The SEC Targets Use of Predictive Data Analytics


Jaqueline Hummel

Publish Date


Compliance Alert

  • Compliance
  • SEC
  • Artificial Intelligence (AI)

The U.S. Securities and Exchange Commission (SEC) proposed rules to prevent registered broker-dealers and investment advisers from using “predictive data analytics” (PDA), technology that helps guide, forecast, or direct an investor’s behavior, in ways that would put the interests of the firm ahead those of its clients and investors. Proposed Exchange Act Rule 15(a)-2 and Advisers Act Rule 211(h)(2)-4 require broker-dealers and investment advisers to evaluate “covered technology” for conflicts of interest and eliminate or neutralize those conflicts.

The comment period ended on October 10, 2023, with many industry groups voicing their concerns about the broad reach of the new rules, the SEC’s failure to provide a meaningful economic analysis of the rules’ effects, the substantial burden of compliance, and the detrimental effect on technological innovation.

What is included in the proposed rules?

By way of background, the SEC defines “covered technology” expansively under the proposed rules, including any “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." The proposed rules cover algorithmic trading, artificial intelligence (AI), machine learning, natural language processing, chatbots, and digital engagement processes if used in communicating with investors or managing investments.

In addition to covering a vast range of technologies, the proposed rules cover almost any interaction with a client or prospective client. They include communications that take place in person, on a website, via smartphones, through computer applications, or by email, and, presumably, advertisements. The broker-dealer version of the rule applies only to "natural person" investors, consistent with Regulation Best Interest (Reg BI). The rule, applicable to investment advisers, includes any prospective or current client or any prospective or current investor in a pooled investment vehicle advised by the investment adviser. The proposed rule covers both investors in private funds and mutual funds.

The proposed rules also require firms to eliminate or neutralize conflicts of interest. Traditionally, investment advisers have dealt with conflicts by providing full disclosure and getting client consent, or by mitigating the effect of the conflict on investors. Under the proposed rules, a “conflict of interest” would exist when a broker-dealer or investment adviser uses a covered technology that takes into consideration an interest of the broker-dealer or investment adviser or its associated persons. By requiring firms to “eliminate or neutralize” conflicts, the SEC appears to prohibit an adviser’s ability to use disclosure and consent to deal with conflicts.

Finally, the proposed rules would impose new obligations on investment advisers and broker-dealers to (1) identify potential conflicts resulting from the use of a covered technology, (2) determine whether the conflict places the firm’s interest ahead of the investors’ interests, and (3) test the covered technology initially and periodically for conflicts. Firms must also document and retain records of their analysis under the relevant recordkeeping rules. Firms must also adopt policies and procedures describing how they comply with the proposed rules.

More work needs to be done

There were 57 comments posted to the SEC’s website on the proposed rule, with 39 commenters coming out against the new rules and 15 commenters expressing support. One letter asked for more time to comment, one supported the general idea of putting guardrails around the use of artificial intelligence, and one didn’t say anything about the proposal.

Undoubtedly, the many comments submitted will give the SEC food for thought as it contemplates the next steps for these rule proposals. In the meantime, however, the SEC will seek more information about how investment advisers use advanced technologies such as artificial intelligence. For example, SEC examiners have been asking for more information about the use of artificial intelligence in private fund exams, as noted in our September 2023 Regulatory Update. The examination staff has been asking for all "disclosure and marketing documents to clients where the use of AI by the adviser is stated or referred to specifically in disclosure." Additionally, the examiners have requested written descriptions of "all distinct artificial intelligence based artificial intelligence models and artificial intelligence techniques developed and implemented” by the adviser to manage client portfolios or make investment decisions and transactions.

Even where firms were not using artificial intelligence, the SEC appears interested in quantitative models and trading algorithms used by firms, asking for details on how they were vetted, what data sets are being used, and whether firms have policies and procedures to ensure that models and algorithms continue to work as intended.

Our guidance

At this point, knowing how these rules will look in their final form is impossible. Other rules enacted under the SEC’s aggressive agenda have been significantly modified from their original proposals. In the meantime, firms should consider taking an inventory of computer systems and software programs that use artificial intelligence to develop marketing and disclosure documents, manage client portfolios, make investment decisions, and engage in transactions. Firms should then consider the data sources for these systems and programs, the due diligence process, and whether using such technologies could cause firms to place their interests ahead of their clients.

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