SEC Proposes Sweeping New Rules on Use of Data Analytics by Broker-Dealers and Investment Advisers
On July 26, 2023, the U.S. Securities and Exchange Commission (SEC or Commission) proposed new rules for broker-dealers (Proposed Rule 15(1)-2) and investment advisers (Proposed Rule 211(h)(2)-4) on the use of predictive data analytics (PDA) and PDA-like technologies in any interactions with investors.1 However, as discussed below, the scope of a “covered technology” subject to the rules is much broader than what most observers would consider to constitute predictive data analytics. The proposal would require that anytime a broker-dealer or investment adviser uses a “covered technology” in connection with engaging or communicating with an investor (including exercising investment discretion on behalf of an investor), the broker-dealer or investment adviser must evaluate that technology for conflicts of interest and eliminate or neutralize those conflicts of interest. The proposed rules would apply even if the interaction with the investor does not rise to the level of a “recommendation.”
“Covered technology” is defined extraordinarily broadly to include 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 Proposing Release makes clear that “PDA-like” technology is intended to include all technologies such as algorithmic trading, artificial intelligence, machine learning, natural language processing, chatbots, and digital engagement processes if they are used in communicating with investors or managing investments.2
The Proposing Release defines “conflict of interest” as using any “covered technology” in any way “that takes into consideration an interest of” the broker-dealer, the investment adviser, or its associated person. This definition is extremely broad and does not include the element of being contrary to the interest of customers that the SEC has previously required for something to be considered a conflict. If the firm identifies such a conflict of interest, it must “eliminate or neutralize” it. The Proposing Release also includes extensive requirements to develop policies and procedures and maintain records about how broker-dealers and investment advisers document their processes for evaluating covered technologies, identifying conflicts of interest, eliminating or neutralizing those conflicts of interest, and designing and conducting an annual review of the effectiveness of these policies.
The broker-dealer version of the rule applies to “natural person” investors, consistent with Regulation Best Interest (Reg BI). But the investment adviser version of the rule applies to any current or prospective client of an investment adviser or current or prospective investor in a pooled investment vehicle, without any limitation on the nature of the investor.3
Our Take
The new rules would impose significant operational challenges and expensive burdens on broker-dealers and investment advisers that use virtually any technology to any degree without citing compelling authority or significant evidence of abuse or malfeasance involving that technology. The scope of the new rules also presents challenges. As Commissioner Hester Peirce observed, the proposed definition of covered technology could include technologies long used by broker-dealers and investment advisers such as “spreadsheets, commonly used software, math formulas, [and] statistical tools.”4 It is unclear why these new rules are necessary or appropriate in light of the Commission’s recent broad-based regulatory initiatives focused on best interest and fiduciary duty.
The Commission cites as authority for the proposed rules little-used and untested provisions adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 15(l)(2) of the Securities Exchange Act of 1934 (Exchange Act), and Section 211(h)(2) of the Investment Advisers Act of 1940. These sections authorize the SEC “to promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.”
The Commission’s approach to PDAs is strikingly unlike its approach in Reg BI for broker-dealers5 or the SEC’s Fiduciary Duty Interpretation for investment advisers,6 where it was enough for a firm to disclose fully and fairly its conflicts of interest to investors. Under the proposed rules, if a firm uses PDAs or PDA-like technologies, it must “eliminate or neutralize” its conflicts of interest. As an example, Reg BI allows a broker-dealer to have a limited product set — for example, certain broker-dealers distribute only mutual funds or private funds advised by an affiliate. Similarly, some investment advisers offer only investments in the funds they manage. These practices are permissible under Reg BI and the Fiduciary Duty Interpretation with full disclosure. However, under the Proposing Release, a broker-dealer or investment adviser cannot simply disclose a conflict of interest; it must “eliminate or neutralize” that conflict.
So as proposed, presumably a broker-dealer or investment adviser could not use any technological tool of any sort to communicate with investors about a limited product set of investments. Nor could an investment adviser use technological tools of any sort to manage investor portfolios if it included affiliated investment products in those portfolios but excluded some other products or if those investor portfolios generated “soft dollars” that were used by the investment adviser in a manner permitted by Exchange Act Section 28(e). The reason disclosure has been the primary tool by which to address possible conflicts of interest is that approach allows activities that may be of significantly benefit investors despite a firm’s conflicts. For example, a broker-dealer’s research report may recommend the purchase of an issuer’s securities despite the fact that a “conflict” exists because the company is a client of the firm. What matters is that investors are made aware of the firm’s relationship to the issuer. They can then weigh the substantive merits of the recommendation. By contrast, the “eliminate or neutralize” requirement effectively will prevent broker-dealers and investment advisers from communicating with investors using business models that are expressly permitted by Reg BI and the Fiduciary Duty Interpretation.
