Prompted by the “gamification” of investment services, the Securities and Exchange Commission (“SEC”) proposed rules and amendments on July 26, 2023, that could reach a broad universe of existing and future technologies and could threaten to make the use of artificial intelligence (“AI”) impractical for investment advisers and broker-dealers. Although the SEC frames the proposal (“Proposed Rule”)1 in terms of conflicts of interest in “predictive data analytics” used by registered investment advisers (“RIAs”) and broker-dealers, it could reach any “analytical, technological, or computational function” used in investor communications and the investment process. The SEC notes that this could include, for example, something as basic and ubiquitous as a model in Excel used to inform an investment decision. The Proposed Rule would require firms to identify each use of such technology, analyze it for potential conflicts of interest and “eliminate, or neutralize the effect of” any conflict of interest that favors the RIA or its associated persons. By mandating that conflicts be eliminated or neutralized, the Proposed Rule may be inconsistent with the Investment Advisers Act of 1940 (“Advisers Act”), which, as formally interpreted by the SEC in 2019, permits full and fair disclosure with informed client consent as an effective means to address conflicts of interest. Moreover, the Proposed Rule’s prescriptive processes and associated recordkeeping requirements are so onerous they could effectively shut down the use of ChatGPT and other LLMs right as fund managers are beginning to experiment with them.
Broad Application of the Proposed Rule. The Proposed Rule would be extraordinarily broad.
• Types of Technology Covered. “Covered technology means an 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.”2
• Uses of Technology Covered. While the Proposed Rule would apply to the use of covered technology in “investor interactions,” that term goes far beyond direct communications with investors and includes exercising discretion over client portfolios, including private funds. “Investor interaction means engaging or communicating with an investor, including by exercising discretion with respect to an investor’s account; providing information to an investor; or soliciting an investor; except that the term does not apply to interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support.”3 “Investor” includes any prospective or current client of an investment adviser or any prospective or current investor in a pooled investment vehicle.4
The Proposing Release highlights how even a model in a spreadsheet and other tools used in the investment process could constitute a “covered technology” for these purposes:
[U]sing algorithmic-based tools, such as investment analysis tools, to provide tailored investment recommendations to investors would fall under the proposed definition of covered technology because the use of such tools is directly intended to guide investment-related behavior. . . . Similarly, if a firm utilizes a spreadsheet that implements financial modeling tools or calculations, such as correlation matrices, algorithms, or other computational functions, to reflect historical correlations between economic business cycles and the market returns of certain asset classes in order to optimize asset allocation recommendations to investors, the model contained in that spreadsheet would be a covered technology because the use of such financial modeling tool is directly intended to guide investment-related behavior.5
The Proposing Release likewise acknowledges that the use of chatbots to answer complex investmentrelated questions would be covered.6
Conflicts of Interest. The Proposed Rule is premised on a novel definition of the term “conflict of interest” to cover any situation where the covered technology takes into consideration an interest of the RIA. The Proposed Rule would require firms that use covered technology to:
• Evaluate any use (or reasonably foreseeable potential use) by an RIA or its associated persons in an investor interaction (including discretionary investment decisions for client accounts), by, among other things, testing such covered technology, to determine whether there is any conflict of interest. Notably, the use of covered technology triggers an obligation to evaluate and test the technology both prior to its implementation or material modification and periodically thereafter.
• Once a conflict of interest is identified, the RIA must determine if the conflict places the interest of an RIA or its associated person ahead of the interests of investors. Such conflicts of interests potentially could be related to, for example: best execution and soft dollar determinations, expense allocations, cross transactions, side-by-side trading of client portfolios, investment allocations, valuations and personal holdings by manager personnel. Any such conflicts of interest must be “eliminated or neutralized.”7
The Proposed Rule is inconsistent with the legislative history of the Advisers Act and the recent SEC interpretation of an investment adviser’s fiduciary duties under the Act, which provides that an investment adviser can satisfy its duty of loyalty by either eliminating a conflict of interest or obtaining informed client consent through full and fair disclosure.8 The Proposed Rule, however, would ban the use of covered technologies where such a conflict exists, even where a client has given informed consent.
Policies and Procedures. The Proposed Rule requires RIAs to adopt policies and procedures if they use covered technology in investor interactions (including the investment process). Such policies must include a written description of the process for (1) evaluating any use or reasonably foreseeable potential use in any investor interaction and the material features of such technology, including any conflicts of interest associated with the use of covered technology, prior to implementation or material modification of the technology and periodically thereafter, (2) identifying conflicts of interest that place the adviser’s (or its associated persons’) interests ahead of investors’ interests and (3) determining how to eliminate or neutralize the effect of a conflict identified in (2). RIAs would also be required to review and document, at least annually, the adequacy of such policies and procedures and the effectiveness of their implementation.
Recordkeeping and Disclosures. The Proposed Rule would impose unwieldy and potentially insurmountable books and records requirements for RIAs that use any covered technology in investor interactions. In addition to requiring records of the processes and determinations referenced above, the recordkeeping obligations would require written records of all covered technologies used in investor interactions (regardless of whether they are associated with a conflict of interest). RIAs would also be required to keep records, with respect to each such covered technology, of: material modifications, testing (and any resulting changes and restrictions) and instances where the technology was altered, overridden or disabled. The current SEC enforcement sweep regarding the use of electronic communications has shown that the books and records rules can prove a powerful (and expensive) enforcement lever. The Proposed Rule does not explicitly mandate investor disclosures regarding the use of covered technologies, but does require that any such disclosure be maintained as part of the firm’s books and records.
Need for Comments to the Proposed Rule. The Proposed Rule was framed as addressing “gamification” tactics targeted at retail investors that purportedly exacerbated trading volatility in connection with socalled meme stocks. Chair Gensler cited recommendations in the staff’s October 2021 GameStop report and comments the staff solicited in August 2021 regarding digital engagement practices as a key basis for the Proposed Rule. However, those recommendations and comments, which predated significant advances in generative AI by more than a year, are a far cry from this sweeping proposal.9 Given the tremendous impact the Proposed Rule could have on the use and integration of current and future technological tools, including AI and LLMs, by RIAs, the comment process will be particularly important.10
