SEC Proposes Sweeping Rules on Broker-Dealer and Investment Adviser Technology Use

The US Securities and Exchange Commission (SEC) proposed on July 26, 2023 new rules designed to address conflicts of interest from the use of predictive data analytics in “investor interactions” by broker-dealers and investment advisers (the PDA Rules). The rules, if adopted as proposed, would impose broad and potentially burdensome conflict-of-interest requirements on broker-dealers and investment advisers that use even simple technologies to communicate with clients and fund investors or manage clients’ assets.

The PDA Rules[1] are short, and are drafted in a broad and vague manner that will make it challenging to assess the full breadth of their potential application to the industry. Although the title of the proposed rules might suggest that they are targeted at artificial intelligence and other sophisticated or opaque technologies, as drafted they would potentially cover virtually any type of technology, ranging from basic spreadsheets and calculators to applications using large language models.

The PDA Rules would impose restrictions on how broker-dealers and investment advisers communicate with clients and prospective clients and how discretionary investment advisers manage client accounts. The proposed rules would regulate conflicts of interest but, notably, would require that firms eliminate or neutralize the effect of such conflicts and would not permit the disclosure and/or consent-based approach typically applied to conflicts of interests.

Further, with respect to investment advisers, the rules would apply equally to their interactions with institutional investors and would extend to the marketing and management of pooled investment vehicles (both private and public).    

We will continue to review the proposed rules over the coming weeks, and we encourage clients to assess the impact that the proposed rules would have on their businesses and consider participating in the public comment process. Comments are due 60 days after the proposal is published in the Federal Register.   

SUMMARY OF THE PROPOSED RULES

The PDA Rules consist of two new rules—(i) Rule 15l-2 under the Securities Exchange Act of 1934 (Exchange Act), which would be applicable to broker-dealers, and (ii) Rule 211(h)(2)-4 under the Investment Advisers Act of 1940 (Advisers Act), which would be applicable to investment advisers[2]—and related amendments to the broker-dealer and investment adviser recordkeeping rules. The two proposed rules are substantially the same, with one key difference in scope noted below.

Scope

The proposed rules would impose requirements around “covered technology” that is used in any “investor interaction” that creates a “conflict of interest” in which the interests of the broker-dealer or investment adviser, or an associated person thereof, are placed ahead of any “investor.”

• What Is a Conflict of Interest? 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 an associated person thereof.
• What Is a Covered Technology? “Covered technology” would be defined as 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.
• What Is an Investor Interaction? “Investor interaction” would be defined as 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, but the definition excludes interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support.
• Who Is an Investor under the Proposal? The proposed broker-dealer rule defines “investor” to only include natural person investors who receive services for personal, family, or household purposes. The proposed investment adviser rule defines “investor” to include any prospective or current client or any prospective or current investor in a pooled investment vehicle advised by the investment adviser, where “pooled investment vehicle” would be defined by cross-referencing to Rule 206(4)-8 under the Advisers Act, which covers both private funds that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 and registered investment companies.

Requirements

The proposed rules would impose the following requirements:

Addressing Conflicts of Interest. A broker-dealer or investment adviser would be required to

• evaluate any use or “reasonably foreseeable potential use” of covered technology by the firm or any associated person in any investor interaction to identify whether such use is associated with a conflict of interest (including by testing each such covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest);
• determine whether any such conflict of interest places or results in placing the interests of the broker-dealer or investment adviser or an associated person ahead of the interests of investors; and
• eliminate or neutralize the effect of any such conflict of interest, other than a conflict of interest that exists solely because the broker-dealer or investment adviser seeks to open a new client account.

Policies and Procedures. If the broker-dealer or investment adviser uses any covered technology that creates one of the conflicts of interest described above, the firm would be required to (1) maintain policies and procedures that are reasonably designed to prevent violations of the requirements described above and (2) review such policies and procedures no less frequently than annually. The policies and procedures would have to include written descriptions of the processes used by the broker-dealer or investment adviser for making the determinations described above (i.e., identifying conflicts of interest and determining how to eliminate or neutralize the effect of such conflicts of interest).   

OUR INITIAL OBSERVATIONS

Breadth

The proposed rules are very broad in their application in a number of respects:

Covered Technology. The definition of “covered technology” is not limited to artificial intelligence and other sophisticated technologies, and includes simple technologies such as any “computational function” or “algorithm.” In its current form, it would apply to many of the investor- and financial professional-facing tools currently in use. The rule proposal notes that even a simple financial model in a spreadsheet would constitute a covered technology.[3]

Further, the definition includes technology that merely “guides” an investor’s investment-related behaviors or outcomes. This language could potentially be applied to almost any aspect of the design or user experience of a website or mobile application that is perceived as encouraging or influencing trading. 