The Proposing Release also is a startling departure from Reg BI and the Fiduciary Duty Interpretation in that it covers every communication to an investor, whether or not that communication constitutes a recommendation. Reg BI and the Fiduciary Duty Interpretation require broker-dealers and investment advisers to make individualized recommendations in the best interests of customers. The Proposing Release applies to all communications, whether or not they are individualized recommendations to specific investors. The Proposing Release specifically cites “digital engagement practices” such as a curated list of, say, most active or largest moving stocks, as triggering the rule.7 For any broker-dealer that earns revenue through commissions or payment for order flow, under the Commission’s apparent view, such digital engagement practices create a conflict of interest because they encourage a customer to trade and thus generate revenue for the firm. If, as the Proposing Release indicates, a broker-dealer is required to “eliminate or neutralize” every conflict of interest, the apparent result would be to bar all digital engagement practices. Among other concerns, such a proposal raises freedom of speech issues that the Proposing Release does not address. Notably, the Proposing Release also would apply to all marketing communications that use technology for targeting potential investors, again a vast expansion beyond the application of Reg BI or the Fiduciary Duty Interpretation.
Strikingly absent from the Proposing Release is any evidence of any actual abuse by broker-dealers or investment advisers involving PDAs or PDA-like technologies subject to regulation under the proposed rules. In 2021, the Commission issued a request for comment on digital engagement practices as a precursor to this Proposing Release, but the majority of comments indicated that industry use of these practices was limited and did not create abuses.8 The Proposing Release cites multiple articles and studies, as well as some generalized concerns expressed by individual investors about the fairness of the U.S. securities markets, speculating without support about the potential abuse of PDA technologies in the securities industry.9 The Proposing Release cites only a single settled enforcement action in which the Commission alleged that an investment adviser had an inadequately disclosed conflict of interest in setting investment allocations but did not allege any use of PDA technology in connection with those allocations or any failure of its existing regulations to address that conduct. It may be difficult for the Commission to justify the significant expenses the proposed rules would impose without a better record of actual harm.
The Proposing Release indicates that the rules are “intended to be technology neutral.”10 However, as the dissenting Commissioners point out, the new rules would impose a substantial burden on the use of any technology in communicating with investors or managing investments. The definition of “covered technology” is so broad that as discussed above, Commissioner Peirce observed that even a spreadsheet could be deemed a “covered technology.”11 It will be especially challenging — particularly for smaller broker-dealers and investment advisers — to identify, evaluate, and eliminate or neutralize conflicts for every technology they use in communications or investment management and to document and update this evaluation every year.
Broker-dealers and investment advisers should review the Proposing Release, inventory all of the “covered technologies” in use across their businesses that could be subject to the proposed rules, and consider providing comments to the Commission. The Proposing Release indicates that the comment period will close 60 days after publication in the Federal Register, so comments will be due by October 10, 2023.
1 Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, Exch. Act Rel. No. 97,990 (July 26, 2023) (https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf) (the Proposing Release).
2 The Proposing Release cites as examples of digital engagement processes subject to the proposed rules: “social networking tools; games, streaks and other contests with prizes; points, badges, and leaderboards; notifications; celebrations for trading; visual cues; ideas presented at order placement and other curated lists or features; subscriptions and membership tiers; and chatbots.” Proposing Release at note 29.
3 The Proposing Release does not explain why it uses different definitions of the term “investor” for broker-dealers and investment advisers or why it includes institutional investors in the definition for investment advisers.
4Statement of SEC Commissioner Hester M. Peirce, Through the Looking Glass: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Proposal, available at https://www.sec.gov/news/statement/peirce-statement-predictive-data-analytics-072623.
5 Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exch. Act Rel. No. 86031 (June 5, 2019) (https://www.sec.gov/files/rules/final/2019/34-86031.pdf).
6 Commission Interpretation of the Standard of Conduct for Investment Advisers, Inv. Adv. Rel. No. 5248 (June 5, 2019) (https://www.sec.gov/files/rules/interp/2019/ia-5248.pdf).
7 Chairman Gary Gensler cited customizing screen-color preferences for an investor as an example of a digital engagement practice subject to the proposed rule. Statement of SEC Chairman Gary M. Gensler, Statement on Conflicts of Interest Related to Uses of Predictive Data Analytics, available at https://www.sec.gov/news/statement/gensler-statement-predictive-data-analytics-072623.
8 Request for Information and Comments on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology to Develop and Provide Investment Advice, Exch. Act Rel. No. 92,766 (Aug. 27, 2021) (https://www.sec.gov/files/rules/other/2021/34-92766.pdf).
9 See Proposing Release at pages 13-22.
10 Proposing Release at page 40.
11 Statement of SEC Commissioner Hester M. Peirce, Through the Looking Glass: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Proposal, available at https://www.sec.gov/news/statement/peirce-statement-predictive-data-analytics-072623.
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