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SEC Proposes Two New Rules Impacting Broker Dealers and Investment Advisors

Last week, the SEC proposed two new rules. The proposed rules were surrounding 1) conflicts of interest relating to the use of predictive data analytics; and 2) reforms relating to Investment Advisors operating exclusively through the internet. Both proposed rules are related to the increased adoption and advances in technology by broker-dealers and investment advisors.

July 26th – SEC Proposes New Requirements to Address Risks to Investors From Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers

The first proposed rule will require firms 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.”

Covered technology was defined in the SEC fact sheet as “a firm’s use of analytical, technological, or computational functions, 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.”

The fact sheet further details the requirements of the proposed rule to include written policies and procedures reasonably designed to prevent violations of or achieve compliance with the proposed rule. This includes a “written description of the process for evaluating any use (or reasonably foreseeable potential use) of a covered technology in any investor interaction and a written description of the process for determining how to eliminate or neutralize the effect of any conflicts of interest determined pursuant to the proposed rule to result in an investor interaction that places the interest of the firm or an associated person ahead of the interest of investors.” In addition, the rule requires that firms establish and maintain a recordkeeping process.

Some concern has been brought up regarding the broad description of covered technology and, specifically, for investment advisors the requirement to neutralize the effect of conflicts of interest instead of disclosing the conflict of interest.

As you can see above, the description of covered technology seems to be as broad as possible to cover future advances in technology. The concern is that it encompasses older technology that may have been used in the past and may not fall under the same concerns that predictive analysis and AI create.

As this is a unique situation for Investment Advisors, requiring the removal of a conflict of interest versus a disclosure, the general approach of the SEC seems to be that disclosure would not be in the best interest of the retail investor due to the speed of changing technology and the complicated nature of possible technological uses. Much of the rule is geared towards predictive analytics and artificial intelligence which have been evolving at a rapid pace. Quite possibly, the new proposed rule will restrict or discourage the use of new technology as defined by the broad scope of “covered technology”.

The SEC has specifically requested comments be submitted that provide detailed recommended changes to the rule. The comment period for the proposal will remain open for 60 days following its entry in the Federal Register.

July 26th – SEC Proposes Reforms Relating to Investment Advisers Operating Exclusively Through the Internet

The proposed reforms to rule 203A-2(e) (Internet Adviser Registration Rule) will allow certain investment advisers that provide investment advisory services through the internet to register with the Commission. The amendments would require investment advisors relying on rule 203A-2(e) to “have at all times an operational interactive website through which the adviser provides digital investment advisory services on an ongoing basis to more than one client.” In addition, the amendment will eliminate the de minimis exception, to have fewer than 15 non-internet clients in a 12-month period, by requiring that the firm provide advice to all its clients exclusively through an operational interactive website. The final new requirement is to make certain corresponding changes to the Form ADV.

“In 2002, the SEC granted what was intended to be a narrow exception allowing internet-based advisers to register with the Commission instead of with the states,” said SEC Chair Gary Gensler. “A lot has changed in the 21 years since, and I believe an exemption written in 2002 allows gaps in 2023. Thus, today’s proposal would modernize the internet advisers exemption to better align registration requirements with modern technology and help the Commission in the efficient and effective oversight of registered investment advisers.”

As you can see, the drive surrounding the amendment is to modernize rule 203A-2(e) due to continued technological advances since 2002. Additionally, the amendments should make it easier and more efficient for the SEC to conduct exams and oversight of firms. This allows the SEC to focus on firms with a larger presence and provides smaller firms oversight by the states. Lastly, it was noted that there have been compliance deficiencies identified in addition to a significant increase in the amount of firm’s relying upon the exemption.

The comment period for this proposal will remain open for 60 days after publication within the Federal Register.