Regulatory Risk Alert: The SEC Proposed Conflicts of Interest Rule

Key elements with the SEC’s proposed conflicts rule

Proposed conflicts rules and their objective

The SEC's proposed conflicts rules are set to be introduced under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940. Their primary objective is to eliminate or neutralize the effects of conflicts of interest that may arise when broker-dealers and investment advisers interact with investors using technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.

Not just disclosure, but elimination of conflict

The SEC stated that merely disclosing conflicts of interest may not be sufficient to protect investors adequately. Instead, it aims to enforce strict rules that would require firms to take tangible actions to identify and address conflicts associated with the use of certain technologies, ensuring that the interests of investors are always prioritized.

Proposed scope and definitions

The proposed conflicts rules would be applicable only when a firm utilizes covered technology during an investor interaction. The rules' definitions are thoughtfully crafted to identify conflicts of interest that firms must evaluate to determine if they may jeopardize investors' interests. These conflicts would then need to be eliminated or their impact neutralized.

Covered technology refers to analytical, technological, or computational functions such as AI, machine learning, deep learning algorithms, neural networks, NLP, and large language models (e.g., generative pre-trained transformers). It also encompasses other technologies that utilize historical or real-time data, lookup tables, or correlation matrices, among others.

Flexibility and technology neutrality

The proposed rules are designed to be broad and principles-based, ensuring they remain applicable as technology continues to evolve. This approach provides firms with the flexibility to implement technology consistent with their business models while adhering to the overarching requirement of safeguarding investor interests.

Moreover, the SEC emphasizes that it is not dictating which technologies firms should or should not use. Instead, the focus is on enabling firms to choose and employ the tools they believe best address the risks specific to the technology they utilize.

Key aspects of the proposed conflicts rules

The proposed conflicts rules aim to establish a technology-neutral approach, steering away from endorsing or restricting specific technologies for firms. Instead, the proposal is built upon existing legal standards, addressing risks to investors arising from firms' use of technology in their interactions. The rules permit firms to employ tools they deem suitable to mitigate such risks, tailored to the specific technology they utilize. The SEC's commitment to investor protection is evident, as it continually assesses and revises protections in response to evolving practices, including the use of advanced technologies. With a focus on predictive data analytic technologies, the proposal emphasizes the elimination or neutralization of conflicts of interest to safeguard investors from any adverse effects on their interests.

The following are the key elements required under the proposed conflicts rules and policies and procedure requirements for covered technologies.

Evaluation and identification

The proposed conflicts rules place significant emphasis on evaluating and identifying conflicts of interest associated with the use of covered technology in investor interactions. Firms are required to conduct a thorough assessment of their current and foreseeable use of these technologies to pinpoint potential conflicts. To achieve this, the SEC allows firms the flexibility to adopt suitable evaluation approaches based on their specific technology use. Whether it involves AI, machine learning, or other complex algorithms, firms must diligently review the technology's documentation and implement robust testing methodologies to ensure that conflicts are accurately identified.

Testing

Transparency and investor protection are further reinforced through rigorous testing requirements. Before implementing covered technologies and during any significant modifications, firms must conduct comprehensive testing to assess whether these technologies give rise to conflicts of interest. The SEC does not prescribe a specific frequency or method for retesting, allowing firms to determine what is appropriate based on the nature and complexity of their employed technology.

Conflicts of interest

The proposed rules define "conflict of interest" in broad terms, encompassing any situation where covered technology considers firm-favorable information in investor interactions. For instance, conflicts may arise when technology — such as AI — considers firm profits or incentivizes increased trading activity to boost firm revenue. It is crucial for firms to carefully evaluate these conflicts and determine whether they prioritize their interests or those of investors.

Determination

Determining whether a conflict places the firm's interests ahead of investors' interests requires a thorough facts-and-circumstances analysis. Firms must consider various factors, including the technology used, its anticipated impact, and the interests of investors. The SEC emphasizes that firms should reasonably believe that their technology use does not prioritize their interests or take the necessary steps to eliminate or neutralize the conflict.

Elimination or neutralization effect

Prompt action is required if a firm determines that a conflict of interest places its interests ahead of investors'. The firm must eliminate or neutralize the effect of the conflict, ensuring that the interaction no longer prioritizes the firm's interests. In a neutralization scenario, the firm may continue using data or algorithms that include firm interests as factors, provided measures are in place to prevent bias towards the firm's interests. This way, the SEC ensures that investor interests remain protected, and the playing field remains fair.

Policies and procedures elements for covered technology use

The proposed conflicts rules encompass a comprehensive set of requirements, including the establishment of written policies and procedures by firms engaging in investor interactions using covered technology. These policies and procedures should be designed to ensure compliance with the rules and may include the following key elements:

• A clear, written description of the process for evaluating any use or potential use of covered technology in investor interactions. This ensures that conflicts of interest associated with the technology's use are thoroughly assessed.
• Detailed disclosure of any material features of the covered technology employed in investor interactions and a comprehensive account of any conflicts of interest linked to its use. This transparency allows investors to have a clear understanding of how technology may impact their interactions.
• A well-defined process for determining whether conflicts of interest identified under the proposed rules result in investor interactions that prioritize the firm's or associated person's interests over those of investors. This step aids in identifying and addressing potential biases.
• A clear plan for eliminating or neutralizing the effects of conflicts of interest that may arise, ensuring that investor interests are consistently protected throughout the interaction process.
• An annual review and documented evaluation of the adequacy and effectiveness of the established policies and procedures, as well as a review of the written descriptions set forth under the proposed conflicts rules. This ongoing assessment enables firms to continuously enhance their practices.

Moreover, firms are encouraged to consider additional elements, such as compliance review and monitoring systems, designated personnel for supervision of functions and individuals, processes for addressing instances of noncompliance, and comprehensive training for relevant personnel on both policies and procedures and the various forms of covered technology used by the firm. By adhering to these guidelines, the SEC believes firms can help build a robust framework that fosters transparency, accountability, and investor protection in their use of advanced technologies.

Amidst the rapid technological advancements reshaping the financial industry, the SEC's proposed conflicts rules hold immense significance as they aim to strike a delicate balance between innovation and investor protection. While the rules mandate the identification and elimination of conflicts of interest related to technology use, concerns have been raised regarding potential compliance challenges and vagueness, which might deter firms from embracing technological efficiencies.

The power of disclosure is highlighted to empower informed investors, allowing them to make independent decisions, which will be eliminated with respect to covered technologies. There are concerns that certain aspects of the rules may not be entirely technology-neutral and could subject specific technologies to burdensome review processes. We will have to wait to see what comments the industry submits, but we can anticipate some conflicts. As the financial landscape evolves, these discussions will continue to shape the framework that governs the integration of technology aimed to help ensure the best interests of investors are safeguarded.

One final note:

The proposed definition would exclude from the investor interaction definition interactions solely for purposes of meeting legal or regulatory obligations. These interactions are subject to existing regulatory oversight and/or do not involve the type of conflicts the proposed rules seek to address. This exclusion would apply to interactions with an investor for purposes of obligations under any statute or regulation under Federal or State law, including rules promulgated by regulatory agencies.

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Tiffany Magri

Senior Regulatory Advisor at Smarsh

As a Regulatory Advisor at Smarsh, Tiffany Magri monitors, evaluates and consults on the financial services regulatory landscape. Tiffany has more than 10 years of experience facilitating compliance with laws and regulations, policies, and risk management. Prior to joining Smarsh, Tiffany was a Senior Associate at Benefit Street Partners and a Compliance Analyst at Broadstone and Manning & Napier Advisors.

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