Concerns percolate about how SEC’s AI proposal aligns with Reg BI

An SEC proposal to eliminate conflicts of interest in financial advisors' use of technology that predicts investor behavior is raising concerns about how it will work with Regulation Best Interest.

A split Securities and Exchange Commission voted 3-2 Wednesday to release a proposal for public comment that would require brokerages and investment advisory firms to “eliminate or neutralize” conflicts related to conducting investor interactions through artificial intelligence, predictive data analytics and similar technology.

The proposal is designed to address situations where the technology places the firm’s or an advisor’s interests ahead of the interests of investors by optimizing client or customer behavior to purchase certain investments, deploy strategies or make other decisions.

The SEC implemented Regulation Best Interest in 2020 to raise the broker advice standard above the previous suitability standard. Under Reg BI, brokers are prohibited from putting their revenue interests ahead of their customers’ interests for high returns. Investment advisors also must act in their clients’ best interests.

But Reg BI says brokers must identify, eliminate or mitigate conflicts. The AI proposal calls for eliminating or neutralizing them. The difference means brokers may have to rethink how they identify and manage their conflicts, said Ben Marzouk, a partner at Eversheds Sutherland.

“Firms have spent years and millions of dollars complying with Reg BI,” Marzouk said. “Now there's an additive requirement that is broader than Reg BI that covers all investor interactions. It's not clear how this new requirement will interact with Reg BI.”

The techniques brokerages can use under Reg BI to address conflicts may not be available under the AI proposal.

“You can’t use the typical tools to mitigate, such as consent and full and fair disclosure, because [the SEC] doesn’t believe the general populace has the ability to understand the complexity of the technology,” said Rich Kerr, a partner at K&L Gates. “This is going to be an additive regime that’s going to get layered on” to Reg BI.

Investment advisors may also have new obligations beyond the current fiduciary duty that governors their interactions with investors when it comes to the use of AI and other technologies.

“For advisors, this is layering on something that may not align with the SEC’s 2019 fiduciary duty interpretation, where proper disclosure generally cures all conflicts,” Marzouk said.  

Financial advisors’ digital engagement practices became an issue when Robinhood and other online brokerages used so-called gamification techniques, such as the bursting of confetti when a trade was placed, to influence online behavior. The SEC and lawmakers zeroed in on gamification in the aftermath of the GameStop trading frenzy in early 2021.

SEC Chair Gary Gensler acknowledged that advisors and brokers have an obligation to act in their customers’ and clients’ best interest when making recommendations. But another rule is required when it comes to AI and other sophisticated technology that can guide client decisions.

"I believe that investors deserve to be protected from predictive data analytics-driven interactions … that result from conflicts of interests, even in instances when those interactions may not amount to providing advice or recommendations,” Gensler said at Wednesday’s open meeting. “Left unaddressed, I believe that investors exposed to conflicted investor interactions in such instances may lack the time-tested investor protections our laws and regulations provide.”

The SEC’s Republican commissioners — Hester Peirce and Mark Uyeda — countered that Reg BI and other existing regulations can be applied to AI and other technologies and that a new rule isn’t needed.

Peirce and Uyeda also expressed concern about the scope of technology covered by the rule. It includes “algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor,” according to an SEC fact sheet.

That litany could encompass a lot of the technology advisors use.

“The industry is going to be looking for clarity around that,” Kerr said. “Sophisticated advisors and brokers are using technology now that we wouldn’t think of as AI that could be captured by [the proposal’s] definition of AI.”

The American Securities Association has encouraged the SEC to apply the same protections around the use of AI in making investment recommendations that surround advisors’ and brokers’ recommendations.

“We’re hopeful this proposal does that,” ASA CEO Christopher Iacovella said. “But as is customary in the [rulemaking] process, regulators tend to overreach.”