For example, under this definition the SEC might characterize a registered fund’s website as a “covered technology” if the fund manager provided a tool on the website that allowed a user to compare the performance and risk metrics of a universe of funds, particularly if the fund manager’s proprietary products were listed first in the tool’s output. As a result, the proposed rules would require such fund manager to conduct an assessment of resulting conflicts of interest and then eliminate or neutralize the effect of them.

Further, the proposed rules would extend to indirect uses of covered technology such as where an associated person uses an internal tool and then shares the output with an investor. This would impact many of the internal tools that firms have developed to comply with Regulation Best Interest (Reg. BI) and could create overlapping and potentially conflicting requirements around those tools. 

Conflict of Interest. The definition of “conflict of interest” includes where a covered technology “takes into consideration” an interest of the broker-dealer or investment adviser or an associated person. Although the rules would only require firms to eliminate or neutralize the effect of conflicts of interest that place the interest of the firm or an associated person ahead of the interest of investors, the requirements in the rule to “evaluate” all conflicts of interest (discussed further below) could be very burdensome in light of the broad definitions of conflict of interest and covered technology.

Investor Interaction. The definition of “investor interaction” includes “engaging or communicating with” and “providing information to” an investor, as well as exercising discretion with respect to an investor’s account. For purposes of the proposed rules, “investors” are not limited to current customers or clients of the broker-dealer or investment adviser, but would also include prospective customers, clients, and investors as well as, in the case of advisers, prospective investors in the adviser’s private and/or registered funds.

Given how broadly “covered technology” and “conflict of interest” are defined, it seems likely that the proposed rules would affect nearly all investment advisers in some way. It is unclear how the proposed rules would apply in the context of subadvisory relationships involving investment discretion.       

Significant Expansion of the Regulation of Communications

When combined, the broad defined terms result in proposed rules that impose requirements on broker-dealers’ and investment advisers’ communications that go well beyond existing conflict-of-interest requirements. We are not aware of any existing requirement for broker-dealers or investment advisers to eliminate or neutralize the effect of conflicts of interest that apply to all communications (including strictly educational interactions) with an investor. With respect to broker-dealers, the conflict-of-interest requirements in Reg. BI are limited to conflicts of interest in connection with recommendations.[4]

With respect to investment advisers, the SEC has previously described how an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest that might incline the investment adviser to “render advice” that is not disinterested.[5] The proposed rules would apply even to a broad array of communications that do not constitute recommendations or investment advice, and the SEC did not appear to give much weight to the extensive requirements that are already applicable to broker-dealers’ and investment advisers’ communications under existing Financial Industry Regulatory Authority (FINRA) and SEC rules. 

Disclosure

The proposed rules would require that broker-dealers and investment advisers “eliminate” or “neutralize the effect of” conflicts of interest, but would not allow for covered conflicts of interest to be addressed through disclosure and informed consent, which goes against existing precedent and SEC guidance issued under Reg. BI and the Advisers Act.

The SEC explained that “disclosure may be ineffective in light of . . . the rate of investor interactions, the size of the datasets, the complexity of the algorithms on which the PDA-like technology is based, and the ability of the technology to learn investor preferences or behavior, which could entail providing disclosure that is lengthy, highly technical, and variable, which could cause investors difficulty in understanding the disclosure.”[6]

The SEC also raised concerns about the strong psychological impact that digital engagement practices can have on investors, suggesting that such psychological impact may be so powerful as to render investors unable to fully understand disclosures and provide informed consent. In this respect, the proposed rules take an overreaching approach that departs significantly from the disclosure and consent framework that forms the foundation of the US securities laws.

Although the SEC has previously taken the position that certain conflicts of interest cannot be addressed through disclosure,[7] these proposed rules would create a massive new category of such conflicts. Even if there is some validity to the SEC’s concerns about the complexity of disclosure that would be required for certain technologies, there does not appear to be any basis for the way in which the proposed rules eliminate the option of disclosure regardless of the materiality of the conflict, the simplicity of the disclosure that would be required, or the sophistication of the relevant investors.

Neutralizing the Effect of Conflicts

The SEC’s use of the word “neutralize” in the proposed rules is unusual, as the SEC’s guidance regarding conflicts of interest has generally been phrased in terms of eliminating or mitigating conflicts. In fact, the SEC’s 2019 release on investment adviser standards of conduct did not contain any mentions of the word “neutralize.” In that release, the SEC also referred to mitigating conflicts a number of times and defined that as “modifying practices to reduce” conflicts.[8]

When adopting Reg. BI in 2019, the SEC equated eliminating a conflict of interest with neutralizing its effect: “By eliminating a conflict, the broker-dealer would neutralize the effect of this conflict on the recommendations provided by the broker-dealer or its associated persons to retail customers.”

Similarly, in the proposing release for the PDA Rules the SEC appears to treat “eliminating” and “neutralizing the effect of” as separate concepts, but ultimately describes the same test for whether a conflict of interest has been eliminated or neutralized: “The test for whether a firm has successfully eliminated or neutralized the effect of a conflict of interest is whether the interaction no longer places the interests of the firm ahead of the interests of investors.”[9]

Thus, it appears that, in addition to not allowing broker-dealers and investment advisers to address conflicts of interest through disclosure, the proposed rules would also establish a stricter standard for how firms address conflicts of interest through other means.          

