On July 26, 2023, the Securities and Exchange Commission (SEC or Commission) narrowly approved (3-2) a proposed rulemaking under the Securities Exchange Act of 1934 (Exchange Act) and the Investment Advisers Act of 1940 (Advisers Act)1 intended to address conflicts of interest related to the use of "predictive data analytics" by broker-dealers and investment advisers (Proposal).2

The Proposal arises, in part, from concerns expressed by some SEC officials regarding digital engagement practices, the "gamification" of retail stock trading and the events surrounding early 2021's volatile trading in GameStop stock.3 Notwithstanding the discrete nature of these concerns, the Proposal is very broad and would capture many communications and interactions that are not the product of "predictive data analytics." It would extend broadly to well-established and mundane forms of technology, such as spreadsheets, research and financial models, and data libraries, that provide input or background into commonplace investor interactions, like email communications from a registered representative to a customer or an investment adviser's exercise of discretion over a client's account.

The Proposal is notable not only for its breadth but also because it would redefine how broker-dealers and investment advisers must deal with conflicts of interest. For example, broker-dealers and advisers could no longer "disclose and mitigate" many conflicts of interest relating to their use of technology (as permitted by the SEC's Regulation Best Interest and long-standing fiduciary standards of conduct). Instead, they would be required to follow a new standard requiring them to "eliminate or neutralize the effect of" these conflicts. If adopted, the Proposal could overlap and conflict with existing rules and standards applicable to broker-dealers and investment advisers, including Regulation Best Interest and interpretations of an adviser's fiduciary duties.

The comment period for the Proposal ends on October 10, 2023.

  1. Which Interactions and Communications Are Covered by the Proposal?

The Proposal has the potential to encompass a wide variety of technologies and interactions with a retail customer (for a broker-dealer) and an advisory client or fund investor (for an investment adviser). It would apply to any covered technology that is used or reasonably foreseen to be used in an investor interaction. Moreover, in contrast to other SEC regulations that impose a duty of care only when there is a "recommendation" (such as Regulation Best Interest), the Proposal would apply to any investor interaction involving a covered technology. Specifically, broker-dealers and investment advisers would be required to:

  • Eliminate or neutralize the effect of "conflicts of interest" associated with the firm's use "or reasonably foreseeable use" of "covered technologies" in "investor interactions" that place the firm's or its associated persons'4 interests ahead of investors' interests;
  • Establish and implement 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
  • Create and keep additional books and records relating to the proposed rules, including written documentation of all covered technologies used in investor interactions, descriptions of all material features and material modifications, and the evaluation and annual testing of each covered technology.

While in a vacuum these requirements may not seem excessively onerous, the triggering definitions have the potential to capture almost every communication and other interaction with a retail customer, an advisory client or a fund investor.

Footnotes

1 It is notable that the Proposal was promulgated under Section 211 of the Advisers Act, and not Section 206, even though the Proposal would operate as an antifraud rule.

2 Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, 88 Fed. Reg. 53960 (Aug. 9, 2023) (Proposing Release). The SEC also refers to "predictive data analytics" as "PDAs."

3 See, e.g., Chair Gary Gensler, Statement on Conflicts of Interest Related to Uses of Predictive Data Analytics (July 26, 2023), https://www.sec.gov/news/statement/gensler-statement-predictive-data-analytics-072623; SEC Staff, Staff Report on Equity and Options Market Structure Conditions in Early 2021 (Oct. 14, 2021), https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf; Rick Fleming, Investor Protection in the Age of Gamification: Game Over for Regulation Best Interest? (Oct. 13, 2021), 072623; SEC Staff, Staff Report on Equity and Options Market Structure Conditions in Early 2021 (Oct. 14, 2021), https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf; Rick Fleming, Investor Protection in the Age of Gamification: Game Over for Regulation Best Interest? (Oct. 13, 2021), https://www.sec.gov/news/speech/fleming-sec-speaks-101321; Request for Information and Comments on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology to Develop and Provide Investment Advice, 86 Fed. Reg. 49067 (Sept. 1, 2021)

4 For purposes of the Proposal, "associated person" refers only to natural persons.

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