a conflict associated with such "technology" be eliminated—rather than simply disclosed—inflicts significant negative repercussions on both asset managers and investors. Overall, it remains unclear how the SEC can justify the abandonment of the approach adopted in Reg BI and its long-standing, principles-based approach to managing an investment adviser's conflicts.
First, the Proposed Rules define "covered technology" as "[a]n 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." According to the SEC, examples of such technology include "predictive data analytics like" tools that analyze investor behavior, algorithm-based technologies that provide investment recommendations, auto-encoder models to predict returns, and machine learning in the use of advertising. As many commenters have noted, the breadth and ambiguity of this definition begs the question of which forms of technology fall outside its umbrella, as the rule could seemingly include even the simplest of tools that have been used by brokers and advisers for decades—such as an Excel spreadsheet. This led one commenter to describe the Proposed Rule as the SEC's "continued war on technology."
Next, and perhaps most problematic, under the Proposed Rule if a firm identifies a conflict of interest, it is required to not only "[e]liminate, or neutralize the effect of" that conflict, but to do so "promptly"—a demand which one commenter described as "pretty much unprecedented." In defense of the Proposed Rules, the SEC has taken the position that conflicts created by predictive analytics in particular are "relatively opaque," complicated, and quick to evolve, such that disclosure is not a useful tool in addressing them. The SEC fails, however, to provide any reason, explanation, or analysis as to how these types of conflicts are any more complicated than others. Moreover, Reg BI and an adviser's fiduciary duty already address managing these types of conflicts. For example, in its 2019 interpretive release, the SEC clarified that the fiduciary duties imposed upon advisers generally under the Adviser Act require the elimination of any conflict which cannot be resolved via "full and fair disclosure and informed consent."
In sum, the industry seems to agree—almost uniformly—that the Proposed Rules' "lack of discernible boundaries" describing which technologies fall within the regulation functions as a "de facto ban on the use of the technology." More importantly, however, such a measure is unnecessary and attempts to solve a problem which does not exist; the complexity of a conflict of interest has traditionally been left to the discretion of the adviser, and the SEC has provided no discernable explanation for why technology should alter the status quo.
Fiduciary Duties
In separate statements, the American Securities Association ("ASA") and the Investment Adviser Association ("IAA") illustrated what has been the overwhelming sentiment among commentators as it applies to the SEC's proposed rule—that the SEC should withdraw its proposal and instead rely on the already existing fiduciary duties which govern the respective duties of care and loyalty among investment clients.
Various members Congress have opined similarly, with representatives Ann Wagner (R-MO) and French Hill (R, AR) offering via joint statement: "If the SEC's goal is to supplant Reg BI and the existing fiduciary standard with the proposal's heightened 'best interest' standard, it should be transparent about its actions . . . [the SEC] should not rely on the recent attention around predictive analytics or artificial intelligence as a pretext." That is, the existing fiduciary duties owed by firms (to investors) already cover the use of technology without the added complication of the Proposed Rules, and without threatening the elimination of basic technologies. As IAA explained, "even where the covered technology would provide financial education, coaching, guidance, or advice that are in the best interest of clients, notwithstanding the presence of a conflict, the adviser would be per se prohibited from proceeding to use the technology without first eliminating or neutralizing the conflict altogether."
Conclusion
Savvy businesses across the nation are embracing the use of technology, including predictive analytics, to optimize workflow and generate cost-savings for themselves and the people they serve. To be sure, unlike other businesses, brokers and advisers cannot put their interests above those of investors when making securities recommendations, but the obligations already imposed on brokers and advisers seem to resolve the same problem the SEC seeks to eradicate, causing understandable head-scratching among those in the industry. As noted above, the Proposed Rules are not necessary and move the regulatory landscape further than needed to accomplish the stated goals, creating sub-categories of conflicts which are treated differently (for unclear reasons) than traditional, run-of-the-mill conflicts of interest. Although the use of some technology—including prescriptive analytics—in finance can be complex, if the Proposed Rules are adopted, many brokers and advisers worry about their ability to utilize technology effectively to serve investors, and justifiably so.
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