Burdensome Requirements

The policies, procedures, evaluations, and reviews required by the proposed rules could be very burdensome, particularly given the broad scope of the rules, and may stretch firms’ compliance resources and budgets if these rules are adopted in their current form.   

The proposed rules would require broker-dealers and investment advisers to evaluate any “reasonably foreseeable potential use” of a covered technology, which could be a burdensome and subjective requirement. In the proposing release, the SEC stated that such evaluations would not be necessary if “the firm has taken reasonable steps to prevent use of the technology in scenarios it has not approved (for example, by limiting the personnel who are able to access the technology).”

Although this exception could provide some comfort, it may not be feasible for firms to prevent the use of all covered technologies given how broadly that term is defined, which could encompass Microsoft Excel and other widely available tools.             

The proposed rules indicate that testing may be required as part of the evaluation process for covered technologies. Although the proposing release indicates that simpler covered technologies may not require testing, the SEC suggests that more advanced technologies may require more advanced testing such as source code reviews and implementing “explainability” features (i.e., a feature that requires the technology to explain why it reached a particular outcome, recommendation, or prediction) into the technology and reviewing the output of such explainability features.            

No Exceptions for Institutional Advisory Clients

While the proposed broker-dealer rule only applies to interactions with natural persons receiving or seeking services for personal, family, or household purposes, the proposed investment adviser rule would also apply in full to interactions with institutional investors. The lack of any exceptions for institutional investors is particularly notable in the context of the proposed rules’ approach to disclosure.

The SEC’s rationale for not permitting disclosure as a way of addressing conflicts of interest was that the necessary disclosure could be too complex or voluminous, but institutional investors should presumably be capable of reviewing and understanding more complex conflict-of-interest disclosures (as well as the relatively simple disclosures that could be drafted to address many of the simple technologies that are swept within the scope of this proposed rule).   

Costs, Liabilities, and Effects on Small and Tech-Focused Firms

The costs of the proposed rules for firms that employ covered technologies, including costs in the form of ongoing compliance, responses to SEC and FINRA sweeps, and potential liability for violations, could be significant. Notably, the proposed rules do not have any scienter requirement. Many firms that rely heavily on technology do so in order to maintain leaner staffing and provide affordable services to investors. The proposed rules would create an uneven playing field where investors’ interactions with technology are more heavily regulated than interactions with a human, and may pose challenges for smaller firms that do not have the compliance resources to design and implement the policies, procedures, and reviews required by the rules.

Policy Basis

The SEC appears to frame the PDA Rules as principles-based and flexible enough to accommodate future developments in technology, but the approach results in rules that are vague and overreaching. The SEC’s proposing release does not make a compelling policy case for adopting these rules. The proposal relies significantly on academic papers, but provides few real-world examples of investors being harmed by the types of technology that would be regulated under these rules.       

Conflicts with Other Proposals and Existing Rules

The proposal also potentially conflicts with a number of rule proposals that the SEC has yet to finalize as well as existing rules. 

For instance, the SEC’s proposals with respect to the restructuring of the US equity markets, its proposal regarding a broker-dealer’s best execution obligations, and the amendments to the definition of an exchange in Exchange Act Rule 3b-16 will likely be impacted. Under the order competition proposal, for example, certain types of retail order flow would have to be exposed to an auction system before being exposed to other execution venues.

In the PDA Rules proposal, the SEC does not address how conflicts of interest would be neutralized in situations where broker-dealers have to use sophisticated data analytics related to a customer and their order in deciding between execution venues in a matter of milliseconds where markets move against investors just as quickly. 

Moreover, broker-dealer risk departments may increasingly have to rely on predictive data analytics to limit the broker-dealers’ risk exposure with respect to customers or certain classes of customers, including limiting the ability of certain customers to trade certain types of securities.

In this instance, and at its broadest reading, a broker-dealer limiting a customer’s ability to trade “meme” stocks, for example, in order to limit its risk (and capital) exposure could be a conflict of interest that a broker-dealer would not be able to disclose away. While the proposed rules seemingly have a carve-out for regulatory purposes, the only example provided by the SEC of such a use involves anti-money laundering compliance.   

The proposed rules may also supplant practices that firms have designed and implemented to comply with existing requirements under the Advisers Act and Reg. BI. For example, the question of whether a technology that offers advice on proprietary products would trigger the rule even if its permissible under existing requirements under the Advisers Act and Reg. BI is raised here.

Given the resources that firms have invested in designing, implementing, and testing systems to comply with Reg. BI, the addition of duplicative requirements under the PDA Rules would be particularly disruptive and costly. Further, advisers using interactive analysis tools in connection with the new Marketing Rule could be required to also comply with the proposed PDA Rules.