Investors Versus Machines: The SEC Cracks Down on AI, Robo-Advisors and Potential Conflicts of Interest

We are probably still years away from Wall Street being overrun by actual robots. Nonetheless, artificial intelligence (AI) tools are divisively integrating into all aspects of society—from the classroom to the courtroom. Many broker-dealers have also implemented AI-assisted analytics and technology. Indeed, over the last several years, many firms have made investing more easily accessible and user-friendly through “robo-advisors.” No one is questioning the “pros” of AI. But many are still concerned about the risks. The SEC is no different, nor are they any less divided. Here, the SEC has honed in on conflicts of interest that may arise through the use of AI.

On July 26, the Securities and Exchange Commission (SEC) proposed a regulation under the Securities Exchange Act of 1934 and Investment Advisors Act of 1940 to combat what it sees as conflicts of interest arising from using predictive data analytics by broker-dealers and investment advisors. In strong language, the proposed rule seeks to “to eliminate, or neutralize the effect of, certain conflicts of interest associated with broker-dealers’ or investment advisers’ interactions with investors through these firms’ use of technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” The proposed regulation would require broker-dealers and investment advisors to take steps to address potential conflicts of interest from predictive analysis and similar technologies that interact with investors to prevent firms from placing their own interests ahead of the investors’ interests.

Specifically, the proposal would require:

  • A firm to eliminate or neutralize the effect of conflicts of interest associated with the firm’s use of covered technologies in investor interactions that place the firm’s or its associated person’s interest ahead of investors’ interests;
  • A firm that has any investor interaction using covered technology to have written policies and procedures reasonably designed to prevent violations of (in the case of investment advisers) or achieve compliance with (in the case of broker-dealers) the proposed rules; and
  • Recordkeeping related to the proposed conflicts rules.

One area of concern is the recent proliferation of robo-advisors and mobile apps that use them. For example, SEC Chair Gary Gensler specifically expressed concern about the conflict of interest that arises between investors and robo-advisor brokerage apps, stating “Artificial intelligence has complexity. But you have a basic, high-level strategic question: Are you optimizing just for investors, or are you optimizing also for the robo-advisor brokerage app? That’s a straight-up conflict.”

The five-commissioners were split along party lines 3 to 2. Democratic Commissioner Caroline A. Crenshaw, while recognizing the benefits for both firms and investors, expressed concern that such technologies can raise potential conflicts of interest. “For example, if a firm’s artificial intelligence makes decisions favoring the firm’s interests over investor interests, it could rapidly deploy that conflicted information to investors via means such as push notifications.”

Republican Commissioner Mark T. Uyeda also issued a statement. He recognized the broad benefits of AI on the industry, explaining “[AI] and other analytic tools can process and analyze vast quantities of information efficiently, which can enhance data driven investment decisions and reduce the cost of investment advice.” As it relates to the proposed rule, he described it as “breathtakingly broad in its reach,” and that its “regulatory vagueness and considerable compliance challenges may cause firms to avoid innovation or efficiencies through automation.”

The public will have a 60-day window to provide comments before the commission votes on a final version of the proposed regulation.

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About the Author: Sandra D. Grannum

Sandra Dawn Grannum concentrates her practice on securities, broker/dealer arbitration, litigation, mediation and regulatory defense. She is co-chair of the Commercial Litigation Team.

Sandy has tried complex multimillion-dollar arbitrations before FINRA, AAA and JAMS across the country. She has represented brokerage firms, banks, clearing firms, and associated persons in over 60 arbitrations before the NASD and FINRA which have been tried through award. In addition, she has successfully pursued cases in state and federal courts and in adversarial proceedings before bankruptcy courts.

About the Author: Jamie L. Helman

Jamie L. Helman concentrates her practice on securities, broker-dealer arbitration, litigation, mediation, employment matters, and regulatory defense. She has experience first-chairing FINRA arbitrations, defended on-the-record testimony of broker-dealer employees before FINRA, and is presently involved in the representation of broker-dealers in several pending FINRA cases as well as regulatory matters.

About the Author: Justin M. Ginter

Justin Ginter is a litigator and advocate for a wide range of individual and corporate clients spanning multiple industries, including financial services and securities, business solutions, products and manufacturing, telecommunications, and real estate. Justin is known for his sensitivity and understanding of client needs and his dedication to achieving excellent results.

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