Regulators rage against the artificially intelligent machines

November 2023 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

November 2023 Issue

Like the broader economy, the financial services (FS) industry continues to experience unprecedented change fuelled by technological innovation. Testifying before Congress on 12 September 2023, Gary Gensler, chair of the US Securities and Exchange Commission (SEC), explained that: “We live in an historic, transformational age regarding predictive data analytics and the use of artificial intelligence…this also raises the possibilities that conflicts may arise to the extent…advisers or broker-dealers are optimizing to place their interests ahead of their investors’ interests.”

Technological innovation is not new in FS, nor are efforts by policymakers to address concerns related to the adoption of technology in finance. As regulators rush to propose rules aimed at predictive data analytics and artificial intelligence (AI), one must consider a few questions. While regulators across the world often tout that they are technology neutral, it is worth considering whether proposed rules address risk or the tool itself.

Is there a need for new regulations? Are the rules proposed the most efficient way to achieve the goal?

Proposed rules

On 26 July 2023, the SEC proposed new rules under the Investment Advisers Act of 1940 and the Securities Exchange Act of 1934 to address conflicts of interest associated with the use of predictive data analytics and artificial intelligence by registered investment advisers and broker-dealers.

In proposing the new rules, the SEC stated its concern that the use of covered technologies in investor interaction places the interests of the financial firm ahead of the investor, which the SEC finds to be a conflict of interest that must be eliminated or neutralised. A “covered technology” is defined as technology that could effect investor behaviour – technological methods or processes, including algorithms and models, that “optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes”.

A covered technology must be used in an “investor interaction”. The proposed rules define investor interaction as “engaging or communicating with an investor, including by exercising discretion with respect to an investor’s account; providing information to an investor; or soliciting an investor”. An interaction is broader than the concept of “recommendation” that is often defined as a “call to action” and serves as an important trigger under regulation best interest and the suitability rule. In issuing the proposed rules, the SEC acknowledged that interactions may not be deemed “recommendations” yet qualify as “investor interactions”.

Note, also, that the SEC has introduced a broad new term “investor” – regulations already use “client” in the Advisers Act and “customer” in the Exchange Act. The term “investor” includes clients (prospective or current) that receive investment advisory services from an investment adviser and investors (prospective and current) in a pooled investment vehicle advised by an investment adviser. For broker-dealers, the proposed rules define “investor” as natural persons or their legal representatives seeking or receiving services primarily for personal, family or household purposes from the broker-dealer.

The SEC also revisits what constitutes a “conflict of interest” – under the proposed rules, a conflict of interest exists if a firm “uses a covered technology that takes into consideration an interest” of the firm or its associated persons. This is remarkably broader than fiduciary concepts. As explained by the SEC, when covered technology takes into account the firm’s profits or revenues, a conflict of interest would arise under the proposed rules regardless of whether the technology places the firm’s interests ahead of investors’ interests.

Under the proposed rules, a firm must evaluate any use – or reasonably foreseeable potential use – by the firm of its associated person of a covered technology in any investor interaction to: (i) identify any conflict of interest associated with that use or potential use; (ii) determine whether any such conflict of interest places or results in placing the firm’s or its associated person’s interest ahead of the interest of investors; and (iii) eliminate or neutralise the effect of such conflicts of interest.

There is an inherent requirement that the firm test each covered technology used in investor interactions prior to the implementation of, or material modification to, the technology and to continue to test the technology periodically to determine whether the use of the technology is associated with a conflict of interest.

FCA focuses on AI

The UK’s Financial Conduct Authority (FCA) has published its latest board minutes highlighting its increasing focus on AI, indicating its continued interest in regulating the use of AI in FS. The FCA raised the question of how one could “foresee harm” (under the new Consumer Duty), and also give customers appropriate disclosure, in the context of the operation of AI.

Similarly, in a speech delivered on 12 July 2023, Nikhil Rathi, chief executive of the FCA, addressed the emergence of AI and the role of technology in FS – noting that the FCA is expected to apply greater scrutiny on this activity: “The Consumer Duty, coming into force this month, stipulates that firms must design products and services that aim to secure good consumer outcomes.”

Regulating the use of AI

The FCA announced a commitment to continue an “outcomes and principles-based approach to the regulation” in addressing AI. The proposed rules advanced by the SEC, however, mark a departure from the FCA, and from longstanding US approach in the regulatory landscape for investment advisers and broker-dealers that keep pace with technology.

Hester Peirce, a commissioner at the SEC, noted that the SEC’s proposed approach rejects one of the pillars of US regulation – disclosure – seeking instead to require that financial firms identify broadly defined conflicts and eliminate or neutralise conflicts. Noting the rarity of the approach by the SEC, Ms Peirce stated that the SEC rejects disclosure as being difficult for investors to understand or contextualise.

In this sense, some note that, rather than technology neutral, the rules proposed by the SEC offer a break for “a firm that only uses simpler covered technologies in investor interactions, such as basic financial models contained in spreadsheets or simple investment algorithms”.

Marlon Q. Paz is a partner at Latham & Watkins LLP. He can be contacted on +1 (202) 654 7101 or by email: marlon.paz@lw.com.

Marlon Q. Paz

Latham & Watkins LLP